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What's your due diligence process?


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I'm not sure if anyone has asked this but I was just wondering what everyone's due diligence process is.

 

For me personally, I usually read the last few 10-Ks, read the latest 10-K of the company's competitors and then read some research reports to round things off and to see if I was missing something.

 

 

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I try to do as much research outside of what is presented in the sec filings as possible. Google goes a long way, as does talking with company sales reps and wholesale/retail distributors. Then I pretend I'm a customer of the industry and see if I would use the company vs a competitor, and why. Supplement that with the Ks/Qs/proxy and conference call transcripts and I think it's a decent approach. I also run through a checklist to make sure I haven't missed anything obvious. My checklist combines fisher, buffet and munger, and then all the reasons past investments of mine failed.

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I try to do as much research outside of what is presented in the sec filings as possible. Google goes a long way, as does talking with company sales reps and wholesale/retail distributors. Then I pretend I'm a customer of the industry and see if I would use the company vs a competitor, and why. Supplement that with the Ks/Qs/proxy and conference call transcripts and I think it's a decent approach. I also run through a checklist to make sure I haven't missed anything obvious. My checklist combines fisher, buffet and munger, and then all the reasons past investments of mine failed.

 

How long does it take you to complete your research?

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I always try to read write ups, blogs etc first. Usually get most of my ideas from other people, that seems to be the most efficient way.

 

Then i do stuff like type industry name followed by 'filetype:pdf' or 'forum' in google. Then I read a bunch of annual reports, look for red flags etc. Read competitor's reports, and i try to read a bunch of quarterly call transcripts on seeking alpha. Sometimes management gives interesting perspectives on the industry there.

 

Then I put all numbers in excel, see what cost structure is compared to competitors, if margins are increasing or decreasing. How cyclical they are. See how they did in 2008-09.

 

When available I read some books from amazon on the industry as well. They can be extremly helpfull if they are available.

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It depends on the size of the company, if it is a popular large cap like AIG, I hardly read 10ks at all. I skimmed through the last 10k a bit. Insurance companies are very tough reading. But it was mostly from reading blogs like seekingalpha, Berkowitz's Faireholm Fund writeup ppt, morningstar evaluations.... There is nothing I can find from 10hrs of reading that others have not found already. especially since it was post-2008

 

 

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How long does it take for you guys to read a 10-K.

 

It takes me around 5-6 hours to read the whole thing with taking notes and I find that whenever I start reading into the notes and stuff comes up about pensions and interest hedges and what not, I just lose interest immediately and just want to go to sleep haha.

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How long does it take for you guys to read a 10-K.

 

It takes me around 5-6 hours to read the whole thing with taking notes and I find that whenever I start reading into the notes and stuff comes up about pensions and interest hedges and what not, I just lose interest immediately and just want to go to sleep haha.

 

1 hour for straight forward companies 2-3 for more convoluted ones. In full disclosure, I do not read every single word. I mainly focus on risk factors, industry dynamics, and enough context on the business to understand the financial statements.

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How long does it take for you guys to read a 10-K.

 

It takes me around 5-6 hours to read the whole thing with taking notes and I find that whenever I start reading into the notes and stuff comes up about pensions and interest hedges and what not, I just lose interest immediately and just want to go to sleep haha.

 

This is why I don't invest in large cap companies.  So many small caps have annual reports that can be read quickly.  If it's taking me an hour to read an annual report I'm not going to be investing in the company most likely.  I've invested in companies where I can read 10 years of financials in an hour.

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How long does it take for you guys to read a 10-K.

 

It takes me around 5-6 hours to read the whole thing with taking notes and I find that whenever I start reading into the notes and stuff comes up about pensions and interest hedges and what not, I just lose interest immediately and just want to go to sleep haha.

 

This is why I don't invest in large cap companies.  So many small caps have annual reports that can be read quickly.  If it's taking me an hour to read an annual report I'm not going to be investing in the company most likely.  I've invested in companies where I can read 10 years of financials in an hour.

 

+1

 

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Here's what I mean when I talk about short.  I "researched" AS Company tonight.  They're a Greek toymaker selling at 50% of BV.  I've attached their annual report, it took about five minutes to read the whole annual report.

 

Someone will reply that there isn't enough information to make an investment decision.  That's possible for some, but for me value investing is a form of quick handicapping.  I'm trying to buy where the odds of something better are higher than the odds of something worse.  At 50% and below of BV the information I need to make an investment decision starts to diminish greatly.  A retort to this is that you have to cycle these things, I agree.  There are 2,000+ net-nets worldwide, that's plenty of ammunition for a portfolio!  A second criticism is these don't grow or are bad businesses.  I agree, there is no pride in owning a Greek toymaker.  But there's the thing, the lower the valuation the less something has to work for a fantastic return.

