D is for Due Diligence
We’ve reached the letter D in the Elite Investor Club A-Z of investing. Once again it’s a really important topic and it applies to every single investment you ever make. And I have double the value for you in this episode, because I have two Ds that stand for Due Diligence. You’re probably aware that we can’t give advice here at Elite Investor Club. We can introduce you to some extraordinary investments in the portfolio section of the website, but you have to do your own research and make your own decision about whether they are right for you.
That research is called due diligence. It’s a lawyer’s term that simply means satisfying yourself that the potential rewards of a given investment justify whatever you regard as the risks involved. The concept is easy enough but the execution can be far from straightforward. Let’s say you fancy owning some Marks and Spencer shares. It’s a great company with a solid track record and a strong brand. But is this the right time to be buying its shares? For that you’d have to look at its price over recent years, what news flow is suggesting about the company’s prospects in the next few years and any trends that might help or hinder its progress.
You could read its annual report, look at some key ratios like price/earnings and at the dividend history. How many times does the profit cover the current dividend payment? Are you confident that the dividend will continue at current levels? Has there been any ill-judged expansion into foreign markets such as M&S’s abortive efforts in France or Tesco’s disasters in America? You might want to consider what the analysts are saying, though they have a habit of looking at the status quo and predicting it will continue uninterrupted in the current direction of travel. As you can see, looking at just one company in this sort of detail is a lot of work. And there are all sorts of factors and inside information that you don’t have access to. It’s worth remembering that you and I are very small players and there are many institutions and professionals with access to much more data than we have. And still they get it wrong as often as they get it right.
So I’d caution against individual shares unless you’re a seasoned campaigner. Using well managed funds or Exchange Traded Funds that track a whole market is a much safer strategy. What about due diligence on other assets such as those in the Elite Investor Portfolio? If it’s a property investment, you’ll be looking for evidence that the developer owns the asset he’s proposing you invest in. If there are guaranteed returns, what is the strength of the income stream that supports those returns? For example, with our care home investments its clear that the need for dementia care for our ageing population will ensure that these facilities are full to bursting for decades to come.
I’m less keen on student accommodation where guaranteed returns are often for a much shorter period and depend on wealthy foreign students whose numbers have already peaked . If the investment is a bond or loan note, the question becomes the strength of the underlying security backing the loan. What would happen in a nightmare scenario if the developer you are lending the money to goes bust? Do you have a first charge over a property portfolio and a law firm in place to administer it? Look at the business model of the company issuing the bond. How do they make their money and how secure is that income? I want to make sure the odds of success are heavily in their favour, otherwise how can I be sure of both my income stream and the return of my capital?
One note of caution. Be wary of delegating this kind of due diligence to a High Street lawyer. They won’t be familiar with many of these investments and could charge you a fortune in fees to fund their learning curve. The acronym to remember is DYODD do your own due diligence!