The Art Of Due Diligence

One of the banes of my existence is the preponderance of false information that constantly circulates. It’s readily apparent on social media. People see a meme that speaks to them and share it without verifying it as factual.

False information can get shared millions of times and it impacts people’s opinions. But it can also cost you money as an investor. It is important that investors know how to differentiate between false information and valid information.

Throughout my career, I have conducted due diligence. That is essentially the art of ensuring that a company, invention, or process is legitimate. It also involves identifying potential weaknesses or liabilities, so risks can be better assessed. It is critically important for me to distinguish between facts and hyperbole, between the honest and the fraudulent.

You often hear a disclaimer that investors should conduct their own due diligence, but what does that really mean? Today I will share a few tips on that.

So let’s say you get a hot stock tip. It could be something you heard from a friend or acquaintance, or it could be from an article you read. What should you do?

Step One: Does The Stock Fit Your Objectives?

The first thing you need to do is determine whether the stock fits your investment objectives. If you are a conservative investor with a short time horizon, you want to avoid high flyers for the most part. One way to make this determination is to look at the company’s beta. That information is widely available from any number of financial sites for free.

The beta is a measure of a stock’s volatility in relation to the market, typically as measured by the S&P 500. A beta of 1.0 means the stock’s moves are about the same as the S&P 500. However, given that this index has been known to decline by 40% over the course of a year, you have to recognize that high beta stocks can have huge swings.

If you have satisfied yourself on volatility, you need to satisfy yourself on other measures. Are you an income investor? Does this stock pay sufficient dividends to meet your needs? Or are you interested in long-term appreciation and about to invest in a stock likely to have low appreciation?

Step Two: Drilling Down

Once you have determined that the company fits your investment objectives, the real due diligence begins. I like to first familiarize myself with the company by going to their website, and reading about their business. Then I will read a few articles on the company, with a particular emphasis on those articles arguing the bearish case for the company.

It’s very important, in all aspects of you life in my opinion, to consider and evaluate opposing viewpoints. But also recognize that sometimes writers have ulterior motives. Maybe they have shorted the company and are attempting to drive the price down. This practice can be especially problematic with thinly traded small cap companies.

This is when you start to get into the art of due diligence. How do you evaluate negative claims against a company? You should first try to cross-check against as many credible sources of information as possible.

Of course “credible sources” is a loaded term itself. I consider mainstream media financial sources to be credible for the most part. The company’s filings with the Securities and Exchange Commission (SEC) should be largely credible.

There is always the possibility of fraud and there’s no easy way to protect against that. Your primary protection against fraud should be to keep your individual position sizing small. That way, if a company does implode due to fraud, a small position won’t have an outsized impact on your portfolio.

One final thing you should do is look at the company’s financial statements to see if they are consistent with the company’s public statements. Are revenues increasing? Are they investing for the future? How is the cash flow position? Does existing cash flow adequately cover any dividends?

These are steps I would take at a minimum before investing in a company. They don’t ensure success, but they should shift the odds in your favor.

Another way to shift the odds in your favor is to focus on investment mega-trends that enjoy powerful tailwinds.

One such trend is the global implementation of 5G (“fifth generation”) wireless technology. 5G will serve as the infrastructure for the Internet of Things. 5G is largely resistant to economic cycles and market ups and downs. To learn our favorite 5G plays, click here now.