Due diligence in analyzing businesses

In the article “my four dividend stock buying guidelines“, I mentioned that when I decide to purchase   a stock, I mean I invest in the company, not just trade its stock.  So there is a very high chance that I’ll buy the stock and hold it as long as possible.  In this sense, I become one of the owners of the business.

Just imagine what you will do if you really own the business. You will make efforts to at least keep up with the company’s business and its outlook going forward.  You’ll need to spend time understanding the business model, its industry and trends, its major competitors, the company’s major competitive advantage or moat, and its management.  You have to drill down to get a whole picture and boost up your confidence level.  To test your confidence level, just ask yourself this simple question: when some analyst from some brokerage firm cut the rating of the stock you own, are you steadfast enough to stand firm?

So what are the due diligence that you need to do in order to at least convince yourself?  Here are the actions that I must take before I purchase any stock of interest:-

1) Spare time to understand the business.

I only buy those companies that I have good understanding.  There are numerous sources to search for the information.  The first-hand resources will be available at the company’s website.  Take Kinder Morgan as an example,  under the “Investors” button, you will see a lot of important information regarding investment, such as corporate profile, several stock symbols (KMI, KMP, KMR, EPB), financial statements, presentation/webcasts of past conference calls, calendar, management introduction, etc..

There are various very good investment websites that offer valuable information and daily updates of almost every listed companies.  Just to name a few, seekingalpha.com, MSN money, morningstar.com, yahoo finance, etc..

A lot of peer investors maintain very good investment blog websites which become the platform for the authors to share thoughts and for peer investors to discuss through comments, facebook, twitter, etc..  Here are two blogs of my daily read: dividend mantra, and dividend growth investor.  I’ll follow their suit in my this blog website.

2) Listen to every quarterly conference call or read the conference script.
This is a must-do.  For me, there is no compromise with it.  Actually this is the short-cut to stay with companies’ updates and to evaluate if the business is still on track.  From the management’s speeches, an overall performance impression will be obtained.  The Q&A section provides the direct answers for critical questions that every investor is interested to know.  For example, before I bought WAG in June last year, Walgreen had been involved in a protracted dispute with Express Scripts over the cost of filling prescriptions within the Express Scripts network.   WAG stock price was below $30, very attractive price, but I dared not to take any action because of the dispute and seemingly gloomy prospect.  However, after listening to the quarterly conference call, I understood that the management had taken constructive actions to cope with the situation and to sustain their existing customers as wells as to attract new customers.  Besides, they also have a strategy for the future — “plan to win”.  The plan focused on leveraging the best store network in America; enhancing the customer experience; and achieving major cost reduction and productivity gain.  It is the conference call that boosted up my confidence level in the management and in the company, and consequently I took action to purchase the stock.  In hindsight, WAG is one of the best stocks that I have ever bought.

3) Read and understand well financial statements.

There are mainly three financial statements that deserve in-depth analysis: balance sheets, income statements, and cash flow. Companies usually update their financial statements quarterly and annually.

Balance sheet summarizes a company’s assets, liabilities and shareholders’ equity at a specific point of time.  These three segments tells what the company owns and owes, as well as the amount invested by the shareholders.   Income statement summarizes a company’s revenues and expenses quarterly and annually for its fiscal year.  The final net profit and various other figures are all important to judge the company’s operation healthiness and efficiency.  The cash flow statement details the flow of cash between the business and the outside world, and classifies it into three main categories  — Operations, Financing, and Investing.  I made three summary slides of how to read and understand annual reports.   For further reading, Jae provides a good source here.

The financial statements provide the convenient short cut to peek into companies’ operations.  Just to give a simple example, accounts receivable from balance sheet is an indication of whether the company is able to collect its payments. If accounts receivables decrease from the previous years, the company  has been able to collect its money, which is definitely favorable for the investors.  Otherwise, if accounts receivable keeps on increasing year after year, it presents an early warning sign and deserve further scrutinizing, even though the company’s revenue may be increasing at the same time.

4) Write at least one article of stock analysis on each stock of interest.

Writing the analyses down has at least three benefits:  Firstly, it clarifies my thinking so at least I am fully convinced before take any action.  Secondly, it provides good resources for my later reference.  With many stocks of interest, it is not easy to memorize the detailed info of each of them,  and with the analysis in writing helps me to recall the basis of my decision.  Thirdly, the stock analyses are worth sharing on the blog which helps me to have some communication and discussion with fellow bloggers.

I’ll also review stocks quarterly and write review updates on this blog to make sure things are on track and there is no divergence from the original direction.

Disclosure: long KMI.