Ultimate Guide to Investment Due Diligence

Congratulations! You have solved the riddle of financial statements and ratios and set yourself on your quest in the exciting world of stock picking. This chapter serves as your guiding star, leading you to discover worthy companies for investment through the full power of fundamental analysis. 

However, do not forget that there is no universal solution. Although we will provide you with a practical checklist, your criteria will grow from your specific investment philosophy and the level of risk you can bear. So, let us start the chapter and understand the due diligence procedure investors must follow. 

Building Your Investment Outlook

Picture you are surfing a sea of stocks. A strong checklist is like a lighthouse directing you to viable companies, much like the nearest visible shorelines. 

However, it is not like a generic lighthouse helping every ship; your checklist is individual and expresses your investment style and risk tolerance. A sample checklist is given as a checklist, but customisation is the most important. All things must be rooted in justified reasoning rather than blind compliance.

Always remember that there’s no perfect standard checklist. Customise your criteria to match your experience and investment objectives.

Coming up With Stock Ideas

Before we delve into the nitty-gritty of checklists, let's address the fundamental question: Where would stocks interest you? 

Here are some effective strategies to ignite your stock-spotting radar: 

• Become a Keen Observer: Release all your Sherlock Holmes potential! Stay on the lookout for consumer trends, new products, and local happenings. Do you recall Peter Lynch, a renowned investor on Wall Street who wrote a book, “One Up on Wall Street”? Some examples where Investors earned handsome returns from sharp observation are investing in Cinemas due to proliferating multiplexes, Engineering companies due to their pervasive diesel generators, and Large holding companies that are popular and successful startups or other such companies. Therefore, be alert, and you may find some hidden treasures!
• Stock Screeners: Your Digital Matchmakers: Picture a miraculous device that scans through a hundred stocks that match exactly what you are looking for. Ok, stock screeners perform that exact role! They enable you to screen stocks according to measures such as Return on Equity (ROE), Profit after Tax (PAT) margins, and others. This is very suitable for shortlisting a few from a very huge pool of alternatives. 
• Ride the Macroeconomic Wave: Consider macro trends to be strong currents in the ocean, which can push some sectors ahead. A case in point is the government initiative on infrastructure projects in India would provide cement companies with a favourable environment. Hence, be aware of macro trends and analyse respective sectors to spot the potential winners. Don’t lose the chance to surf this mighty swell!
• Dive Deep into Sectoral Trends: Delve deeper into the particular sectors. Are there trends that are coming up, which, if so, disrupt the current situation? Which companies in these sectors are favourably placed to benefit from these movements? For example, the energy drinks segment of the non-alcoholic beverages market is quite promising. Conduct a company analysis within this sector to select companies most suitable to capitalise on this opportunity. Don’t forget, the most thrilling adventures are hidden underwater!
• Unearthing Special Situations: Even special cases are secret doors to special investment opportunities. Such doors could be stumbled upon by closely tracking company news, events, and developments. A colleague gained from further investigation and a profitable investment when renowned for transparency and efficiency, Keki Mistry, was added to Cox & Kings’ advisory board. Therefore, remain curious, you can also uncover the hidden treasure!
• Leverage Your Expertise: The circle of competence. Wouldn’t it be interesting to have a superpower that enables you to see through the intricacies of some particular industries? This is the superpower, my friend, that you have - your circle of competence. As a healthcare professional, you probably have more knowledge about the healthcare industry than a generalist investor. Benefit from this information! Pick investments out of your circle of competence where your knowledge will provide you with a competitive advantage. Keep in mind that only he who owns such knowledge has power, and your unique specialisation can be a real asset!

Do not forget that stock investigation triggers may occur at any place. Hence, make a “watch list” of stocks that seem attractive but do not satisfy your checklist today. The business dynamics are dynamic, and these companies can later be viable choices. A watch list kept nearby can hide many of the gems!

Competitive Advantages or MOATs 

Before implementing your checklist, take a look at the company’s competitive advantage, also known as the “moat”, a concept popularised by Warren Buffet, which refers to the fact that a company possesses something that is not available for its competitors, assuring its long-term profitability.

Consider it a strong wall, protecting the castle from the enemy. In the same way, a powerful and lasting moat protects a company from its rivals, preserving its market share and profitability. Hence, it is vital to evaluate the size of this moat before the investment.

Imagine Eicher Motors Limited. Their iconic Royal Enfield bikes command extreme brand loyalty and meet the needs of the rapidly growing niche segment. It would be very difficult indeed for its rivals to move them from this sweet spot. Therefore, the company has an unbreakable moat. This also makes them a worthy investment candidate for those investors looking for companies with substantial competitive advantages.

Look for companies with built-in competitive advantages or wider economic moats, such as:

• Strong Brand Names: Fevicol by Pidilitie, Parachute Hair Oil by Marico or the iconic Royal Enfield by Eicher Motors. Companies selling these branded commodities wield tremendous power, enabling them to demand top-dollar prices and retain loyal customers.
• Pricing Power: Think of products that can command premium pricing without any decrease in the demand for the product. A couple of examples are sin goods like tobacco products sold by ITC or alcoholic beverages sold by United Breweries. 
• Market Share Dominance: IRCTC in railway booking, Nestle with Nescafe and other products and Maruti Suzuki all enjoy a hefty market share, thereby rendering entry even more daunting for prospective competitors.
• Network Effects: The network effect between supply and demand makes platforms like D'Mart or Zomato increase in value because if more consumers join, then more suppliers join, creating more choices for the end consumer and, therefore, creating a virtuous cycle. Such an effect can provide a significant barrier to entry for competition.
• Switching Costs: In cases of complex software or banking services, for example, Infosys or SBI, the cost and time of switching is too expensive or even impossible in a few cases, making it a moat.

