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What Is Due Diligence? Here’s How I Do It
Posted by: Chuck Carnevale (IP Logged)
Date: October 9, 2013 10:24AM
Introduction: The lexicon of the financial world is full of phrases and jargon that are often tossed about without considering that there may be those who are not exactly familiar with the true meaning of the terms. It recently came to my attention that due diligence may be one of those idioms. In my own writings, I routinely recommend that readers conduct their own due diligence and/or comprehensive research. However, I recently had a reader ask me exactly what due diligence was and how to do it?
Consequently, the question inspired me to share how I conduct my own due diligence when evaluating common stocks I am interested in. But before I get too deep into how I personally perform due diligence, a few clarifying remarks may be in order. First and foremost, I consider due diligence an ongoing process rather than a specific act. Therefore, I consider due diligence an activity I engage in prior to investing, followed by the continuous monitoring of the company to stay current.
Furthermore, the term “due diligence” has different applications regarding whether it is being applied to areas of law, finance or other industries. Therefore, my remarks will deal exclusively with due diligence as it applies to researching a company (common stock) for investing purposes. Moreover, I believe this is an essential and extremely important process that especially applies to retirees that have elected to manage their own retirement portfolios.
At its core, the concept “due diligence” implies investigation or research. I will refrain from offering formal definitions in favor of a more straightforward explanation. In simple terms, due diligence implies doing your homework. The vast majority of the greatest investors that ever walked on this planet will echo the sentiment to know and understand the business behind any stock you are interested in owning. Thus, due diligence at its most basic level is the process and act of acquiring this necessary knowledge.
Therefore, on the face of it, due diligence seems rather simple. In reality, conducting due diligence properly and thoroughly can be both a daunting and time-consuming task. On the other hand, in spite of the required effort, I believe it is vital to success. Moreover, even when conducted properly, there are no guarantees that success will follow. However, I do believe the odds of success are greatly enhanced through making the necessary effort, but the following caveat must also be considered. Often it is not what we can know that may hurt us as much as what cannot be known.
Therefore, as essential and necessary as I believe due diligence is, it must also be recognized that it is not failsafe. Nevertheless, I contend the more you can know, the better your chances for success will be. My point is that although every investor will be better off by performing due diligence, they must also be willing to recognize and accept its limitations. In other words, we can learn a great deal from studying a company’s history, but at the end of the day we must, as accurately as we can, forecast the future. Making reasonable forecasts represent the most challenging aspects of due diligence.
There is one final aspect of due diligence that I believe worthy of mentioning in this introduction. My comments and this article will deal with due diligence exclusively from the perspective of the true investor. Speculators, day traders, options traders, etc., might perform an entirely different type of due diligence or research. The primary difference relates to whether you are interested in owning a business or attempting to make guesses about price movements. Therefore, my concept of due diligence applies to trying to understand and learn as much about the business behind the stock and attempting to calculate its intrinsic value as accurately as possible.
My Methodical Approach to Due Diligence
Fortunately, thanks to advances in technology, to include the Internet, financial information is more readily available and accessible to investors than it has ever been. Therefore, due diligence is significantly easier to conduct today than it was in years gone by. Even better, much of the essential information can be gathered at little or no cost. However, my own personal experience indicates that the best information must be purchased. But, since I market fundamental stock research I feel it’s only fair to alert the reader to my potential bias. On the other hand, I stand behind my statement.
What follows next is an example that I offer to illustrate the methodical approach that I use when conducting my own due diligence on a business (common stock). I want to be clear that my focus is based upon sharing my due diligence process, and not specifically about the example that I am using. In other words, I ask the reader to evaluate the process I am sharing over the specific company that I am using as my example.
Moreover, my process is oriented to supporting my own preferred investment philosophy. Nevertheless, it is once again, the process and methodology that I am sharing. Stated more plainly, an effective due diligence process is, and should be, investment-philosophy agnostic. In other words, it’s about being as thorough and comprehensive with your research given the tools available to you, in conjunction with the time and effort you are willing or capable of expending.
