Due Diligence: Knowledge Is Power, Knowledge Is Money
Before you go to class or before giving a presentation you need to do research, read ahead, and review the material. Hence, when you present or go to a lecture, you will be prepared for what lies ahead. The same happens for investing. Before investing, you need to know on which company are you going to invest and why. This is called due diligence. The classic definition of due diligence is to take the precautions a rational man would take before engaging into an activity. Basically, this means prepare before act, or you will have a lot of trouble.
Benjamin Graham, the author of the book “The Intelligent Investor”, defines investing as “an investment operation is one which, upon through analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative”. This means that for investing you need to do due diligence, otherwise you are speculating.
For some people speculating sounds appealing, but on the long run is not safe. Speculation has its benefits like to help to raise capital for new companies in new industries (let’s say Amazon on the late 1990’s, or Facebook on the mid 2000’s), and if you are lucky enough, you can make a lot of money. But, speculating is gambling. If you have money and feel like gambling, book a flight to Las Vegas and play Blackjack. The odds of winning at Blackjack are of 42.22%; on the other hand, a study conducted by the North American Securities Administrators Association revealed that only 30% of speculations on day trading were profitable and only 12% had the prospect of long-term income.
For people like you and me that don’t have the luxury to give away our savings (because we just wanted to invest on a “cult stock”, or putting money on a stock because it will likely make a profit), investing is not a weekend in Vegas where you go to the Casinos and if you lose, you go back home. Investing requires us to be cautious and understand why we are investing on a determined company.
Now, the question is what to look before investing. The answer is everything. But, with the myriad of metrics and details is practically impossible to know everything. Here are some basic things that you need to look before you invest:
>The financial statements: On the website of the Security and Exchange Commission (www.sec.gov) you can access the statements of every public traded company in the United States. Make sure to compare the recent statements to the previous two or three years to understand what has been the path of the company and if there are numbers that affect the most recent ones.
>News: Check recent news of the company to understand the context of the numbers on the point above. In addition, look for news about their management practices, new technologies, and major scandals that could bolster or damper the company’s position.
> Market: Look for the market in which the company operates — e.g. Fast food, Pharmaceuticals, Technology, etc. Analyze the market and check if they have future and how does your company perform on it
These three things are fundamental on every research that you can do before investing. Keep it as simple as possible and look for things that you understand. Consider that there are firms and professionals that do this for a living, so don’t overreact if you make a mistake or you do not fully understand. You can also read professional analysts’ reports to aid yourself.
To illustrate this on an example, we will take Monster Beverages (MNST) to do some basic research and understand better due diligence. For the sake of the exercise we will analyze the company using the three points above:
· Financial Statements: On March 1st, 2017, Monster Beverages released their 4th Quarter results. The sales for the year increased from 2.7 Billion to 3 Billion or 11% growth. Net income increased from 564.7 Million on 2015 to 712.6 Million on 2016. They also used 2.2 Billion to purchase common stock, which boost some financial ratios like Earnings per share (on 2015 it was of $0.95 and on 2019 increased to $1.19). This cash comes from selling rights to Coca-Cola of some beverages on 2015. The buyback of shares affects the cash position of the company and if they incur on a big expense, Monster will be forced to issue debt.
· News: Despite their strong 4th Quarter last year, they are delaying the release of their new sports drink “Hydro” and this is already affecting the stock price. The release of the 4th Quarter earnings provoked an increase of the stock price to $48.04 on March 2nd, the stock has not been above $48 since then. On March 21st, JP Morgan announced that the stock was “over-weighed” at a price of $56 (this means that the stock currently trades below the “correct value), but this has not stopped the decline of the stock.
· Market: Monster is involved in two Markets, soft drinks, and energy drinks. For the first one, the industry has declined since 2009 from 45.5 Billion to 427 Billion per Ibis World. The energy drinks industry has soared on the same period from 4.5 Billion to 8.2 Billion according to the same research tool. These two markets face threats from the healthiness on people’s diets. Since fitness movements have rose and people is more conscious of their nutrition, the industry needs to provide healthy alternatives to these new segment, but is failing.
This is a very basic research which serves as a start point to learn how to learn relevant information from a company. While you learn more, you will start using more complex instruments and research as a tool to invest. One last thing, due diligence is researching not forecasting, and there can be event that will suddenly affect your investment. Due diligence will not guarantee you 100% success but it will help you to be more cautious and increase your likelihood to earn more.
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Disclaimer: This article is based purely in our own knowledge, experience, and research. It should not be taken as an expert’s advice for stock picking
