How to do due diligence when investing in stocks? Here are the steps you should follow

Due diligence when investing in stocks is a crucial process. It is a step many investors can disregard, just buying into a stock after one positive announcement by the company, or perhaps one legislative change that may benefit its industry although not necessarily the company itself.

Doing due diligence on a company involves researching and evaluating a company’s financial health, management, industry position, and potential risks to make informed investment decisions. And by that, we mean making a decision that will be most likely to make you money. Here’s a step-by-step guide on how to conduct due diligence.

4 steps of due diligence when investing in stocks

1. Understand the Business and Industry

Obviously investors should research the company. Learn about the company’s products, services, mission, and business model – if any of them actually exist, because they may not. Look at their annual reports, press releases, and investor presentations to understand what they do and how they make money, again if they do anything or make money.

You should also understand the industry in which the company operates. Is the industry growing, stable, or declining? Consider factors like competition, market size, and trends that could affect the company. Also understand the company’s position in the industry. Is it the largest player – and if so, does it have a sizeable moat to protect it from competition? If not, what could help your company dethrone its largest peer and/or competitors its size?

2. Financial Health Assessment

Review the three financial statements – the income statement, balance sheet and cash flow statement. The latter of these is a dark horse because the first two can be manipulated to give a more favourable impression of the company but the cash flow statement cannot be. Also look at its ratios, not just its trading multiples like P/E but internal ratios like Return on Equity and Return on Assets, as well as operational assets like the current ratio.

3. Management and Governance

Research the experience and track record of the CEO and key executives. Are they experienced in the industry? Do they have a history of creating shareholder value? Do they have ‘skin in the game’ – that is to say shares in the company?

Also, you should understand who the major shareholders are. A company with institutional backing is one that those institutions have done due diligence on themselves and have decided to risk their investors’ money for. In our view, if any of the following companies are investors, it is a good sign: Spheria Asset Management, Wilson Asset Management and Australian Ethical Investing.

And whilst we are at it, keep an eye on whether any of them (directors or instos) are buying or selling shares. While buying can be a positive sign, insider selling could signal concerns, though it’s not always indicative of bad news. Just keep an eye on the explanations given, if any.

4. Risk Factors

Consider all the risks that could come with investing in stocks generally, and that particular stock. These include:

• Competitive Risks: Are there threats from new competitors, new technologies, or substitutes?
• Economic and Market Risks: How sensitive is the company to changes in the economy, interest rates, or inflation?
• Regulatory Risks: Does the company operate in a heavily regulated industry? Are there any potential legal or regulatory challenges that could impact its operations?
• Management Risks: Assess if there have been any past controversies or issues with management’s handling of the business.
• Geopolitical Risks: If the company operates internationally, are there any geopolitical risks that could impact its operations (e.g., trade tariffs, currency fluctuations, or political instability)?

And if you go beyond the ASX, you need to consider the risks of investing in overseas stocks.

Conclusion

Due diligence is not a one-time process. The market conditions, the company’s performance, and external factors evolve over time, so regular monitoring is important. A successful investor combines thorough research with a disciplined approach, focusing on both the current state and future prospects of the company. You investment thesis on the company may change in some circumstances and you may need to exit your investment – you need to determine whether or not any valuation decline is a short-term issue or something more permanent.

This is not be all and end all of due diligence, but we hope the above can get you started.

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