Co-produced with Beyond Saving
If you have been hanging around investment websites, you have likely read a comment about doing “due diligence”. Do you have to do “due diligence”? – as an individual investor investing your own money, you don’t. You are free to buy random tickers and roll the dice. I have an in-law I overheard saying that the stock market was “just like the casino”. If investing feels like gambling, you are doing it wrong.
Investing shouldn’t feel like going into a casino as a customer. It should feel like owning the casino. You see, the casino is taking a risk every time you step in. There is a chance that any particular customer could walk away with more money than they came in with. Yet, in the long run, the house always wins. Why? The casino has done its due diligence on every game it offers. The casino will occasionally suffer some losses, and luck will occasionally go against it, but over time the casino will win much more often than it loses. The casino is taking a risk, but it is a calculated risk with the odds substantially in its favor.
Good investing is similar. Every investment is a risk. I don’t care if you invest in the “safest” companies you can find, there is always a risk. Sometimes, the ball won’t bounce in your favor, and you will realize losses. Just like the casino will occasionally pay out that big jackpot.
Investing is not about avoiding risks. It is about taking measured and thoughtful risks to consistently realize a return on your investment. Doing your due diligence on your investments is how you determine which risks are worth taking and which are not.
Simply put, due diligence is gathering and analyzing the facts necessary to make an informed investing decision.
Where To Start
There are plenty of people out there willing to provide investing ideas. HDO is one of them. We provide numerous investing ideas to our readers. A lot of people have their favored authors to follow that have similar investment styles to them. Often, they will follow an author who provided a prior pick that turned out especially well.
Great. Following someone who devotes a lot of time to studying the market and following stocks makes sense. There are thousands of tickers to choose from, and you don’t have time to do due diligence on them all! Finding a resource you trust to point you in the right direction of stocks that fit your investment style is a huge time saver, you should seek out such resources!
Yet, at the end of the day, who cares more about your money than you? Your spouse, maybe your heirs. Not the person who gave you a hot stock tip. When you are managing your own portfolio, the buck stops with you. Only you know what the priorities for your portfolio are, what your risk tolerance is, what your goals are and needs are.
Do You Know Yourself?
I’ve found that a lot of people tend to overestimate their risk tolerance. When you talk to them in the abstract, they will tell you they have a “high” risk tolerance and want a pick with the highest potential upside.
High reward often comes with high risk. They will buy the highest yielding picks and make investments that are best described as “swinging for the fences”, hoping to realize huge gains.
Then the heat comes. Prices fall, and they panic. The reward might still be possible, but the investor panics, often selling at the worst possible time. They often are not selling because news or an earnings report caused them to lose confidence in the stock. They sell simply because the price went down more than they were comfortable with. They thought they could tolerate the risk, but when faced with the volatility, they couldn’t.
If you are looking at a stock, and you say to yourself, “If it goes below $x, I’m selling,” – save some money and sell it now.
Know yourself and know the risks that you are comfortable with and which risks you are not. This isn’t a competition, and you don’t get bonus points for being the toughest or the bravest.
I can’t tell you how many investors have told me they have a “high” risk tolerance, that they want to swing for the largest returns, and then when the volatility hits, they are telling me they are selling. Failing to adequately recognize your own risk tolerance can be a very costly mistake. If you are more conservative, focus on more fixed-income and lower beta investments.
For most people, it is appropriate to have a mix of investments. They should have some that are very conservative “boring” investments, combined with some investments that are higher risk but have significant upside if things go well.
What mix is best for you? I don’t know. I’m not you. My mix is in the Model Portfolio with a 40% allocation to fixed income with 2% a “full allocation” for most single holdings. That is what is appropriate for my wife and me.
Do You Know Your Investments?
Every stock is a small portion of ownership in an underlying company. This is a business that does something to earn revenues, has expenses, and has a profit or a loss. Some companies are very familiar to everyone. Like Walmart (WMT), even the least business-oriented person in your family probably has a reasonable idea of what WMT does.
Other companies aren’t as well known or are in businesses that most people aren’t even aware exist. When they walk into a Walmart, it probably never occurs to them that Walmart probably doesn’t own the building. Companies like Realty Income (O) buy the real estate and make a profit being landlords for businesses.
Most people probably aren’t even aware when they pay their mortgage that the bank that originated their loan usually doesn’t get the money. Instead, the interest and principal are being redirected to investment companies like PIMCO or AGNC (AGNC).
When you step into the investing world, you might be surprised how many things you never even thought of before are businesses. I often humor (or annoy) my wife while we go about our daily lives, and I’ll remark, “hey, I own this business”, or “this company owes me money”. When you have a well-diversified portfolio, you’ll find that you own, lend to, or are a landlord to thousands of businesses. Many of which you will have interactions with during your daily life.
I enjoy owning businesses that I can connect with my day-to-day life. I enjoy knowing that as I spend money, a portion of it will return to me as dividends.
What businesses do you own? What do they do? What factors will drive their profits or losses?
Unfortunately, too many investors don’t have the answer to these questions. Spend a little time understanding the basics of the businesses you own. Now, you aren’t going to become an expert on every facet of the economy and every business that exists, that’s too much for any one person. That’s why HDO is a team of authors, not just me. However, you should at least have a big-picture understanding of your investments and the major factors driving them. Know what you own, then when something happens in that sector, and you see a news story, you can research more in-depth to see if it impacts your investments.