The first step in my due diligence process is the determination of whether or not I believe a given business (stock) is worthy of the time and effort required for further scrutiny. Since my approach relates to investing in the business behind the stock, my initial investigation relates to the fundamental strength and health of the business in question. In other words, do I believe the fundamentals underpinning the business are strong enough and therefore worthy of my continued efforts (note: I purposely make it a point to ignore price or valuation with this first step).
The successful implementation of this first step requires digging into the company’s financial statements (10-Ks and 10-Qs). In the past, I struggled with this necessary first step because it required poring over and digging through spreadsheets in order to access the fundamental data and information that I desired and needed to evaluate. But worse yet , since many companies typically only provide historical data going back two to five years on any single financial report, it required digging through several years of the company’s filings in order to gather and evaluate the essential data that I felt I needed. I found this task tedious, difficult and even boring.
Therefore, I developed the F.A.S.T. Graphs™ a Fundamentals Analyzer Software Tool that enabled me to review essential fundamentals at a glance. To those of you that do not have access to this powerful research tool, or a similar research tool, I cannot stress enough the importance of reviewing a business’ fundamental financial data as a crucial first step in your due diligence efforts. Nevertheless, I will utilize F.A.S.T. Graphs™ extensively throughout this article in order to clearly articulate how I personally conduct diligence.
Medtronic Inc. (MDT) My Due Diligence Example
Medtronic Inc. was a company that I had long admired based on the historical operating excellence that it achieved through good and bad times. However, Mr. Market was consistently pricing it too high for many years, perhaps because of its excellent operating record (consistent and above-average earnings growth). Therefore, I placed it on my dream list, periodically checking its valuation and patiently waiting for an opportunity to purchase it at a sensible valuation.
The following earnings and dividends only graph clearly depicts why I was attracted to Medtronic Inc. Earnings (the orange line and green shaded area on the graph) and dividends (the pink line and light blue shaded area) both steadily advanced without missing a beat even through our last two recessions. Therefore, Medtronic represents a quintessential example of the type of company that I prefer being a long-term shareholder of. In other words, this record of excellence made me very motivated to want to own this company. The reader should again note that I have left price out of the equation at this point.
With my next graph, I add monthly closing stock prices that reveal how overvalued Medtronic was prior to the Great Recession. Although I admired Medtronic greatly, the stock was significantly overvalued (the price significantly above the orange earnings justified valuation line). Therefore, I placed it on my pending deeper due diligence list, but refrained from exerting too much time or effort until valuation came into alignment. However, once the price aligned with earnings in October 2008, I began getting serious about digging deeper into this excellent company.
Once valuation became sound, my next step was to click on the link to the company’s website provided at the top of the graph. Once I’m in the company’s website I immediately look for the investor relations section. Although I can also find the company’s financial reports here, I save that tedious task for later. What I look for instead are any presentations that the company may provide. I am especially interested in presentations made at investor conferences or analyst days.
My reasoning is based on the recognition that these are the same presentations that analysts attend and represent the base of information they will utilize when preparing their estimates of the company’s future earnings growth. Therefore, I can avail myself of the same information that analysts receive which I can later use as a basis for my own judgments regarding the accuracy of their estimates. The following slides represent excerpts of a presentation that my example company Medtronic made at a Sanford C. Bernstein conference in New York City on May 31, 2013.
Of course it’s important to point out that I recognize these presentations by the company’s management team are designed to put the company’s prospects for the future in the best light possible. However, I simultaneously realize that they are also chock-full of factual information about the company, its business model and its product lines.
Next, and after reviewing any presentations I find interesting, I will spend time reviewing other sections of the company’s website in order to better familiarize myself with the company. In addition to trying to learn more about the company I will always include a review of the company’s management team. Here is a link to the executive management team of Medtronic.
