Four Pillars mused recently that we (the blogging world, authors, financial institutions, television personalities etc.) throw around the term “due diligence” a lot as a “cop out” (or prudent litigation proofing depending on your point of view) after extolling on the virtues of a certain investment. To paraphrase Four Pillars, the term “do your own due diligence” is like a great movie with an utterly bad ending; after this massive build up, it ends with a let-down. I am just as guilty, if not more so, of using the term “do your own due diligence” without explaining what exactly that means or how one goes about doing so.

First of all- what is due diligence? In its simplest terms, due diligence is doing your research and investigation and determining what someone says about something is true. Is this actually a good stock? Should you lend money to someone?Is this house a great investment?

We all do due diligence every day of our lives. For example, you are thinking of hiring someone at work. They claim on their resume that they went to Harvard, graduated at the top of the class, worked at Acme Consulting Inc. and have references from noted leaders in your industry. They sound like a perfect candidate but you wouldn’t hire this person without checking up on their claims would you? Most employers would ask for university transcripts, call the Harvard alumni registry, check up with Acme Consulting and call the references. We call this “reference checking” but this is due diligence (in the broadest sense of the term) just in the HR context.

In the investing world, due diligence primarily concerns whether the financial numbers can support the claims made or valuations given for stock, real estate or a business. On an non-exhaustive basis, here are some typical types of investigation one should make before buying typical investment products:

STOCKS

• What does the company do? Does it do it well or poorly? Is it an industry leader or just another competitor?
• Where does it do business? Is this a safe jurisdiction or are there a lot of risks doing business in that jurisdiction?
• What is its stock price compared to its peers? If it is higher than industry average? If so, why? Is it because it is the undisputed leader in the field or is the price high because of some one time event (i.e.  is it being bought)?
• I always like looking at the statement of cash flows, especially cash flow from operations (i.e. cash it makes from operating the business rather than from its investments). Is it positive? If so, for how many years? It is harder to fake cash; earnings can be manipulated.
• If you are investing in a dividend yield stock, how much of its profit is being paid out as dividend (aka the dividend payout ratio)? Does the company consistently increase dividends? Is there cash on hand to pay the dividend (see my above question about cash flow from operations)

This all sounds very daunting and, frankly, a lot of hard work but most financial websites will now summarize a lot of this information for you rather than reading through hundreds of pages of the financial reports.

MUTUAL FUNDS

• What is the mutual fund’s fundamental objectives? Growth or capital preservation? Does this match your goal?
• What does this mutual fund actually buy? Are they good companies or bad?
• How does this mutual fund perform compared to mutual funds in a similar category?
• What is the mutual funds management fees? Are they higher than lower than other mutual funds in the same category?
• How long has manager of the mutual fund been with the fund (on the assumption that the longer the tenure, the more likely it has performed well)?
• What restrictions are there on selling the fund? Do you have to hold on to it for a period of time?
• What is the investment advisor’s compensation for selling you the fund?

Most of this information is summarized in a mutual fund prospectus which is a disclosure statement required by law to be given to you. Please read this before you buy a mutual fund even if your advisor thinks this is the greatest thing since sliced bread. Most web-sites will also compare mutual funds in the same category.
REAL ESTATE

• Bring your own contractor with you (not your real estate agents) when you see a house, ask them about the house and how much it would cost to fix the deficiencies in your home. Don’t cheap out on this part. Get a true estimate of how much it would cost to bring the house to your desired level of livability.
• Try to meet the vendors of the house- do they look like they kept up the house (for example, if the vendors are in their 90’s, chances are they don’t have the physical capacity to maintain the house in the last few years)?
• Look at the historical pricing for similar sized homes in the neighborhood- is the house listed above or below historical pricing? If it is below, ask why- is there something wrong with the house or has it been priced for a bidding war?
• Is this a safe area? How is the local school rated? Your insurance agent can implicitly tell you if the area is safe or not by the insurance rate they quote you.
• If this is an investment property, conduct a true financial analysis of the costs of upkeep including items such as property tax, utilities (if it is included in the rent), upcoming maintenance issues (which is why you bring a contractor with you), local by-laws (i.e. how many tenants can you put in the house or is the duplex a legal duplex) and compare with rental rates in the area.

Your real estate agent can help you with a lot of this research (make them earn their commission!).

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Effective due diligence is equivalent to being a 7 year old kid. Keep asking “why, why, why” until you get the answers. Drill down into someone’s claim until they can substantiate it. It is not that difficult of a process just a lot of hard work. Good luck.