Whether to buy an investment is not always straightforward. In this introduction to our new series - How to be a better investor - we discuss six principles that will help you take an investment case apart and make better investment decisions.
One of the hardest skills to learn as a professional investor is the art of stepping back from an exciting opportunity and taking a completely objective view of the investment case. ‘Buyer beware’ is an easy proverb to quote at people, but actually finding a due diligence method that consistently works across the breadth of the market - with its huge range of companies, funds and trusts - is not easy without a clear set of basic principles, particularly if you are trying to avoid being dazzled by the latest trend. Fortunately, help is at hand.
Because we understand how hard it can be to unpick industry jargon and reach a decision on whether to buy or sell, we’ve created our own guide to carrying out pitch-perfect due diligence.
If you read to the end of our series of articles, you should be able to make better and more rapid and accurate appraisals to help improve your individual investment performance. We will take you through the steps, where to find relevant information and understand the technical jargon that might be hiding a deeper, or darker, truth about your investment idea. This series is based on hard-won personal experience.
What does due diligence mean?
The mere mention of the phrase due diligence is often the cue for going and busying yourself with another task. I remember once making the mistake of asking an accountant this question and gave up trying to understand the answer about halfway into a 25-minute explanation. Never again.
Still, as a financial journalist, the most common question I get asked by investors is: “What do you think of this share/trust/fund/company?” After many years of answering that question, I came to the conclusion that, in general terms, what an investor thinks about an investment proposition is largely irrelevant – the key to answering that question, fundamentally, is what do you know about it, and how do you arm yourself with the knowledge you need to make a well-informed and rational investment decision?
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Information, information, information
The thing to remember is that investing is not gambling. Putting £50 each way on the 3.10 at Epsom is a different type of risk – the information you need to make an informed decision just isn’t available unless you are an obsessive viewer of The Morning Line, or you have the time to plow through the Racing Post. It is surprising how many investors get hooked on the investment parallels with gambling – which isn’t a good thing if it is your pension, or your house, that is at stake.
By contrast with gambling, the beauty of investing nowadays is the instant availability of information. No longer do you have to send away to the local library for annual reports, or ask Companies House for lists of individual directorships - investors have all possible information available to them at the touch of a button.
However, this creates its own problems, particularly with the issue of information overload. Buying or selling an investment needs the same care and attention as you would put into buying a house, a car, or any other big-ticket item, but it is surprising how often people will skimp on basic due diligence, particularly if it is the investment story that they have fallen in love with.
Due diligence in this context means going through a series of steps to organise and evaluate all the information available to you in a way that won’t overwhelm your capacity to absorb and understand it.
It is important to remember that by organising your method, you make your decision-making easier.
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The due diligence steps
For investors, due diligence in its simplest form means doing your homework on an investment proposition by looking at the financials, the capital structure, the management, the market history, a share’s current level of popularity and the incentives that the directors are working to achieve. There are arguments over the level of detail involved in each of those categories, but this is the basic formula to organise your research.
Over the coming weeks, interactive investor will bring you an in-depth look at each of these steps, with examples and case studies, but as an introduction, the due diligence process can be broken down into six simple categories.
Most investment vehicles, companies, trusts, but particularly funds, have a history in the market. How do we assess how well they have done in the past? How would this performance be relevant to the investment case now?
How to do balance sheet analysis. What are the key numbers to look for and what information in the annual report will be most useful to you? This is also where we will discuss valuation metrics, as often the balance sheet numbers will form the basis for these valuations.
3) Directors’ benefits
Directors’ benefits, or emoluments in company-speak, is a complex area to explore but it can provide a clue as to the direction of the investment. Directors who are too fixated on earnings per share may be cutting spending such as research & development to boost the bottom line. This is part of understanding “the deep value” of an investment.
4) Free float and share capital structure
“Is it easy to invest?” is a very important question. What if the share price spread – the difference between the price you can buy at and the price you could sell at - is just too wide? Capital structures are an important area to explore. It is often where you find strange things such as A & B preference shares and minority investors versus family trusts. By understanding the capital structure, you can assess how easy it will be to sell out and make a profit.
5) Who’s buying?
Getting the gist on why an investment is popular goes part of the way to answering some fundamental questions. Directors buying large packets of shares is usually a good sign. Endless bulletin board posts from a small number of traders probably means trouble. The social mediatization of investing is not quite as new a phenomenon as recent events with GameStop (NYSE:GME) in the US would suggest, but it is worth taking the time to look out for vigilantes.
6) The management
Who are they and are they any good? Managers have a history, just like everyone else. Have they learnt from any mistakes? Is there a track record of success, or failure? This segment will look at how to access and assess the information available to you.
We hope you will enjoy reading the series as it is published and that it will prove useful in your investing life.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.