Let us understand that due diligence is different from taking a valuation call on a stock. It is also different from deciding whether the stock is attractive or unattractive. Due diligence is all about a checklist of items which you must finally tick off before deciding on a stock. You can do a due diligence before selecting the stock but that becomes too vast and laborious and hence ineffective. Alternatively, you can do the due diligence after the stock has been identified and analysed and before making the final buy decision. That is more effective in practice. That brings to the question, how to do due diligence on a stock and what are the items to be checked off? Remember, you need to due diligence of a stock the same way as you would do due diligence before buying a business. Let us also understand the due diligence process steps to be ticked off..
1. How clean is the company’s balance sheet?
This is an important part of the check list. When we say balance sheet, we look for red flags in all the three financial statements. Are the company’s profits coming predominantly from operations or from other income? Does the company have a very long debtor cycle? Is too much of working capital locked in inventories? Are the cash flows from operations taking care of a substantial portion of the capital spending required? These are some of the basic questions that will form part of your due diligence check list.
2. Does it have risks in the form of contingent liabilities?
We all know what happened to Enron back in 2001. The company had huge derivatives positions which were not reflected in its balance sheet. These contingent liabilities were not adequately provided for. When the price of their power contracts moved against them, their entire capital got wiped out. PNB is a more recent case right here in India. It had huge contingent liabilities in the form of LOUs issued to diamond merchants which created a $2 billion hole in the balance sheet when they defaulted. These are clear check list risks.
3. Can the company sustain its competitive position in the industry?
Has the company created a moat which gives it a unique positioning in the market? We all saw what happened to Nokia between 2007 and 2012. In a span of just 5 years since the launch of Apple I-Phone and Samsung Smart phones, Nokia went from a telecom giant to the verge of bankruptcy. That is what happens when you are not able to sustain your competitive advantage because you never bothered about creating a moat.
4. What are the off-balance sheet borrowings of the company?
This is indirectly related to the second point because off-balance sheet items basically amount to borrowings which are not reflected in the books of the company. For example, the company could borrow through a group company or subsidiary and then the funds would be getting routed through inter-group transfers. While the company is getting the benefit of the funding, it is not showing the money in its balance sheet and to that extent it is overstating its Return on Capital Employed (ROCE). Leases are also an example of understating your actual borrowings. Such companies are best avoided even if they appear to be attractive in valuation terms.
5. Check what the proxy advisory firms are talking about the company
These are the new breed of firms that focus on shareholder activism. They normally have a counter view in cases where they believe that shareholder views and interests are being compromised. While their views may not have legal sanctity, they give a good idea of how the company is adhering to standards of transparency and corporate governance.
6. What are the governance standards and are there conflicts of interest
What do we understand by governance? It reflects whether the management of the company is acting in the larger interests of shareholders. If the interests of the management are not aligned to that of the shareholders then we have a governance problem. We have seen such cases so often when companies borrow recklessly just to avoid diluting equity. In the process, they expose their shareholders to substantial financial risk.
7. Has the company’s ROE been growing consistently?
The best sign of a robust growth company is to check that the ROE is growing. The return on equity (ROE) shows what the company is earning for its shareholders. As long as the ROE is higher than the cost of equity, the company is creating value for its shareholders. That is why a rising ROE trend is very important in case of companies. ROE reflects two things viz. the profitability of the business and the efficiency of utilization of assets.
8. How does this stock fit into my long term financial goals?
This is the last but, probably, the most important question that you need to check off. Everything is great but the key question is if it really gels into your long term financial goals. If it is adding to your risk or increasing your equity concentration risk then it has to be clearly crossed out.
The equity due diligence check list is a kind of a final sign off document which ensures that after all the research is done you actually take a second look at the key aspects. It helps to make your investment decision process more refined!