Due diligence is a checklist for your mind.
First, why is due diligence common practice?
It is done by hedge fund managers, investment bankers, individual investors and anyone else thinking of buying a company. To begin, there are seven areas to focus on for due diligence. In this guide, we will break down each area in great detail.
You’ll learn why valuations matter and how to qualify management. Learn the essentials of a balance sheet so you can talk like an expert.
This material is designed to help minimize risk. Your investment risk. This content is not numbers focused and designed so anyone can learn the process. It's not technical so don't expect any number crunching or valuation models. A useful but lengthy practice. But not necessary at the moment.
To be honest, not even Warren Buffett makes financial models. He doesn’t use Excel or calculate EBITDA. He focuses on the industry, management and key operating metrics. Again, you’ll discover that investing is an art, not an exact science.
By the end, you will find yourself making better investment decisions by simply asking the right questions.
It's time to exercise your portfolio’s mind
Chances are you've had some winners in your portfolio. One or two home runs can go a long way. But how do you improve your batting average?
It begins with cutting the losers. Getting rid of bad ideas so you can double down on your best ones. This is the secret to master. You've heard Buffett's rules, right?
- Rule No.1: Never lose money.
- Rule No.2: Never forget rule No.1.
Well we're going to focus on rule number one. By improving your investment decision making process.
What does that mean? To reduce the chance of errors with every investment. This requires you to ask the right questions so you can beat the market.
Simple but not easy.
This checklist is as much for your mind as it is for your portfolio. We will focus on compounding good ideas. You see, a 1% improvement in your daily screening will compound over 37x in one year. Focusing on your winners will require cutting out all the losers.
Invest like Buffett
Over time I narrowed my focus on the best investors. Like Warren Buffett.
I noticed he had a simple process for every deal. He asked the same questions across different industries and business models. The problem is you can’t screen for the best ideas. There are no shortcuts.
So over the years I began to use what worked and cut out what didn't. My process was simple.
Focus on the best ideas. Then double down on them.
To do this well, I needed to ask a series of questions.
By repeating this exercise over and over again, my investment muscles improved day in and day out. Creating my own mental model. Seven focus areas to improve my process.
In this guide, you'll find the process I've used and how to replicate it in your investment portfolio. It will make you a better investor and business person.
Mastering the Basics
1) Business Basics
- Do I want to spend a lot of time learning about this business?
- Can you describe how the business operates?
- Can I explain how this business makes money?
It’s not insider trading
You see, plumbers know what products to buy and engineers know what goods to create. Being an expert in your craft is the first step to being an expert investor.
This is your circle of competence.
So the first question to ask is: do you want to spend a lot of time learning this business?
It's easier to go down the wrong rabbit hole. But it's worse to do so in an area you don't want to invest your time.
Because time cannot be replenished.
Think like an Owner
Investing is about owning a piece of a business. Not day trading or speculating.
What would you do if you became the boss? How would you operate your day?
Here’s our next question: can you describe how the business operates, in your own words?
Operating requires the same mentality as an investor. You would focus on the customer, invest in the best products and hire the best people. You're doing the same thing as an investor. But now your money is working for you.
This is how you create an edge.
As an owner you need insight into great products and management.
You see every investment is an investment in people. So start with the top. Who is the CEO? Does he or she make the company/industry better? Would you want them to work for you?
Now if you can explain what the company does, can you explain how it makes money? When studying the financials, check if profits are increasing or decreasing over time. Profit margins are a good indicator of how the company operates. More on this later.
Create a one pager
Describe the company in one sentence. Then expand.
Investment analysts create one pagers for their best investment ideas. Some will create lengthy pitch decks and complex financial models. But I prefer a single page covering the basics, as seen on the next page.
This one pager was published by billionaire investor Chamath Palihapitiya. He does this so retail investors can better understand the workings behind Wall Street and his own investment style.
Explaining your concept in a few words is a real challenge. But not impossible.
