To me, “Due Diligence” simply means doing the necessary work to determine if a company meets your investment criteria. If you do the necessary legwork and you feel confident with what you have learned through your due diligence, then you generally feel pretty good about moving forward and investing in the company. But if you come across red flags during due diligence, or anything that makes you feel uncomfortable with a potential investment, you likely will decide to pass and move on.
Due diligence means different things to different people; there is no right or wrong way to conduct due diligence on an opportunity you are looking at. What I thought I could do is to lay out my process below in the event it may help you formulate how to conduct your own due diligence going forward.
My due diligence steps after locating a potential investment opportunity are as outlined below. You will notice that I start very broad and become very specific with each additional step.
1. Learn about the Industry
The very first thing I want to do once I identify a potential investment opportunity is to research the industry. I want to make sure that it is an industry that I feel has a lot of growth ahead. Specifically, I like for the industry to be interesting enough to me that I am confident I will enjoy constantly learning about the industry. After all, if something doesn’t interest you, particularly as it relates to the companies you are investing in, it is likely that your patience will be tested and you likely will sell out of “boredom”. Be sure that the industry is somewhat exciting to you before continuing to the next step. If it doesn’t excite you, move on to another idea that you may be watching.
2. Get focused on the company
This step is crucial and often times for me is where my due diligence stops. For this step I want to be absolutely certain that the company is one in which the business model is fairly simple to understand. If, after learning about the company, I cannot summarize their business and how they make money in no more than two sentences, than I generally consider the business too complex for me and I pass. Warren Buffet said it best… “never invest in a business you can’t understand.”
3. Read the most current 10-Q (US stocks) or MD&A (Canadian stocks)
The next step in my process is to closely read the most recent quarterly filing for the company. Some of these filings are 30+ pages, and it’s critical you read every single one of them, as the page you decide to skip over almost always will have the nugget of information that is most critical to your decision! As you read through the filings, take notes and write down anything that you are having trouble understanding.
4. Read older 10-Qs and MD&As
You’ve made it this far so now it’s time to ensure that Management is someone you can trust. My recommendation is to read over the last 24 months of 10-Qs and MD&As to ensure that Management has done what it said it was going to do. This step requires quite a bit of time, but it one of the best ways to know if Management has executed against it’s business model. If you begin reading through the documents and you notice that the business model keeps changing or that cash isn’t being utilized in a manner in which management suggests it will be used, than you may want to reconsider moving forward. Again, write down any questions you have so that they can be properly addressed in the next step, should you decide to move forward.
5. Setup a Call with the Investor Relation Firm of the company (if applicable)
This is an often overlooked step, but one to me that is pretty crucial. I want to ensure that there is a team working with the company that is fully competent about the company. Moreover, I want to be sure that it is an IR firm that is a cheerleader for the business and company, constantly meeting with potential investors and doing all they can to increase awareness of the company. Now, in no way am I suggesting that an IR firm should be “pumping” a stock (if you sense that….run!), but what I am suggesting is that you want to be sure that the firm is very knowledgeable about the business and can answer a majority of your questions without having to run to management to find out every single answer.
If the company doesn’t have an IR firm engaged (which can often be the case with very small companies), then skip to the next step.
6. Setup a Call with Management of the Company
Generally the last step in my due diligence process is to talk to the folks actually running the company. I like to think I generally have a pretty good gut instinct, so this call is absolutely crucial to whether or not I chose to invest in a company. At this point I know almost everything I need to know about the industry, business, and how the company makes money, so I am simply looking to start a “relationship” with the company and to let my gut instinct make the ultimate decision as to whether the Management team is someone I truly believe in.
Note that it is important to always keep in mind that Management is very busy running a company. I have found that Management has no problem speaking with individual investors, and often times embrace it, but be patient in arranging a call. Also, test the waters with email as well to ensure that Management is somewhat responsive to you.
You may be thinking to yourself that the above 6 steps can take weeks or months, and the truth is that it can. However, you have to determine the best moment in time for you to begin investing in a company. For me, for example, I may put on a small position if I get halfway through my due diligence and I am building a pretty strong conviction level with the company and the business model. Personally, I would rather be early into an investment (and take on more risk) than late to an investment (and potentially give up more upside). Some of the best investors I know, however, may wait several quarters before entering a position after completing a very positive due diligence process to see how the company executes during that timeframe.
Remember, there is no wrong or right way to do this. Let your gut instinct guide the way, and let the steps above help you formulate a gameplan for the process.