Spend some time learning about an investment before plowing your money into it. Articles written by an author you respect are a great starting point. Also, spend some time reading or listening to earnings calls. Management frequently discusses various details of their business that they see as important, and the analysts in the Q&A period often bring up areas of concern. Don’t just listen to the one company you are looking at investing in. Read about its peers as well.
Why Are You Investing In This Business?
You might have heard the term “investment thesis”. This is a brief statement on why you believe this business will make a great investment. What type of investment are you making? Are you investing in:
- A well-established business with recurring and predictable cash flow. These investments tend to be the lowest risk but are also typically at premium valuations, you can expect a lower dividend yield.
- A business that has fallen upon tough times but is likely to turn around. Sometimes businesses are humming along, and things change in the economy. Demand shifts, technology changes, and pandemics change the world. Something happens, and what the business did before is no longer as effective. These investments can be fantastic if management can reposition the company to adapt to the new environment. They tend to be a higher yield. However, dividend cuts can be a real risk if management fails to change the company.
- A business that is following in the footsteps of a previously successful business. When one business is successful, copycats come out of the woodwork. As a younger company, the copycat will generally trade at lower prices than the peers that have “made it”. Sometimes the copycat has a new twist that might make it better (or worse). These investments can be very attractive alternatives to a company that is very expensive, but be careful. Sometimes copycats just aren’t as good as the original thing.
- A business that is trying something new. The most successful single company investments in history are businesses trying something unique. They revolutionize the world by bringing new products and services that nobody else has provided before, it can be insanely profitable. The FAANG group of stocks all fell into this category, and a well-placed investment early on in them would have provided outstanding lottery ticket returns. Of course, for every winner that became the next great thing, numerous similar companies failed and went bankrupt. This is a very high risk, very high reward type of investment.
The key is that you want to have a good idea of what “success” looks like for your investments. Do you expect the company to keep doing what it has been doing? Or do you expect the company to do something different that you believe will be better than in the past?
Companies typically are not shy about telling their investment story. They will tell you what their strategy is and what they expect. Always take it with a few grains of salt because management’s job is to make the company sound attractive.
Set your expectations. For HDO, we are always focused on income. So, we will have an outlook for whether we expect the company to continue paying the same dividend and whether we expect dividend growth. We will keep an eye on cash flow and ensure that it is meeting our expectations.
When buying a stock, jot down a couple of lines about why you are buying it and your future expectations. This will give you something to reference as the company reports earnings so you can see if the company is headed in the right direction or the wrong direction.
Do You Know Your Numbers?
So, you have a heart-to-heart with the mirror to come up with a fair estimation of your risk tolerance. You’ve read a few articles, read what management had to say in presentations and transcripts, and are persuaded that the business is a compelling opportunity that fits your risk tolerance.
Now is the time to dive into the numbers. Look at the past few years’ balance sheets, income statements, and cash flows. Do these numbers match the “story” that management, pundits, and analysts are telling?
What is the leverage relative to peers? Are the earnings competitive? Is the company allocating capital efficiently? Is it covering its dividend?
If management has been saying it will “reduce leverage” for the past 3 years, and you look and see that leverage is going up, that is a red flag, that happens a lot. If management says it will reduce leverage and has been making progress, then the numbers match their story. Maybe you have an opportunity to invest when the company is being penalized in the market for being overleveraged. Getting a better price than you will get if you wait for leverage to hit the levels Wall Street wants.
Other stories you might hear from management are about “growth”. A company might be investing hand over fist, but are earnings per share actually growing? Or is the company on a treadmill, running faster and faster but ultimately going nowhere?
Reading the financials isn’t the most exciting part of due diligence, but it is the most important. This is why we published “How To Read A Balance Sheet” last month. We are following that up with additional “how to” articles.
On the internet, I can find recommendations for virtually any stock that is tradable. Stock “tips” are a dime a dozen. They used to come in newsletters through the mail, then through e-mail, and are posted all over the web. They can be very valuable as the people providing these tips often have significant expertise. However, at the end of the day, the person who has the most to gain or lose from a stock tip is the person who follows it.
Seeking Alpha has been transformative. It provides a platform where stock picks can be discussed in-depth. Not just the surface level buy this or sell that. Authors present their thesis, other authors often provide counterpoints, and there is frequently very good back and forth in the comment sections.
Instead of just throwing out picks and collecting money, we have an opportunity to educate and discuss in-depth why we are buying this pick or that pick. Why are we holding through a downswing, or why are we selling?
Providing investment ideas is great, but what I believe retail investors are hungry for is understanding. Your brokerage account is likely the bulk of your life savings. It is extremely serious business to you, and the returns you realize or losses you incur will likely have a very real impact on your financial future.
This is why I encourage you not to follow anyone blindly. Ask questions, delve deeper, and make sure you understand the investments you are making. The HDO team is here to help!
In the coming weeks, we will continue our “How to” series, providing you with the tools you need to be confident with your portfolio and investment strategy. I think the HDO Model Portfolio and the Income Method is a superior portfolio and a superior strategy. Yet regardless of what you choose is right for you, due diligence skills are an essential part of being a successful investor.
Don’t gamble your retirement on the casino of swinging prices day to day. Make sure you are making well-reasoned investments that provide an attractive return relative to your risk.