 

I own a company at 15% of BV, there's an awesome bear case against them.  Peers are trading at 80-100% of BV.  Sure, maybe the company I own isn't worth BV, but is it worth at least 30% of BV?  If so that'd be a double. 

 

Figures_and_Information_for_the_period_010113_311213.pdf

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  • 3 weeks later...

One thing to add would be looking at management.

 

Look at where they have been in the past and - if possible -  read some annual reports from that time. Look at what they promised and what they delivered. Over the long term stock performance can be an indication of value creation. Compare the stock performance to competitiors (maybe the industry is just doing well as a whole). Give it some context (Fincial crisis is not the CEO's fault...).

 

I wouldnt rely too much on mainstream media to research CEOs. They hype people that turn out to be bad and miss the big winners.

 

I also find it useful to maintain a watchlist of great CEOs. It might reveal a great investment opportunity when they start at a new company.

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I always read letters to shareholders and conference call transcripts: that’s where you can find the most qualitative information about a business: both its model, if it is predictable enough or otherwise, and its management, if they are and behave as owners.

 

If I like what I see from a qualitatively point of view, I start looking at numbers: usually I look at the three financial statements, the Income Statement, the Balance Sheet, and the Cash Flow Statement.

 

If then everything is clear to me also from a quantitative point of view, I invest… always leaving some room to average down.

 

If, on the contrary, I have some doubts about the numbers, I scan the Notes to the three financial statements, searching for some answers. How long it takes me to find those answers obviously depends and might vary a lot.

 

Usually, I am the most comfortable when I find a company that has passed all my qualitative requisites, and also presents financial statements that speak for themselves. :)

 

Gio

 

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I invest mostly in Asia so getting hold of a lot of the qualitative information that Gio talks about is much harder. Rather, I've devoted a huge amount of time not in finding whether management is great, but whether they can be trusted. Lots of time spent at looking at the books and the footnotes to find suspicious transactions to see if they are looting the company.

 

Cheers!

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I also find it useful to maintain a watchlist of great CEOs. It might reveal a great investment opportunity when they start at a new company.

 

This is very interesting: though I don’t keep a physical watchlist, probably I have one in my head! ;)

 

Cheers,

 

Gio

 

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I always read letters to shareholders and conference call transcripts: that’s where you can find the most qualitative information about a business: both its model, if it is predictable enough or otherwise, and its management, if they are and behave as owners.

 

If I like what I see from a qualitatively point of view, I start looking at numbers: usually I look at the three financial statements, the Income Statement, the Balance Sheet, and the Cash Flow Statement.

 

If then everything is clear to me also from a quantitative point of view, I invest… always leaving some room to average down.

 

If, on the contrary, I have some doubts about the numbers, I scan the Notes to the three financial statements, searching for some answers. How long it takes me to find those answers obviously depends and might vary a lot.

 

Usually, I am the most comfortable when I find a company that has passed all my qualitative requisites, and also presents financial statements that speak for themselves. :)

 

Gio

+1, also if they have like publicly traded bonds or something, look for presentations on that. Usually they go more in dept then  the average annual report on the business model.

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I don't have a consistent DD workflow. It really depends on the business and how well I understand it. Usually, once I have an idea, I try to figure out what the heck they do. Could be "business of the company" in a 10K or a website, or a call to customer service or sales or whatever.

 

IF (and only if) I can get a feel for the sort of business they're in, I try to get a feel for how they do it, how they measure themselves, and how they reward management. Usually start with ARs/10Ks going back a few years to get a feel for a business in transition (which is my primary interest), then presentations, check VIC/Distressed Debt/CoBaF/etc. for writeups, then conference calls of the past year or so.

 

IF (and only if) after finishing the above I have an idea what the two or three most important factors are going to be for valuing the company 2-3 years out, I'll try to value it and test my assumptions under very punitive scanarios.

 

I probably get a bit deeper in than most, but I really like trying to figure out what makes businesses tick. I take the 5-8 positions theme seriously, so my historical max position was ~40%, and a minimum investment is around 10%. Hey, after doing all this work, I want to get paid for it!

 

Luckily, it's my full-time job. Last year made a total of two (almost- one was just a shift in investing in the same co's capital structure) major new investments.

 

Probably the most important part of my DD is a two-week-or-so hemming-and-hawing period in which I pace back and forth in my office and try to talk myself out of investing. Usually it works. Has saved me a lot of pain. Also, helps me sleep better after having taken a position knowing I exhausted my arguments against it and have committed to playing the odds (whatever they may be).

