Due Diligence

[Robandcindy2]

due dil·i·gence
noun
reasonable steps taken by a person in order to satisfy a legal requirement, especially in buying or selling something.
a comprehensive appraisal of a business undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential.


This is a term that I often find perplexing as I have a tendency to suffer from "The Paralysis of Analysis." As an Aviator I do my share of analysis at work. Decisions are often very clear cut, perhaps because I've been at it for so long. Stock analysis not so much.

Often my self induced confusion is fueled by the many financial opinions out there. This is why I have whittled my list of authors/experts that I follow down to a handful here at DGF and SA.

Often the glass is half full-half empty argument sends me into a tailspin. I know why I invested in Company X over company Y at that brief moment in time. Months later things have changed. If I see some red on the spreadsheet I'm hoping to learn what I did wrong. Or is it simply that Mr. Market did it to me?

So the question for the weekend is "What criteria are you most concerned with when performing your due diligence?"

[Kerim]

It is a great question, Rob.

Sometimes I worry that I am an under-thinker and that I do not do nearly enough diligence before making a buy decision. When I am considering a purchase, I check all the usual important DG metrics (as I explained at length in a very old series of posts). I read all the recent articles about the company that I can find, which usually includes both pro and con opinions. I check where the current yield and p/e are relative to the company's historical range. And I consider the economy generally, whether I am ready to buy, and what role the new shares will play in the portfolio. If after all of that I am comfortable, I pull the trigger.

I do not bury myself in the last few annual and quarterly SEC reports. I do not scrutinize balance sheets and income statements. I do not pore over analyst reports. I do not calculate my own estimates of book value, and I do not perform detailed calculations to come up with my own estimate of fair value.

For me, this balance works. Am I adding risk by not doing all of those extra steps? It is hard to know. For the most part, though, I am buying the largest and most heavily scrutinized companies on the planet. Companies that have established and proven business models, competent management, wide moats, and that sell goods and services that will be in demand decades from now.

And importantly, I plan to hold for decades, which removes a lot of pressure to buy at *exactly* the right moment. This is one area where I feel the individual investor has a huge advantage over the "professionals." I can patiently wait years for my purchases to excel. I do not need to see results next quarter or next year. Even fairly valued companies will appreciate over the long term if they are able to grow earnings. And even better, I can calmly accumulate shares in great businesses that are going through rough periods, only to enjoy the ride when then eventually (inevitably?) recover.

So to answer your question more directly -- what am I most concerned about? I am most concerned about getting an excellent business at a fair price. In seeking that out, I'd say I do an average, but not thorough, amount of diligence. And I am pretty comfortable with it!

[EricL]

I am pretty similar to Kerim in my due diligence.

First check is FAST Graphs to see how the PE compares with historical norms. I also like to look at the last 10-15 years to see how consistent the company is during a business cycle. I like to have a steady increase in dividends and earnings and analyst estimates predicting similar growth in the future.

I like companies with good balance sheets, good cash flow, low debt, good credit ratings. I don't dig into SEC filings or anything, but general look at Morningstar and Yahoo Finance to see the cash/debt and trends.

If both of these look good I generally check out the company website to see if any investor presentations are available and then read the last couple of quarters worth. I will also try to check out a transcript or two from recent conference calls.

If all looks good I make my purchase.

[Dividend Watcher]

Yes, it is a good question. The criteria I use are in my business plan. I posted it here in this thread. I'll copy them here and add some comments so you don't have to search ...

• Stocks must pay a dividend and should have been paid at a higher annual rate for more than 5 years. Use the CCC list as a primary source for investment ideas.
  
  [This is where I usually start my search although if I see something I know a little about take a big drop for no apparent reason, then I start digging in with recent news and the company's latest reports. Amgen (AMGN) was one recently and, though it's not a long-tern dividend payer, I would've bought some if I didn't have my cash allocated for others. These are more special situations than the dividend growth stocks I usually look at.]
  
