4 Benefits & 7 Ways to Conduct Due Diligence in Picking Stocks

By Chika

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Last Updated: October 27, 2021

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With so many people professing their genius on stock investment on social media, it can be challenging sifting through the mountain of chaff to get the substance.

Most people now view the stock market as a get-rich-quick scheme where millionaires are minted every day. There are countless stories about people buying into meme stocks or penny stocks and making a huge profit. 

Unfortunately, getting rich quick in stock investing is akin to hitting that lucky jackpot. A lot of people have had their portfolios blown to smithereens because of poor financial advice.

Investment, like any serious venture in life, requires personal responsibility. Since you are putting your money at stake, it is only appropriate that you take out time to understudy the company that you want to invest in.

One way to go about this is by conducting due diligence. This not only helps you understand the company better but also enables you to avoid bad financial advice exemplified by poor stock picks. 

So what is due diligence and how can investors use it to pick the right stocks? The following sections shed more light on this subject matter.

 

What is Due Diligence?

Due diligence refers to using financial metrics to evaluate a company to know the fair value of its stocks. It entails looking at a business’ operations, how it makes its money, how it stands in the market in relation to its peers and taking into consideration the effect of the economy on its long-term performance.

An investor who engages in due diligence is like a detective, looking for clues or facts that would help in solving a crime, or in this case, helping to know which stocks (investments) are worthwhile.

These clues or facts are usually contained in financial materials such as financial records, past company performance, management style, product ecosystem, quality of management, or industry forecast. 

Read this next: Maintaining Your Investing Strategy in Times of Turmoil

 

4 Benefits of Due Diligence

3. It helps in the proper valuation of stocks.

Perhaps, the most obvious benefit of due diligence is that it enables you to know the true value of a stock.

  • Value is different from the stock price.
  • Price indicates what the stock is trading at the moment.

On the other hand, value tells you what the stock is worth. A stock may have a low value, but a high stock price and vice versa. By conducting due diligence, an investor can identify stocks that have been mispriced and make profits from them.

For example, if he discovers that a stock with high value is priced low, investing in such a stock increases the propensity for making profits. 

2. It prevents one from making hasty decisions.

Conducting due diligence prevents an investor from making a hasty decision.

The market is always fluctuating and reacting to the news. Sometimes, these reactions are without a fundamental basis, and most likely an effect of a herd mentality. An investor who has conducted due diligence on a stock is less likely to react to market moves in the way other investors do.

Because the true value of the stocks is known, it is easier to zoom out and see if such news affects the fundamentals of the stock or it is just market noise. They enable them to make better investment decisions and the knee-jerk reactions that are commonplace in the stock market.  

3. It improves understanding of the business.

Due diligence enables you to understand a business in toto.

You would know how the business makes money, its operational challenges, market forecast, and how policies can affect or help the business. Knowing this enables you to know the true value of the stock and make appropriate investment decisions.   

4. It reduces portfolio risk.

One of the most viable ways of reducing investment risk is conducting due diligence.

This is because due diligence helps to filter out low-value stocks which may pose a great risk to your portfolio, thereby increasing your probability of incurring a loss. 

 

7 Ways to Conduct Due Diligence

1. Go through financial records.

One way to conduct due diligence is going through the company’s financial records.

This entails looking at its:

  • Quarterly report
  • Annual financial reports
  • Guidelines
  • Forecasts, etc.

This would enable you to ascertain the financial capability of the business. You would understand if the business is profitable or keeping its head above water with loans.

Financial records also allow you to compare past performance with the present one, which you can then use to project its performance in the future. 

2. Financial ratios.

There are a plethora of financial ratios which money managers use to evaluate stocks.

Metrics such as P/E ratio, DTI ratio, dividend yield, free cash flow, amongst other financial ratios are used to know how investable a stock is. These financial ratios act as signs to look out for to know if a company’s stock is a good investment or not. 

3. Understand business cycles and macroeconomics.

You don't need to have a degree in economics to understand business cycles or evaluate how the macroeconomy affects a business.

Some sectors and businesses have seasons or operate in cycles. Some businesses experience increased revenues during certain periods than others. 

For example, during the holiday season, airlines, hotels, and tourism experience increased revenue because a lot of people would be traveling. As such, investing in such sectors before the holiday season and trimming your position when the holidays are over is a viable strategy.

In the same vein, in periods of rising interest rates or inflation, sectors such as financials and real estate would fare better than sectors such as technology. 

The key is identifying how sensitive a sector is to the economy. Some sectors perform well when the economy is growing (i.e. people are spending money), while there are sectors that perform well even if the economy is down.

Having an idea of the business cycle and macroeconomy can help form your investment thesis on a stock. 

4. Industry forecast.

When conducting due diligence, it is appropriate to factor in how the industry would fare in a decade or two from now.

The proliferation of technology is altering the way industries and businesses conduct business. As such, many businesses would be affected by the change positively or negatively. 

When conducting due diligence, identify which sectors would profit from the change and position yourself accordingly, while you should reduce your position in sectors that you believe would not do well.

For example, the push for sustainable energy implies that there would be less emphasis on fossil-based energy stocks and more interest in renewable energy stocks. 

5. Government policy.

One aspect to consider when evaluating industry forecasts is government policy.

The policy from the government can make or mar an industry. Because it shows which areas or sectors that the government hopes to increase spending or encourage investment in.

For example, the push for infrastructural development by the Biden administration is a green light to the industrial and manufacturing sectors. 

6. Analyze the competitive advantage.

  • How does a company fare when compared to its peers?
  • What size of its market does it control?
  • How are its products performing in the market?

These are some of the questions that would pop up when you try to analyze the competitive advantage of a business. Just because a sector is doing well, does not automatically imply all companies in that sector would perform well.

You have to get into the nitty-gritty to know the company’s products, marketing strategy, supply chain channels, etc. try to look out for whatever gives the company an edge (or lack of it) over its competitors. 

7. Quality of management.

The quality of the management is one factor that most investors overlook when conducting due diligence.

The management determines the strategic approach of the company and what direction the company intends to take to achieve sustainable competitive advantage.

There are numerous cases where companies have gone under due to poor management. There are also cases where companies have been revitalized due to a change in management which brought about a new focus and direction. 

For example, in recognition that it can no longer compete in the mobile phone market, Blackberry has changed its focus to cybersecurity services.

In the same vein, Netflix, in recognition that newer players in the streaming business would reduce its market share is now entering into new markets such as toy merchandise and games.

The quality of management determines how well a business can reinvent itself and remain relevant in the face of aggressive competition. 

 

Key takeaway

Due diligence is simply taking responsibility for your investment decisions.

Rather than depending on the advice of others, you are taking the bull by the horns by searching for a company that would be a worthwhile investment. It is a painstaking process, but a very rewarding one!

You may not get all the knowledge at once. But if done consistently, it would improve your understanding of stocks and make you a better investor.

Photo by cottonbro from Pexels

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