How does one feel comfortable about his or her due diligence before entering a position?

due dilligence

Recently, I’ve had the pleasure of answering a question posted online in a value investing forum. As mentioned in the title, the question poster was interested to know the threshold at which an investor would feel confident enough in his or her due diligence (DD) to enter a position.

I do not believe that a person can be truly 100% confident in his or her due diligence simply because we do not possess a crystal ball which tells us what the future holds. If anyone claims that they can tell you the returns of a company’s stock price or whether the stock’s price will outpace the market for certainty, just call out their bullshit please.

The market is dynamic in nature with a million cogs ensuring that the economic machine chugs along. It is not a consequence of a single factor (e.g. interest rates, consumer confidence etc) but an amalgamation of them all. These people would likely have been the same people who proclaimed that Lehman Brothers were an outstanding low risk investment back in the mid 2000s.

What we can realistically do is to make educated predictions of a company’s future performance, using sound fundamental micro and macro analysis to derive a holistic perspective. By doing that, we significantly mitigate the downside risks of under-performing the market or receiving negative returns.

Anyway, here was my response:

I’m in the management consulting field so I’ve had the (fortunate or unfortunate, depends on which side you pick) task of analysing multiple industries within a short project time horizon based on my clients. I’m pretty confident with my DD so attempt to answer your questions.

How do you perform such extensive research to be able to discover and correlate matters of the company in question?

I don’t want to go on and on about my career and major since I’ve discussed it multiple times. But putting myself in your shoes, I would go to Finviz’s group screener to understand what the major overarching industries are.

Here’s a tip from my industry, it will be relevant for anyone who wants to conduct their own due diligence (feel free to buy me a coffee if you find it useful lol). If you want to search for industry reports by major banks or research firms which are free from paywalls, just add a .pdf to your search in Google.

So for example, a search for ‘Global payments industry .pdf’ will immediately yield research from BNY Mellon and McKinsey. Saves a ton of time doing research.

After getting acquainted with the industry you’re looking into, you might want to start reading articles from Seeking Alpha or other websites of similar theme.

The idea is not so much to get influenced by the free articles there, but rather to get an understanding of how an informal due diligence should look like. For formal sources, there are buy-side equity research reports which have paywalls attached to them with limited distribution so I don’t recommend actively searching for them unless you’ve proprietary resources like the Bloomberg Terminal. That said, there are built-in fallacies within buy-side reports anyway.

To sum it up: (1) Understand the industry (2) Understand the form of a DD.

It’ll be much easier for you to draw the connections between a specific company and its macro trends / industry when you have a good understanding of the big picture. These two points paired with fundamental analysis of a company’s financial positions through the balance sheet and income statement should set you up well for any future DD.

Then from there, at what point do you feel confident that your research has provided to you the full picture of the company to govern your decision whether to buy into it or not?

Right. So I do my own DCF models which I’ve been formally trained in.

Once I’ve developed an understanding of the industry and like what I’m dealing seeing (might be because the industry is burgeoning or if its a clear sunrise industry) , I’ll start finding companies with great balance sheet strength and past cash flows.

Leveraging my research from industry trends and after assessing the company’s business model (economic float, strategic thrusts etc), I’ll derive my own values for the company’s growth and profitability levers (revenue growth / earnings growth and pre-tax margins).

The end result of the DCF provides me with a range of fair values which I believe the company will be at. In order to improve the effectiveness of my model, I add in a margin of safety into every analysis I do.

Hope this helps! Lmk if anything.

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