After I have finished reviewing the company’s website I will turn to reviewing additional information from independent sources. As I previously stated, investors today have the luxury of numerous sources of independent financial information at their disposal. These include, but are not limited to, financial websites such as Google Finance, Yahoo Finance, MSN Money, and many others where an abundance of additional financial information is readily available. These include current news and press releases regarding key developments or announcements about the company.
As an important aside, I am at this point still looking for factual information over opinions. Therefore, I will ignore reading any articles presenting opinions about the company as I will save those for later during the final stages of my due diligence process and effort. My objective is to keep as much bias out of my due diligence effort while I am still exercising my own personal independent fact gathering.
However, since it is facts that I am now after, I will attempt to organize and gather all of the financial and fundamental information that is available to me. Of course, as regular readers of my work would expect, I personally rely on F.A.S.T. Graphs and FUN Graphs (fundamental underlying numbers) to organize and reveal essential financial information that cumulatively will be vital regarding my ability to make a sound investing decision. Of course, it is only fair for me to recognize and disclose that there are many other fine research tools available.
At this point in my due diligence process my focus is on ascertaining the financial health and strength of the company. Therefore, I now turn to a review of the company’s balance sheet, cash flow statement and income statement. Of course, this can only be accomplished through a review of the company’s financial statements found in their annual and quarterly reports. Since this can be a tedious and time-consuming task comprised of digging through and pouring over financial reports and spreadsheets, I developed FUN Graphs to make the task easier, more efficient and fun (pun intended).
The following example 10-year FUN Graph on Medtronic graphs key components of their balance sheet. (Note: In all the FUN Graph examples in this article, I have included a snippet of the navigation bar and placed it to the left of the graphs.) These include assets per share (atps), cash and equivalents per share (cashps), debt long-term per share (dltps), debt per share (dtps) and invested capital per share (icaptps). Although I can look at each of these balance sheet items one at a time, the following is offered as a sampling of the information I feel is important to review.
This next graph looks at common equity or book value per share (cepqs) in isolation as an example of reviewing one important balance sheet item in isolation. When I review this financial information I’m not only concerned with the detail of these important financial metrics, I’m also concerned with their direction. Clearly, Medtronic has been consistently increasing their book value over the past 10 fiscal years. That is a good sign, and it’s the kind of information I am looking for regarding all of the company’s important financial metrics.
However, I don’t stop with the balance sheet because I believe that past and future performance is a function of the earnings and cash flows that a company generates on behalf of its stakeholders. Therefore, I next turn to the cash flow statements in order to examine how successful the business has been in generating cash flow. The following graph plots Medtronic’s capital expenditures per share (capxps), cash flow per share (cflps), dividends per share (dvpsp), the critically important free cash flow per share (fcflps - note: this metric is calculated after dividends are paid) and operating cash flow per share (ocflps)).
Although this example includes all these metrics graphed at once, I can also look at each of them in isolation. Moreover, for the sake of avoiding redundancy, I will also review a similar graph of their income statement which provides information on earnings, costs and sales. However, I think the reader gets the picture, and therefore, I have not included an example of the income statement graph.
Next, I turned to an evaluation of gross profit margin (gpm), net profit margin (npm), return on assets (roa), return on equity (roe) and return on invested capital (roi). The example below only includes gross and net profit margin, however, I review data on all the metrics stated above.
Next, I run graphs on liquidity ratios and additional data on various valuation ratios to include price to book value (pb), price to cash flow (pcfl), price to free cash flow (pfcfl) and others that can be seen as options on the navigation bar to the left of the sample graph which only plots the current ratio (cr), a quick ratio (qr) and for those diehards concerned with volatility a five-year beta calculated at fiscal year ends. Again, I run all these metrics, but only included the one sample below.
Once I complete this critical step of digging into the company’s financial health and strength, I then turn to looking for any additional information on the company that I can gather. This will include articles on prestigious financial blogs such as Seeking Alpha, GuruFocus and others, looking for articles and/or any other meaningful information I can find. Of course, this would also include news services such as the Wall Street Journal, Barrons, Forbes and The Street, etc.