Begin with the customer
2) The Customer
- Who is the core customer of the business?
- Who is the ideal customer?
- What is the customer retention rate for the business?
- What are the signs a business is customer oriented?
3) The Product
- Do you understand the product or service offered by the company?
- How does inflation affect the business?
- Is there a unique marketing distribution channel?
- Do you understand the product or service offered by the company?
- How does inflation affect the business?
- Is there a unique marketing distribution channel?
Begin with the end in mind.
This is my favorite piece of advice written by Stephen Covey in his book the 7 Habits of Highly Effective People.
Start with one customer.
Bonus points if you're the customer in the company you're investing in.
Make the Customer Count
Follow the money.
For example, who are the core customers? How many are there and are they satisfied?
In the world of seamless technology, is it easy to buy the product? If not what challenges are not being addressed? Too many obstacles create opportunities for competitors. This is not a good sign.
If a company has a churn and burn model then it will exhaust its potential customer base. Remember, no retention = no revenue.
Some investors love to talk about recurring revenue streams which really means happy customers. Retention is key for building a good foundation.
A good way to test this is find out the impact a product has on customer’s if the business disappears overnight. If the business is not critical then maybe it’s worth looking for another business.
It's easy to look at big branded customers and feel comfortable investing.
But customer concentration can be a serious problem.
If the customer base is more than 10% it should raise a yellow flag. If it is greater than 25% then I would start asking more questions.
Think about this.
Do you want McDonald's to be 30% of your revenue or have 250 individual small businesses as customers?
Sure McDonald's is a promising customer but they may delay payments and swap suppliers at any time. Two things you have no control over as a company owner.
But it's tough for 250 customers to walk away overnight. In fact, they may be relying on your target company to stay in business.
I prefer diversified revenue because it's easier to predict.
Who are the cheerleaders?
It's easy to find great companies. Their customers love talking about them.
Tesla is the best example of this.
You would know a Tesla car owner before you met them. The same goes for Apple and Amazon. Loyal customers love their brands.
These are businesses you want to get behind.
There are several ways you can look for customer reviews or ratings. Amazon has millions of reviews and Consumer Reports provides excellent product feedback.
Let’s use a small yet mission critical technology company as an example: Microsoft.
Everyone uses Microsoft Windows.
It is essential in business.
Most businesses could not function without Windows or Microsoft Office.
So during your investment process you will want to know who is providing these critical products. You'll find that these revenue streams are everlasting and the growth compounds over time.
One question to ask yourself is if this product disappears tomorrow who will hurt the most?
If your answer is ‘the customer’ then that means the product is unique and different. If it's the business then it means the industry may be quite saturated.
Identify the customer pain points. If you can understand the challenges then you will understand the industry.
The [Net Promotor Score](https://www.netpromoter.com/know/) is a good way to understand customer experience. Check out the NPS calculation to learn how it measures brand value.
Start with the Product
To understand a business, you need to touch and feel its value. And the product is a good place to begin.
Create a circle of competence
Warren Buffett only invests in products he knows.
Sometimes it's products he eats like See’s Candies.
Ask what you know about the product or service in the company. It's a simple yet effective way to understand the business model. If you're a consumer that's great.
But that can't always be the case.
For example trucking, oil fields or data centers businesses are hard to relate to. Unless you're in the industry you don't know who the end user is or use case.
This is why I like investing in mission-critical products.
These are businesses that are at the core of an industry. One example is payment processing. Enterprise customers can exist without a good payment solution like Visa. Another might be great software like Adobe.
The first step should be to look at a list of all the products and services. Today this is very easy by visiting a company’s website.
Consumer companies will have transparent pricing. But Enterprise companies will have more custom options.
You want to understand how products are priced to reverse-engineer the economics.
Products with the unique intellectual property or branding will have higher price points. Which means the company will be generating more profits to invest in better products.
If you can't find the pricing then look for the number of customers. You can divide the total revenue by the total number of customers to get an average product price.
