The best way to reduce risk in an investment is to do your due diligence, but even the most rigorous due diligence will not eliminate all of the dangers of buying a business.
Warren Buffett (Trades, Portfolio) is undoubtedly the world's greatest investor, and he has become famous for his handshake deals. He is quite happy to invest tens of billions of dollars in companies with little more than a handshake and eschews the lengthy takeover process most other businesses follow.
That's not to say that Buffett does not do his research before investing. He famously read over 100 years of annual reports for the Coca-Cola Co. before initially buying shares in the business. However, he is also fully aware that too much research can be detrimental. He believes that as long as you know and understand the general direction of the business and economy, you will end up in a relatively good result.
Problems with due diligence
He made these comments at the 2016 Berkshire Hathaway annual meeting of shareholders. One shareholder wanted to know why Buffett was so confident doing deals with his relatively streamlined process, and if he was ever worried about making a mistake with a deal as a result.
Buffett replied by saying that Berkshire always makes mistakes. In fact, the conglomerate has made "plenty of mistakes in acquisitions," but these mistakes are always about a "making an improper assessment of the economic conditions in the future of the industry of the company."
The Oracle of Omaha went on to add:
"They’re not a bad lease. They’re not a specific labor contract. They’re not a questionable patent. They’re not the things that are on the checklist, you know, for every acquisition by every major corporation in America. Those are not the things that count. What counts is whether you’re wrong about — whether you’ve really got a fix on the basic economics and how the industry’s likely to develop, or whether Amazon’s likely to kill them, you know, in a few years or that sort of thing."
What it appears he is saying here is that, no matter how much research you do, no matter how granular your investment process, unless you have a broad understanding of the company and the industry it operates within, you will never truly be able to understand its potential. Buffett added that neither he nor Berkshire's Vice Chairman Charlie Munger (Trades, Portfolio) have been able to find a "due diligence list that gets at where we think the real risks are when we buy a business."
Assessing management
In Buffett's mind, the quality of the management is much more critical, but assessing, as he says, "whether a manager ... is going to behave differently in the future in running at business than he has in the past when he's owned it," is incredibly important and there is no simple checklist you can follow to answer these questions.
Large companies will always face problems. There is no way of telling whether or not a multi-billion dollar multinational business has a problem at one of its small subsidiaries -- no matter how much research you do. However, these minor issues will not determine the direction of the business over the next 10 or 20 years. This outcome will be determined by macroeconomic trends and the company's overall direction. There is no need to focus on these small, irrelevant points when the overall big picture is positive, in Buffett's opinion.
"I’ve seen deals fall apart because people start arguing about some unimportant point," he said, before going on to add, "I think we gain a lot when we start to make a deal, it usually gets done."
For the average investor, who is buying just a few hundred shares in a company, rather than multi-billion dollar businesses, this viewpoint is even more critical. When Buffett buys a business, he can exert a degree of control over the enterprise.
Minority shareholders cannot and, therefore, it is even more important to make sure that management is trustworthy and the business is being pushed forward by strong tailwinds that will allow it to continue to grow even if a crack emerges at some subsidiary.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:Â
Buffett and Munger on the Power of Not Being Stupid
Learning From Sequoia's Valeant DisasterÂ
Walter Schloss' Advice on Relative ValueÂ
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