Just Due It

If I had a nickel for each time I included the words "do your own due diligence" in one of my pieces . well, I'd have a lot of nickels. It's a good generic suggestion, and I most often mean something like "Don't just take my word for it -- investigate for yourself and see if you reach similar conclusions."

Since we at The Motley Fool have a wide range of readers, it's high time to give a little attention to what exactly constitutes due diligence. Different investors will have different needs and expectations, but I hope to offer a general guide that can get most investors on the right track.

The first steps
First of all, you should do enough research to really know the company's business. This means knowing not only what it produces, but how those products are made, the customers and competitors, and the company's major risks. That might sound simple, but you'd be amazed how many times I've seen people buy into mining companies with no mineral rights, biotechs with no drug candidates, or e-commerce companies with no profits, no customers, and little prospect of either.

It's also important to learn as much about management as you can. Obviously, no company filing will ever say "Our CEO is a crook." There's no surefire way to separate the next Starbucks (Nasdaq: SBUX  ) management team from the next KrispyKreme, or the next Dell (Nasdaq: DELL  ) from the next Gateway.

What you can do, though, is use the available info to make some judgments. If you find that the CEO has a history of promotional pump-and-dump penny stocks, do you really want to bet that this time will be different? You can also watch for related-party transactions, to see if management is lining their pockets (or those of friends and family) at shareholder expense; examine stock option policies; and see whether the management has stacked the board with family members or marginally qualified friends.

Last but not least, due diligence means knowing a company's relevant numbers. You don't need to memorize third-quarter revenue or last year's cost of goods sold, but you should gather important details like margins, capital structure, and returns on assets, equity, and capital. These numbers are readily available on many investment-oriented websites, and we can show you how to calculate most of them yourself.

Where to begin
As investors, we're all lucky to have systems in place in the United States that require publicly traded companies to divulge much more information, more frequently, than in many other countries. Once every three months, you're guaranteed a look at Pfizer's (NYSE: PFE  ) balance sheet, income statement, and cash flow statement. Not so with Roche -- a fine company in its own right, but one that isn't subject to the same level of mandatory disclosure.

A fair amount of all the information you'll ever need as a shareholder can be found free of charge at the SEC's EDGAR website. Be warned, though -- there's a shorthand here that can be a little intimidating for newcomers. Here's what you need to know:

  • 10-K-- annual report: This report will not only have the financial statements for the full year, but also a reasonably detailed summary of the company's business operations, risks, and accounting policies.

  • 10-Q-- quarterly report: Not as complete as an annual report, it will still include financial statements, and more details about financial performance than may be included in press releases or conference calls.

  • 8-K-- report of a material event: If something big happens to a company, they are required to file an 8-K. While these are often just repeats of press releases, every once in a while you'll find a nugget of information that wasn't delivered to the press.

  • DEF-14A-- proxy statement: Want to know who's on the board and how much stock they own? Want to know how much the CEO makes, or what kind of options the company gives out? This is the place to look.

  • S-1 -- prospectus: Filed by companies before share offerings, these forms somewhat resemble 10-Ks. They generally have detailed information about the business and its finances.

Company annual reports can also tell you a lot about a business. These are different from the SEC-mandated 10-K's, though many companies will simply just tack a letter from the CEO onto the 10-K and call it a day. When you read these reports, ask yourself: Does management openly and objectively address its accomplishments and deficiencies, or is the report an exercise in excuses and self-congratulation? I don't often find much information in these glossy reports, but sometimes you learn a lot about management by reading between the lines.

News is also an important part of information-gathering. Company websites will almost always have an archive of company-issued press releases, but various financial websites like The Motley Fool will also offer other industry information, commentary, and analysis.

Next steps
For most investors, the library can be an invaluable resource in conducting due diligence. In addition to providing books on various industries and academic topics like competitive strategy, many libraries also subscribe to services like Value Line that can be invaluable in getting up to speed on a given industry and/or company. Magazines and trade journals can also be important resources, and many public and university libraries subscribe to a wide breadth of them. Do you need to read every month's copy of Beverage World before investing in Coca-Cola (NYSE: KO  ) ? Of course not, but it can help if you're considering a stock in an industry that you don't know so well.

Last but not least, the Internet can be an excellent source of information. I particularly like to search out industry association websites, as they often have good statistical information readily available. There are also plenty of investment-oriented websites that provide all manner of information and data for your due diligence needs.

Final steps
Although most people probably wouldn't think of valuation as a part of due diligence, I'd argue that it's an inseparable part of the process. It's all well and good to understand Tyco's (NYSE: TYC  ) many and varied business units when calculating its return on invested capital, but unless you have an idea about what constitutes a bargain price for the shares, your work isn't done.

There are plenty of ways to value stocks. Eventually, I'll write an entire column about it. What I'll say here is that it's important to play around with your assumptions a bit. It's easy to get revved up about a stock and plug optimistic numbers into a valuation model. But make sure you also knock 10% or 20% off your key assumptions, just to see what happens.

It is also important to consider how a given stock would factor into your overall portfolio. If you own 12 stocks, and two of them are Pfizer and Merck (NYSE: MRK  ) , you might want to carefully consider whether or not the addition of Novartis (NYSE: NVS  ) would unbalance things too much.

This same concern should extend to risk as well. Even allowing for differing risk tolerance among investors, it's still wise to make sure you're not overstuffing your portfolio with sleepy fuddy-duddies or hair-raising fireballs.

The Foolish bottom line
Hopefully, we've helped to show you how to do more thorough due diligence on your own. But don't fall into the trap of thinking that it's just a one-time exercise. Companies are almost like living creatures, changing over time, which makes due diligence more of an ongoing process. Prudent investors stay on top of their companies' changes and adjust their holdings accordingly.

Fortunately, you don't have to do all of the work by yourself. We at The Motley Fool offer dozens of articles and columns on investments and investing strategy every day. We've also got message boards manned by experienced investors who are more than willing to help out newcomers. And don't forget our suite of investment newsletters, either. Want help finding a great mutual fund? Are you a value hound, or a fan of the aforementioned fireballs? We've got you covered. Take one of our newsletters for a test drive, and see if it can't help round out your suite of due diligence tools.

Dell is aMotley Fool Stock Advisorrecommendation. Pfizer, Tyco, and Coca-Cola areMotley Fool Inside Valuerecommendations. Merck is aMotley Fool Income Investorrecommendation.

Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).


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