How much does the company spend on marketing? What distribution channels are unique?
Every company has its own development cycle. This tells you when a company is focusing on new products for the future. And a healthy research and development budget is good for the future.
Jeff Bezos likes to say that the current quarter earnings were priced in two years ago.
If management has a track record of delivering positive returns then you are on the right track.
But remember it's easy to burn cash to develop new ideas. But sometimes you need to take big bets to generate outsized returns.
Apple’s first iPod is a good example of this.
In January 2001, Steve Jobs hired Tony Fadell to create the first generation iPod. By March 2001 he greenlit the development project.
By April 2001, Apple hired a manufacturer and announced the product in October 2001. And began shipping the first iPod by November 2001.
The first iPod took 290 days to develop from start to finish.
You want to find companies with similar ambitions to develop great products in a short period of time.
Otherwise they are just burning cash.
Strengths and weaknesses
4) SWOT Analysis
- Does the company have a competitive advantage?
- Is it sustainable?
- Can the business raise prices without losing customers?
- What is the competitive landscape?
In business school, we learned about strengths and weaknesses. But in school the learning stops at the end of class. Now ask yourself...
Invest in yourself and a competitive advantage
Have you heard of moats? Warren Buffett speaks of them all time.
Moats are a competitive advantage in business. But can you identify the source of a moat? Some of the best companies make it very clear. Like Coca-Cola with brand value. Or Google with its search engine.
But a majority of companies provide zero guidance here. Meaning there's no distinct advantage and it's tough to identify a competitive advantage.
I have one way to test a company’s competitive advantage: raise prices.
If a company cannot raise prices without losing customers then it indicates a poor business relationship.
Now I know what you're thinking.
Raising prices can seem unethical. Especially if you have a competitive advantage.
But if it's good business the company will reinvest its profits into building a better product.
Therefore enhancing its competitive advantage. While improving the customer experience with a better product. Sometimes even reducing the cost of a product like Amazon has with free shipping.
But this can be difficult. Products cycles can take longer than anticipated. But raising prices is a good way to measure the size of a moat.
Another example of this is high margins.
Apple sells all of its products at a premium. It commands brand loyalty and pricing power. Apple's customers don't think twice when new products launch. This is a great example of pricing power as a competitive advantage.
Define the competitors
When looking at strengths and weaknesses, you want to identify the industry competition as well.
You see, sometimes the best investments are in boring industries.
Yes I' aware there are higher returns in software and social media but the competition is intense as well.
That's why high growth technology companies lose money for many years before making a profit.
They're always someone competing for the next big thing. And will fund growth at all costs. You need the ability to avoid loss leaders.
Competitive threats and opportunities
Understanding the competitive landscape will provide you with better insight into the company. Longer product cycles will also give you a chance to understand the landscape. If products continuously change then you need to invest ahead of the evolution. This is hard.
Businesses are always under pressure to perform. So investing in companies that have withstood the test of time is a good indicator of future success.
Think about the Auto industry.
Cars are being released every season for different customers. Some manufacturers design for families, others young bachelors. Either way, cars require the most advanced computers, best transmissions and highest safety ratings. And each of these verticals are changing at any moment in time.
Tesla is one example of this.
Not a single car manufacturer was developing an electric sports car.
No one had thought about combining hardware, engineering and software to develop self-driving cars.
But when Elon sold the first few models, every other car manufacturer had to play catch-up.
This is an example of a threat and an opportunity.
Companies like Toyota and Ford had to rebuild their entire line up to include electric cars. Something that wasn't on anyone's road map. So how is this a threat?
Well first, if the electric car is better than a gas car then the old manufacturers would be out of business. So this gave an opportunity for Tesla to grab new market share.
On the other hand companies like Toyota could build hybrid or full electric vehicles to cater to current customers. Since Tesla didn't have the distribution like other manufacturers, the incumbents can create a new opportunity to compete.
Financial health of the Business
- Has the company had consistent earnings growth?