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Probably the most important part of my DD is a two-week-or-so hemming-and-hawing period in which I pace back and forth in my office and try to talk myself out of investing. Usually it works. Has saved me a lot of pain. Also, helps me sleep better after having taken a position knowing I exhausted my arguments against it and have committed to playing the odds (whatever they may be).

 

+1! ;)

 

Gio

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If i come up with an idea i first look at the 10y overview of the business numbers. If i like what i see, it mostly depends on where the idea comes from. When its a clone from Buffet or Prem i rarely read a business report or SEC filing, because i doubt that i find something that they have not. Only with my own ideas i start reading annual reports, news headlines and search for articles to get a feeling what is going on with the company.

 

When i am comfortable with the idea i put it on my watchlist where i track the company and the projected annual forward rate of return, that gets automatically updated when the price changes. I always sort them by my fror and then look at the charts of the ideas with greater than 20% return and compare them with what is in my portfolio.

When there is an idea on my watchlist with double the return of the worst stock in my portfolio i search for an entry point and make a switch. (The last point is theory, in praxis i switch more often and use technical analysis to find good switching points.)

 

I still make a lot of mistakes, but i write them down to avoid making the same mistakes a second time. (That was the last addition to my process.)

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My quick screens is to look for stable gross margins and high ROIC for at least a business cycle or two. Then I quickly read what the company does and think of a mental model for it. This helps with visualizing how the company functions in its particular ecosystem. Next I quickly run through Porters Five Forces of competitive advantage to see how I can compete/kill the company.

 

95% of the companies I look at fail that last check. For those that remain I go through the filings and see how management speaks about the business and see if they admit mistakes from past acquisitions. I try to see if GAAP income converges with my FCF estimates over a business cycle or two. You learn a lot by doing this... very surprising how some companies are spot on whereas others are miles apart (massive red flags).  If everything checks out I'll throw it on my shopping list with a rough estimate of what I think it is worth. Most of the time these companies are trading at high valuations... shouldn't be a surprise.

 

I figure if you build a list of about 50-100 companies you really understand and know then all you have to do is play the waiting game. Usually you are waiting for a recession, some institution investor puking shares for whatever reason or some bad headline news/scandal that won't impact the company long term, but will freak out investors short term. I assume there's a 1% chance (probably too low) of something happening that will create a superior buying opportunity in any given year for a company. With 50 - 100 companies that you are tracking this creates decent odds you can deploy capital about once a year.

 

Oh yeah I also keep a journal whenever I purchase something and record why I am buying it and my state of mind. It's really interesting going back and seeing how off basis you can be, hah.

 

 

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How much value do you guys place on equity research reports?

 

I occasionally find them helpful in learning about a business I'm unfamiliar with. Sometimes weird metrics, legal analysis, or commentary can help me think about the business in a good way. And sometimes it helps for me to check my work against when I disagree. Nothing is as much fun as a report coming out that knocks down a core holding ~10% which, upon closer analysis, is severely flawed in one way or another.

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This really is a great thread.  Throughout my investing career I've really struggled with the question, "When do you have enough information to make a decision."  I've found myself getting "caught in the weeds" reading about things that have little value in the decision making process.  I also think its a bit overwhelming for novices reading 10ks and so-forth because of all the legal jargon.  You learn quickly that 10ks and other filings are all laid out in a similar fashion.  With practice you'll recognize what can skimmed or skipped entirely. 

 

When Weschler and Combs were on CNBC several months ago, Becky Quick actually asked the question I submitted surrounding this topic.  I've attached the transcript which you can read for yourself. 

 

To paraphrase, Weschler and Combs said they both look at basically the same things others have already mentioned (corporate filings, trade magazines, transcripts, etc.).  The amount of time they spend is another story.  Weschler actually said he'll spend 500-1000 hours researching.  That seems crazy and perhaps is in need of greater context.  I've also heard Wilbur Ross explicitly state that his firm usually will follow a business for several years before making an investment.  Conversely, I believe Monish Pabrai has said a few days of solid research on an idea is adequate for him.  And Buffett is famous for making investment decisions in mere minutes. 

 

This is a curious topic however.  Clearly the more time you spending investing, the more efficient you get with your process and decisions can be made much faster (this is what experience is all about).  This is where Buffett's "compounding knowledge" comes into play.  I think you also have to be very careful reading into things like Weschler's "500-1000 hours" proclamation.  What is he really talking about when he makes that statement?  For most companies, does enough relevant reading material even exist to spend that kind of time on?

 

I've learned that you just really need to do what works for you.  It seems that at some point in the research process, additional information can just become a distraction from the basics of investing: What is the approximate value of this asset?  Can I get it at a discount/reasonable price?

CNBC_transcript_of_Weschler__Combs_investment_process_answer.docx

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