A Deeper Look at Due Diligence

In your answer about conducting due diligence on potential investments, you wrote, “The way to get the most bang for your buck is where you have an insight into the CEO and leadership team.” Can you unpack that statement? What do you mean?

Business history is filled with management teams that are not quite incentivized to make decisions that serve the long-term interests of their companies.

Perhaps modern corporate culture has led to the emergence of a sort of “renter CEO,” rather than “owner CEO,” who don’t have the same investment in the long-term future of their business. If they don’t see themselves with the company more than five years, they may be overly focused on the short term. Their incentives package could be poorly calibrated. They could be a victim themselves of poor organizational culture. Regardless, in these cases, their decisions fall out of alignment with the company’s best interests.

I want to avoid those businesses. Instead, I am looking for CEOs and leadership teams that are actively aligned with my objective as a shareholder. Do they have the insight, ability, and willingness to make decisions that are going to serve the business well for years into the future?

If I have specific reasons to think the answer to that question is yes, then I have an insight into that company’s leadership that will give me an edge when choosing between positions.

In my article on due diligence, I used Netflix as an example. Its CEO, Reed Hastings, made clear he had an ambitious vision that meant moving beyond its original DVD rental service. He saw the writing on the wall: at some point, movies would become more cost-efficient to stream online than to mail through the postal service. That switch happened sometime around 2007, and he had prepared for it. During those early years, investors weren’t making a bet on Netflix and its DVD business; they were making a bet on Hastings, his vision, and his smart preparations for a changing market.

When you do due diligence, how do you avoid getting lost in the weeds? With so many different factors to consider, how do you keep everything in perspective, discern the consequential from the trivial, and avoid getting lost in detail?

In short: don’t clutter an analysis that can be simplified.

I addressed a similar question late last year when I talked about evaluating an individual asset against the larger economy. I noted, “It can become very cluttered as you try to weigh so many different questions and factors.”

The answer is to simplify down to the four or five most essential factors that will drive value over a long period of time. These are usually customer-focused metrics. In technology, for example, I might look at:

• Monthly active users on the site,

• Whether that number is growing

• Where that number stands relative to the total addressable market

• How much time users are spending on the site

All of that will impact how much revenue the company makes per user.

Those are the core factors that an investor needs to understand to make sure that that the company isn’t faltering. If I do see slippage in those areas, that tells me I need to dig deeper to understand why and what's happening there – or I just need to move on without getting bogged down.

Of course, as I noted in my due diligence piece, the quantitative dimension is only half the analysis, but the same principle applies with qualitative analysis too. At heart, that’s a simple analysis too. As we were discussing in the previous question, keeping your due diligence focused on the CEO and management team will take you where your analysis needs to go.