Conducting Due Diligence

What steps can I take to figure out if an asset is a good buy or not? What pieces of information do I need to look at, where do I find that information, and how do I use it?

For my own part, I follow a multi-step process that works like a funnel. At the top of the funnel, I do a lot “information scanning” to identify companies that might be of interest to me. From there, I go through a qualification process that starts with quantitative metrics and then moves into qualitative assessments. By that point, I’ll have a small number of high-interest companies in my sights, but it might not yet be the right time to buy. I have to wait for the right circumstances for that. But before we get there, let’s start at the beginning.

Scanning:

I consider time to be my most valuable resource, so I carefully curate my inbox – everything I read and subscribe to, watch, listen – to offer high-value information. It’s not necessarily all directly investment-related, of course. But all of it is interesting, thought-provoking, and informative. This carefully curated inbox functions as my top-level filter for prequalifying companies. If a company doesn’t make it into my inbox, through one channel or another, it’s unlikely to be interesting to me. Nevertheless, a lot of companies come across my inbox, so this top-of-the-funnel stage has me looking at a lot of potential opportunities.

One of my favorite sources is my subscription to Value Line, mostly for their weekly list of 15-20 companies within each major industry. This is a great resource because it lets me scan a lot of potential companies while also providing me a ton of information that I can use to qualify them.

Qualifying:

Here’s where I start digging into each company, starting with quantitative metrics. I try to research companies comprehensively and look at their business performance from as many angles as possible: sales, sales per share, cash flow per share, operating margin, net profit margin, long-term debt, etc. Are sales growing? If yes, then what’s driving that growth? Is it organic growth, the result of merger/acquisition, or something else? Assuming I can satisfy those questions, are earnings also growing? Cash flow? What's the level of CapEx required to sustain the business? Where are we relative to normalized operating margin? What is normalized return on capital/return on equity?

Altogether, I want to make sure I’m looking at a strong company with all its underlying fundamentals where they should be. In turn, this exercise enables me to significantly pare down my options. If I start by scanning 100 companies, maybe 5 will pass the test up to this point.

From there, I do a deeper dive into the company and start making some qualitative assessments.

I’ll read SEC filings, look at the company website, listen to podcasts, read articles about company and its leadership team, talk to people in the industry, and so on. At this stage, I’m trying to form an opinion that marries my quantitative analysis to a qualitative assessment. When I invest in a company, I’m buying the future, not the past, so I want to get a sense of where management is positioning the company for the future. Is it reasonable? Is there a moat? Are they following other people down some rabbit hole?

This might slim my list of 5 companies down even further. It also starts my process of making a judgment about valuation.

Valuation:

In general, I think qualitative insights tend to be mispriced more than quantitative, so I try to be careful here. Too many people can fall in love with a company they like. The way to get the most bang for your buck is where you have an insight into the CEO and leadership team. Think about Netflix. Ultimately, the bet an early Netflix investor was making wasn’t on its DVD business and where that business model was going. It was on CEO Reed Hastings and where he was leading the company.

I don't want to be overly narrow about how I think about valuation, of course. I don't want to find a cigar butt and think I can extract value from it. That’s what we might call a value trap, a company that looks attractive on a surface-level but is actually just a melting ice cube. People fall into value traps when they get myopic. They see it’s selling at 6x earnings and get excited, but they stop short of the quantitative and qualitative questions they need to explore. Is it deserving of that valuation? Are volumes up? Are prices up? Is it sustainable? You don't want to be overly simplistic on any single number on a financial statement. You've got to look under the hood, asking enough questions and the right questions.

A value trap is a company to pass on. But equally possible is that I’ll find a great company, but it’s just not time to buy. Even great companies are bad buys if they’re overpriced relative to intrinsic value.

So, once I’ve identified companies that are strong contenders, I have to figure out if and when they’ll be good buys. Sometimes that takes patience.

Waiting:

Often, the end result of my due diligence is a waiting period. Yes, I spend all this time developing my thesis around why a company is valuable, but I also have to be able to say, just because it fits 95%, that doesn't mean it’s the right buy right now.

Value investors must have the ability to sit on companies for a while. But if you’re patient, eventually those companies on your “buy” list will hit a bump. That’s when you jump, and your due diligence pays off. It’s a good feeling, too, because you know you’re getting a steal at that point.