For the final step in my pre-decision due diligence process, I personally turn to several research services and tools that I subscribe to. One of my primary sources is the Standard & Poor’s Capital IQ Global Database which, in addition to being the data provider for my F.A.S.T. Graphs™ research tool, also provides extensive outside research from other sources. I also have been a long-term subscriber to the Value Line Investment Survey, MorningStar, Zacks and others.
Frankly, these research services are quite expensive and may be beyond what the individual investor might be willing to spend on research. Nevertheless, I have them so I take advantage of the information they provide me. However, as I previously stated, the individual investor does have access to many free research tools that they can turn to. The bottom line at this point is that knowledge is power, and I strongly suggest that all investors access all the information that is available to them. As I often say, there are no shortcuts, and comprehensive due diligence and research is, in my opinion, a necessity for successful results.
The Culmination of Due Diligence: The Decision to Invest
The following F.A.S.T. Graphs™ illuminates the culmination of my due diligence on Medtronic to include my ultimate decision to invest. As I indicated in the beginning of this article, I had long-admired this company based on its operating results, but was unwilling to invest due to what I considered excessive and unrealistic overvaluation by Mr. Market. However, I was willing to wait patiently for what I personally believed would be the inevitable opportunity to find this blue-chip dividend growth stock at an attractive valuation.
The Great Recession gave me that opportunity, and at that point the due diligence process described in this article was put into full gear. Although I regret not “jumping in it” as the opulent Russian in the DirecTV commercial suggested during the throes of the Great Recession in November and December 2008, I still had work to do. Therefore, I was happy to begin building my position in late April 2010 at approximately $44 per share since my due diligence was now complete. At this point, the stock had been moving steadily back into alignment with fair value (the orange earnings justified valuation line), and I was content to buy at fair value.
By the end of July, 2010, Mr. Market was once again being accommodative and I added to my position at approximately $36 per share. Although I was not able to buy at a perfect bottom, I was quite happy with my $40.50 average cost basis because thanks to all my hard work, I was confident that I had a position in this blue-chip that represented a discount to its fair valuation which I calculated at somewhere between $47-$48 per share. After all, my goal was to become a long-term shareholder in this business that I had long admired, but best of all at a valuation that my research suggested simultaneously provided both a margin of safety and an enhanced long-term opportunity.
Continuous Monitoring and Due Diligence
Moreover, in addition to reviewing all the company’s historical fundamental and financial data, I also routinely run several forecast calculations. I do this both prior to making my initial decision as well as continuously revisiting forecasts to stay current. The following Estimated Earnings and Return Calculator examples represent the various scenarios that I like to run, consensus, high growth and low growth. Note that these are based on current data whereas the estimates I base my initial decisions on in 2010 may have been different. My point being, due diligence is an ongoing process of a continuous monitoring of my decisions.
Thesis For Growth
At this point, I believe it is critically important to point out that the primary purpose of my due diligence and comprehensive research process is to develop a thesis for growth. I clearly understand that I cannot buy the past and that I am required to invest in the future. However, although I believe there is a great deal to learn from the past, my true objective is to determine whether or not the company continues to possess the quality characteristics that enabled it to produce excellent historical results into the future. Therefore, as part of my process I will create a thesis for growth based on the information and analysis that I have conducted.
Summary and Conclusions
There simply is no substitute for conducting comprehensive research and analysis before investing in and/or holding any stock. With this article I merely scratched the surface regarding how I personally approach researching a company. In essence, it is but the outline of the rigorous process I go through. The hard part, beyond reviewing the data points as presented in this article, is the actual reading of all the news, articles and additional research reports.
But perhaps most importantly, and to repeat, it is a continuous an ongoing process that I believe is critical to long-term success. My hope is that readers of this introduction to due diligence and comprehensive research might have a deeper understanding of what due diligence entails. At the end of the day, it all comes down to understanding and knowing the businesses that you are a shareholder of. Knowledge truly is power.
Disclosure: Long MDT at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Stocks Discussed: MDT,