• The P/E ratio for the trailing 4 quarters should not exceed 20. Additionally, it is preferable that the P/E ratio be less than or equal to the average P/E over the last 10 years. No more than 2 outliers may be excluded when calculating the average P/E.
  
  [I go back to the last 4 quarter earnings and not the the prior FY's earnings. The average P/E should tell me what Mr. Market normally prices this company at. This is versus FastGraphs ideal P/E which is too stringent for me, especially as the market keeps going up]
  
  
• Dividend yield at time of investment > 2.5% or 150% of the S&P 500 yield (whichever is higher). This excludes the Special Situation portion mentioned in the Tactics section.
  
• Dividend growth rate > 4% for the lesser of the 3, 5 or 10 year periods. Using the lowest rate of the three time frames should be a conservative estimate of future dividend growth.
  
  [If you recall, I estimate inflation at 4%. All I'm looking to do is beat it. Now what am I doing with T? Well, that's a discrepancy I'm wondering about too and think I will be revising this in the near future.]
  
  
• Payout Ratio < 70% of free cash flow (EPS + depreciation – capital expenditures) for public corporations. For some investments, such as REITs and MLPs, a higher payout ratio may be allowed provided other financial factors are deemed adequate.
  
• Current ratio should be > 1.0 and the higher the better. Some companies have operated for years with a current ratio less than 1.0.
  
  [GIS is a prime example. This is where the digging comes in.]
  
  This should be taken into account when analyzing a company's finances. Investigate cash flow, free cash flow and interest coverage to ensure the company can pay its bills and the dividend.
  
  
• Earnings Per Share (EPS), or Funds From Operations (FFO) in a REIT, increasing at a Compound Annual Growth Rate (CAGR) > 3% over the last 5 years.
  
• Debt/Total Capitalization < 50%. REITs and MLPs may exceed this due to the nature of the business. In this case, investigate debt maturity dates to ensure they're spread out over the long term.
  

As to what I use, I usually skim a few years annual reports/10Ks, read the latest shareholder letter, S&P stock report available at my brokerage, look for news from other sources, read here & SA and look for other sources at Yahoo! Finance. If there's a recent industry presentation posted on the company web site, sometimes I'll watch them. I really like videos since you can watch management's mannerisms. Is the CEO animated or excited about the company? Do other company reps share that enthusiasm, does what they are doing match what they are saying? Of course, you have to take into account some of these people are really boring and inept in these presentations but you can sometimes get a feel. Sometimes I wonder why the hell these people get paid so much and couldn't talk their way out of a parking ticket in East Podunk.

Quote:Often the glass is half full-half empty argument sends me into a tailspin. I know why I invested in Company X over company Y at that brief moment in time. Months later things have changed. If I see some red on the spreadsheet I'm hoping to learn what I did wrong. Or is it simply that Mr. Market did it to me?

This is where I like to have a 'story'. What has the company done? Why is it doing things the way they are now? Does it make business sense? Does it seem to be kingdom-growing rather than business-growing? Do I expect things to be slowing for the company temporarily? Will the company recover even if the business climate deteriorates for a while?

I think WAG was the prime example in the last few years. I've written about why I own it several times here and on SA in the comments section. The whole Express Scripts showdown, the Alliance Boots acquisition, the AmerisourceBergan agreement, the Duane Reede purchase all signalled to me that management was positioning to grow the business over the long term including overseas. WAG seemed to have saturated the U.S. market with over 8,000 outlets so they needed to do something and business-as-usual wasn't going to do it. You have to accept the "red" on your spreadsheet for a while if you expect management to transition the company.

Ensco is another. I just put that in my wife's portfolio. They are investing in more deepwater rigs with the latest technology on spec. It also seems they are trying to standardize their rigs. This makes maintenance easier (and sometimes cheaper) along with flexibility in their operations. They can take a crew from rig to rig and they're already familiar with its idiosyncrasies so they can operate it effectively. Seadrill has done the same recently but ESV's debt load was a little better and they've always seemed to be a quality company that knows their business. If you look at a lot of contract ocean drilling companies, their rig fleet is older and they don't seem to have enthusiasm that ESV has for being a quality and efficient contractor for the oil majors. Maybe I've misread it but time will tell. In the meantime, we are in the red right now.