- How does the business make money?
- What operating metrics do you need to monitor?
- What are the key risks the business faces?
Now the fun begins.
We've covered customer and product but nothing about the finances. Let's dive deep into the financials.
Every business is different
Now every company and every industry is different.
And this is why due diligence matters. You need to understand how the company defines success.
How does it track performance? Can you gauge the future of the business?
For example, I found net new revenue to be the best growth indicator in business. If the company is not growing on a consistent basis then there something is wrong with its internal systems.
You need to identify the key performance indicators to track performance. How will you measure the success of the business overtime?
Other financial indicators may be profit margins and operating expenses. Management may give you several KPIs so you can better understand their North Star.
Once you understand the key drivers, you can begin to break down the key risks.
You want to begin with the downside for every trade.
What can go wrong and how fast?
One important piece when making a long-term investment is to understand all the negative drivers.
What is the bear case of the scenario?
For example, trillions of dollars and stimulus will have a long-term impact on pricing power. Both from the business and consumer. But in commodity businesses pricing power can improve with more inflation. Pricing correlation may be a positive impact to the bottom line.
Will your business be affected by inflation?
Start with the assets and liabilities
With every investment, the balance sheet is a great place to begin.
Let’s start with the accounting equation.
You want assets to increase and liabilities to decrease. This will increase your stockholder equity!
One of the best indicators of a successful investment is a high return on investment capital (ROIC).
Warren Buffett uses retained earnings to indicate the strength of a business over time. Retained earnings is included in stockholder's equity.
If the company cannot deliver profitable quarters over several decades it indicates that it does not have sustainable business.
Your return on capital
Coming back to the return on capital. Profitable earnings are crucial. You see the balance sheet is a good place to begin but it doesn't cover the entire story.
The balance sheet is a snapshot of a single moment in time. But the income statement will show you a story over a period of time. And the statement of cash flows will combine the balance sheet and income. But that’s for a more advanced class.
Now if you're not a numbers person, a lot of the accounting standards can go over your head. That’s ok.
In public companies you'll find management provides discretionary notes on these topics. Sometimes this can be confusing. If it is too confusing then it's a good idea to pass on the investment.
But let's say it's simple. What are the right questions to ask during the due diligence process?
Begin with the assumptions
First is management conservative with its assumptions?
Are they projecting double digit growth? Are estimates too aggressive?
Assumptions will give you an understanding of how to project the company’s future.
The income statement will also tell you if the revenue is recurring. And if profit is sustainable over the long term. Or whether it’s seasonal.
You see during different business cycles, revenue can be cyclical or countercyclical. You'll want to know which is which when making an investment.
Think like an owner
6) The Team
- How would you evaluate this business if you were to become its CEO?
- What type of manager is leading the company?
- How did the manager rise to lead the business?
Now that we've covered the quantitative piece of investing, let's discuss the qualitative piece.
You see it's easy to screen companies based on profit margins and growth potential. But it's more challenging to figure out what's going on behind the scenes.
Good vs Great Managers
You see good managers will have discipline investing in people and products.
And in most cases good management is very accessible.
So if you plan to make a big investment don't be shy from speaking up.
If you want to be an active investor it's important to voice your concerns with management and other investors.
In some cases you'll learn, in other cases they'll learn.
Understanding the management story is an important piece of being an investor.
For example, in legacy businesses the founder may not be around anymore. If they are, you're lucky because they will know the industry and product better than anyone else. In other cases, management has inherited a legacy system.
It is important to differentiate between the two.
Your next job is to identify how management leads the business and his/her team.
Management compensation is a key indicator of this. If management owns a good piece of the business that's a positive sign.
With public companies you can find out if management is buying or selling the stock.
Monitor LinkedIn and Glassdoor
You can learn a lot about a company from their recent hires. Employee reviews are helpful as well.
If you identify a lot of churn executive positions consider that a yellow flag. Yahoo! was a good example of this in the early 2000s.
