How To Do the Best Due Diligence When Buying a Stock

Let’s face it, we’ve all been guilty of buying a stock without doing complete due diligence, aka DD. I know I’m guilty of it. There are countless other investors with various amounts of experience that buy Apple and Amazon companies before realizing too late that earnings were around the corner.

We find out the hard way that we should have waited.

Doing the best due diligence possible reduces surprises. Notice I used “reduces”. Even GM was caught off guard by Citron’s report and then later Hindenburg Research (read report) on Nikola Motors.

An old friend, former corporate GM employee, invested in Nikola & held the stock after the report. His reasoning was GM invested 2 billion & was still in it. He explained that Nikola would bounce back.

They did not. Nikola’s stock plunged further in late November when GM pulled the plug on the deal.

There are things we can’t foresee. No matter how much planning and research we do. However, when you’re buying a stock, you can reduce your exposure to risk by doing the best due diligence you can do and feel good about a stock, even if there is a pullback.

 Doing the best due diligence possible reduces surprises. Notice I used “reduces”. Even GM was caught off guard by Citron’s report and then later Hindenburg Research (read report) on Nikola Motors.

Scratching the Surface of a Stock with Due Diligence

When evaluating the stock there are a few things you can do right off the bat fairly quickly. However, we can all get through all these quickly with a little repetition. Some of these tasks may be easier than others for you. However, the more difficult ones should be done or at least given some thought.

These are in no particular order.

Visit the company site. Understand what they do

If you can’t explain what the company does in less than 30 seconds then you probably shouldn’t invest in it.

Read their Wikipedia. Learn about the company's story

Sometimes you can find some controversy about the company. If you check Nikolas Wiki, it explains they were under investigation by the SEC in the 2nd paragraph.

Use tools for research

Koyfin.com – Koyfin is an indispensable free tool that has a lot of information in one place. This is where you can find the company’s fundamentals. Some investors value some metrics more than others. Find out which metrics are most important to you.

Fiviz.com is another one that lays out all the important information in a table.

Datatoma.com – It’s always good to know what the institutional investors are thinking and then following the money. Dataroma shows the information on what the “super investors” are holding. It also shows a lot of other valuable information, like insider trading too.

Seeking Alpha: Latest Analysis

Seeking Alpha is a great resource, but it’s not free. 3 articles are, after that they require $30 a month. That being said, you should try to check out any recent stock analysis written.

Reading the 10k and 10Q

There is a lot of  information in the annual 10-K report. You can find the risk factors, legal issues, the numbers and financial notes. The 10-Q report is quarterly. It discusses similar issues as a 10-K but allows investors to see how a company performed compared to the previous quarter, among other things.

Reports can be over 150 pages. Also, it can be difficult for many to know what to look for. Below is a clip of how to efficiently examine a 10-K report.

Company Risk

Understanding the risks the company faces is important. When a company wants to sell cars, but doesn’t have a car on the road, it’s nearly impossible to evaluate. Then there are the legal issues, competition, growth and of course, cash. Finding out the risks will help you make better decisions on a stock.

What is your circle of competence?

The circle of competence is a model developed by legendary investors Warren Buffett and Charlie Munger. It’s essential how much an investor understands the company’s business. When you are within your circle of competence, you avoid issues & risks while clearly identifying and understanding opportunities.

Of course, broaden your circle by reading and understanding. Ask yourself if you know what the market doesn’t. Perhaps more importantly, does the majority of the market understand the risks more or less than you?

At what cost?

These days it’s not uncommon for a stock to have insane P/E ratios. Companies won’t make a profit for years, but are valued high. Remember, the stock market is forward looking. It’s looking for the next big thing.

That being said, there are several ways to calculate a stock. Using P/E ratio, PEG, P/B, & FCF. You can check out this article to understand each one.

Diving Under the Surface of a Stock with DD

The next series of questions can be done relatively quickly in your head or with quick online searches.

Ask yourself:

  • Is this company within my Circle of Competence?
  • Do I understand what the company does when researching what they have in the company pipeline?
  • Do the people who told me about the stock, positive or negative information, benefit from me making the decision they want?
  • Explain what the company does in a few sentences.
  • What are the economic cycles, if any, of the industry?
  • What are the challenges of this industry?
  • How will the company grow & scale in the future?
  • Will the stock peak within 5 years? 10?

Understanding the Companies Moat

Jeff Bezos silently (and brilliantly) built one of the largest moats in his industry. In 2006 he started AWS (Amazon Web Services). His version of cloud computing. Microsoft debuted Azure in 2010. In 2011 Apple debuted iCloud for its customers. However, Bezos & Amazon did not advertise Amazon Web Services much, they were busy building a moat around his business model.

AWS is the largest infrastructure of servers in the world that host Netflix, Air BnB, and Disney+ (source).

  • Does the company have a moat?
  • Will it be difficult to compete with this company?
  • What are the Big 4 Growth Rates? Net income, sales, operating cash, and book value.
  • Are they increasing or decreasing at a faster rate quarter per quarter?
  • Does the company have cash?
  • How did the company fare during Covid-19 and other catastrophic periods for the market?

Understanding the Company's Leaders

We’ve seen Tom Brady completely change a franchises culture. CEO’s, COO’s, CFO’s and other leaders in a company are equally important. They set the company culture.

  • What are your first impressions when management speaks candidly?
  • Does the CEO have a good reputation among his peers?
  • Does management discuss company matters freely no matter what the situation is?
  • How are the employees’ satisfaction in the company?
  • Is the CEO on social media?
  • Does the CEO speak about political matters? (hint, not good)
  • Are company insiders buying shares?
  • Does the company have a lot of debt in comparison to its competition? If so, how long would it take to pay it off?
  • Does the company plan to reduce its debt anytime soon?
  • Do the Return of Invested Capital and the Return of Equity numbers look good?

Conclusion

There are many questions to ask when investing in a company. Many people have different ways of understanding the company and if they are worth the stock price.

Knowing the answers to these questions will give you a clear understanding of what the company is about, which will make you much wiser, and provide more confidence as an investor in the company.

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