Remember, the wider the moats, the more sustainable the wealth creation. Think of Infosys’ early labour arbitrage advantage, Page Industries’ exclusive Jockey manufacturing and distribution license, and Prestige Industries’ leadership in pressure cookers. This attribute has served as a cornerstone of their prosperity.

Due Diligence Check 

So, let us arm ourselves with the instruments of a thorough review of investment candidates. Equity research due diligence involves three crucial stages:

1. Understanding the Business

Picture yourself as a detective who is probing a company. The annual report is your main information source. Read it carefully, asking fundamental questions like:

• What do they do? What do they sell?
• How do they operate? Their business model is?
• What are they good at, and what are called weak areas? Who is their competition?
• What do they intend to do in the next few years?
• Consider your investment preferences: Do you like businesses with fewer competitors? Are you an advocate of stable and predictable businesses? 

Adapt your questions and analysis to the principles of your investment philosophy.

2. Applying the Checklist: Your Individualised Investor Navigation System

Here's the sample 10-point checklist we mentioned earlier, now equipped with detailed explanations to guide your analysis: 

SrNo	Variable	Explanation	What it signifies
1	Gross Profit Margin (GPM)	> 20% indicates a healthy profit margin, suggesting efficient operations and potential for a sustainable moat.	Higher the margin, the higher  the evidence of a sustainable moat.
2	Revenue Growth	In line with gross profit growth. Consistent and balanced growth across profit and revenue is crucial.	Revenue growth should be in line with the profit growth
3	EPS (Earnings per Share)	Consistent with Net Profits. Dilution through excessive equity issuance can harm shareholders.	EPS should be consistent with the Net Profits
4	Debt Level	Low debt indicates financial stability and flexibility. High debt burdens the company and eats into earnings.	The company should not be highly leveraged
5	Inventory (Manufacturing)	Growing inventory with a growing PAT margin signifies efficient inventory management and alignment with profitability.	A growing inventory, along with a growing PAT margin, is a good sign
6	Sales vs. Receivables	Low receivables relative to sales indicate healthy sales driven by actual payments, not credit extension.	Sales backed by receivables are not a great sign
7	Cash Flow from Operations	Positive cash flow indicates a company's ability to generate its own cash, crucial for long-term sustainability.	Cash flow from operations has to be positive
8	Return on Equity (ROE)	> 25% indicates efficient use of shareholder capital. However, consider debt levels too. High debt with high ROE might be risky.	Higher the ROE, the better it is for the investor, however, make sure you check the debt levels along with this
9	Business Diversity	1-2 core business lines. Focused expertise in core areas often leads to better performance compared to conglomerates.	Avoid overly diversified companies
10	Subsidiaries	Limited number. Numerous subsidiaries can increase complexity.	Not many

Remember: This could still be a beginning, a stepping stone. Adapt and customise this checklist to your investment approach and industry-specific considerations. Don’t just follow the criteria of someone else. See that every item corresponds to your investment targets and risk tolerance.

3. Valuation

Ultimately, you will have to look at the valuation of a company, even if it ticks all the checklist boxes. DCF analysis is probably the most popular method, which estimates the company’s intrinsic value by looking at its future cash flows. This guides you in knowing whether the prevailing market price is attractive or overvalued.

Remember: Valuation is a mixture of storytelling and numbers, not an exact science. Analysts would value the same company differently. Before investing in any valuation analysis, the assumptions and methodologies should be clear.

Beyond the Checklist

The world of investments is both dynamic and evolving. New entities are born, industries change, and economic pictures change. To keep up with changes, life-long learning is a must. Here are some resources to fuel your investment journey:

• Read Books and Articles: Dip yourself in the knowledge of famous investors and financial gurus.
• Follow Market News and Analyses: Know the latest news and thoughts of the experts.
• Connect with Other Investors: Interact and gain knowledge from varied angles.
• Seek Professional Guidance: Think of talking to financial advisors for individualised recommendations.

Remember: Although professional advice may be helpful, the final decision of your investment plans is upon you. Therefore, arm yourself with information, research extensively, and rely on your scientific temper. 

Conclusion

Empowered with the might of fundamental analysis, a custom checklist, and a passion for knowledge, you are ready to conquer the thrilling realm of stock picking. Recall that this is a journey, not a goal. It’s the same as with any other business or anywhere in life. There’s the good and the bad, the wins and the losses. However, by remaining disciplined, adapting, and constantly learning, you can increase your chances of success and unleash the potential of your investments. 

Therefore, are you prepared to start on this journey? Breathe deep, get your metaphorical compass in hand and sail through the waters of the stock market! 

This was all about investor due diligence, and moving forward, we’ll dive into specific aspects of investing, such as valuation techniques and investing styles. However, before learning such nuanced aspects, please go through the previous chapters to get a basic understanding of financial statements and ratios to make your investing senses sharper.