Check out Glassdoor. This is one of the few websites that provides employee reviews of executives. It’s one way to find out how the company operates inside.
Management’s level of competence
Management begins from the top. With the CEO.
If you don't work at the company it's hard to know the day-to-day operations. But that doesn't mean you can’t learn.
Again don't be afraid to call management. Even the CEO.
When I started investing, I would attend dozens of shareholder meetings. This included Warren Buffett’s annual shareholder meeting to small cap companies hosting in New York. This is a great chance to get close with management and understand their motives.
Sometimes you need to meet someone to understand who they are.
You see, the CEO is speaking with hundreds of people all the time. From employees, investors, vendors and customers. There's so much you can learn from them that cannot be read in an annual report.
Talk with all the leaders
Next in line is the CFO.
This is a more exclusive role and requires a deeper understanding of accounting.
But how the CFO tracks and records revenue is a good indication of how healthy the business is. It also gives you an understanding of how the company finances itself.
You will learn more from the CEO and CFO during quarterly earnings call than from anything else.
Guidance is important.
It lets you know if the company is delivering on what they say.
Remember we are only as good as our last at bat.
Operators vs managers
I prefer to invest in operators.
These are people who like to get their hands dirty.
They're not simply delegating to delegate.
They didn't graduate from business school yesterday. These are executives who understand the product and industry demands.
Also I like to know if companies have a decentralized management. Which means they reduce the stress at headquarters and rely more on employees and managers. A good sign of employee trust.
With public companies, you can also find management's compensation, how financials are managed and if the company is focused on building great products or cutting costs.
P.S. Doesn't hurt to know that the CEO and CFO are buying company stock as well.
The Quality of Management
Now there are no shortcuts to building character.
And ethics are important in business.
You can't read someone's integrity in the newspaper.
Sure acts of kindness may come up once in a while but it's not enough.
This is a challenge with any investment.
Clear and consistent communication is a good place to start.
If the management team cannot follow through on future projections, then you need to ask what else may be inaccurate.
- Have past acquisitions been successful?
- How does management make M&A decisions?
- Does management outperform its competitors?
Now business is about growth.
And if you're not growing you're dying.
This is an important element. Do not overlook it.
You see, investors and management love talking about acquisitions, also known as inorganic growth. These strategies need a mix of equity and debt to fund growth.
A simple yet compelling growth strategy.
But they are not unique and difficult to execute. It requires discipline to buy good businesses at a great price. Or to buy great businesses at a fair price.
Either way you need to understand the growth opportunities of a company. And it cannot just be acquisitions.
Organic growth is the best kind of growth. It requires team effort. It cannot be bought. It must be built.
Organic growth also requires the right incentives by the team. It will give you an understanding of how management motivates employees and works with customers. No room for dirty sales tactics here.
To understand growth, start from the beginning.
Does the company have a track record of being profitable over the long period of time?
Remember the discussion about pricing power?
If a company is continuously reinvesting profits into the business they are growing. Even slow growth compounds over time.
Management’s Growth Strategy
Ask management about the future growth prospects.
Where does the company plan to invest? No one can predict the future but this is a good place to start.
A well thought out answer is worth its weight in gold.
You will find that a lot of companies won't have the right answer. In fact they'll may whatever seems good.
High Growth has a short half-life
You see, high growth comes at a cost. Constantly having to reinvest money hoping that it will pay off.
And high growth requires investment at high speed.
It can be tough to reinvest at a higher rate of return in periods of uncertainty.
On the other hand, companies can produce a more profitable business at a lower growth rate.
But low growth isn’t exciting for everyone.
Yet consistent growth compounds to greater profits.
Final thoughts on Due Diligence
I hope you enjoyed the 7 ways to improve your due diligence process.
My goal was to improve your decision making process to make better investments.
So you can understand the importance of due diligence and how great minds like Warren Buffett think.
Feel free to contact me if you have more questions.
Thanks for reading.