If it's retail, have you ever shopped in the store or at it's web site? Do you like it? Do you think others would like it? I like to use TJX/ROST for this example. Their web sites aren't much (except for TJX's Sierra Trading Post where I've spend $$$$) but if you're looking for some household knick-knack, a one-off cooking utensil or some cheap clothes to knock around in, then TJ Maxx or Marshalls is my first choice to go looking. I don't want to buy junk at a dollar store where it falls apart while using it for the first couple times. We don't have any of ROST's stores around here but people say they're similar. Yes, I could go to Amazon but, if you look at how Bezos runs the company, I don't think he gives a tinkers-damn about the shareholders. You need to rely on Mr. Market for your money instead of the company. That's not what I'm looking for.

Once you've done all this, you have to be patient. Give management time to execute. Big companies take time to change or for their changes to take effect.

Sorry I wrote so much. I hope that helps with your quandary.

[earthtodan]

(08-24-2014, 08:14 AM)Dividend Watcher Wrote: Does it seem to be kingdom-growing rather than business-growing?

I've never heard this term before, can you elaborate?

[Robandcindy2]

These are all excellent replies! Thank you!

What had me in this train of thought was seeing some "red" I didn't expect to see in our portfolio (stocks I had bought at a good price-FastGraph, PE, historical, etc.) and reading a post on a blog I follow debating CPB vs Disney. I especially value that authors opinion but *gasp* disagreed with his conclusion. Knowing exactly where I am in the "financial knowledge food chain" it had me wondering if i had veered way off course.

Thanks to your responses I'm still OK. As in the CPB/DIS debate, it all depends on where sitting looking at the issue (30 years old vs 58 years old) and what you give priority to in your analysis.

Thanks again...hope you enjoy the rest of the weekend.

Rob

[KenBob]

I want a good company with a good dividend at a good price.

For a good company, I concentrate on blue chip companies with a well known and proven business model.

For a good dividend, I am looking at how the dividend yield compares to the corporate bond yield minus inflation, the payout ratio must be less than 80%, and the expected earnings growth rate must be greater than the inflation rate. Earnings growth should be roughly proportional to dividend growth.

For a good price, a sound valuation technique is required, so stocks can be bought at or below fair value. I have gone back and forth on what is a good valuation model. I now use a market forward PE ratio which is essentially the inverse of the investment grade corporate bond index yield plus an equity premium. Of all the methods I have looked at, this method appears to have the best correlation with actual stock prices.

I believe that the history of a company is good as a qualitative parameter, but can't be used to predict quantitative performance; therefore, history is good for looking for finding a good company, but not much else. Otherwise, I am relying upon Wall Street estimates for forward earnings and earnings growth. As a nonprofessional, I simply don't have time to go deeply into the books and to research all the moves of a company.

[Kerim]

(08-24-2014, 10:45 AM)Robandcindy2 Wrote: What had me in this train of thought was seeing some "red" I didn't expect to see in our portfolio.

Some red in the short term should not cause too much worry -- all it means is that you can buy a little more and average down your cost per share. Accumulating shares in a good company at a good price can take a nice long time.

For example, I bought my first shares of TGT when it was at about $71, and even though it has fallen a lot since then -- in the "red" for me -- I've continued to buy. I've gotten shares for as low as $57.30, and my average share price is now around $62. If it hangs out below $60 (still in the red for me), I'll keep adding opportunistically. It may take a few years before the company rights itself, but it will, and when the stock eventually climbs back into the $70s and $80s, I'll be happy that I did. Am I sure it will work out this way? Nope. But I am confident.

It was the same story with JNJ a few years back. All the talk was about recalls and lawsuits and how JNJ was finished. Meanwhile, I piled up shares at an average price of just over $60. They eventually righted the ship, and now shares are over $100. The short-term "red" period was an opportunity, not an indication that I had made a mistake.

MCD is another name that might fit this bill these days.