Exercising due diligence

The most common advice given in this column is “exercise due diligence.” What exactly do we mean? How do we exercise due diligence? The dictionary defines due diligence as “the care that a reasonable person would exercise in order to avoid harm to herself, her property or other persons.” We exercise due diligence in all areas of life. A driver who checks her tyres, radiator, brake fluid and gear oil before driving out is conducting due diligence on the car. For investment purposes, due diligence is defined as “a comprehensive evaluation of an investment by a prospective investor to confirm the genuineness of its claims (especially revenue and profit), and ascertain its money-making potentials.” From this definition, it is obvious that due diligence is tedious and time-consuming. Yet we still have to exercise it?

Warren Buffet, the world’s most successful and richest investor has two rules of investing. Rule 1 – never lose money. Rule 2 – never forget rule 1. From the sad experiences of many Nigerian investors earlier this century both in the stock market and money markets during the banks consolidation exercise, we should have learnt that ignorance is not bliss; it is expensive. What you don’t know (in investing) could lose you money. A thorough due diligence process is essential to determine if an investment meets your requirements in ROI (return on investment), risk tolerance, ethical standards, portfolio diversification etc. It is only after due diligence has been exercised that one can make prudent investment decisions and ensure one keeps Buffet’s 1st Rule of Investing. The initial work would lead to savings down the road. Like we have said many times, due diligence should be done on all types of investments – real estate, stock market, money market, retirement savings, insurance annuities, private equity/small businesses, etc.

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Here are the questions to ask for stock and money market investments. Is the stock price stable or volatile? Is the company making profit? Are they consistently declaring suitable dividend? Is their revenue stable and growing? How are they managing competition? Is their market growing, stable or receding? Are they compliant with regulations? This is very important especially with banks and companies under NAFDAC’s supervision. How good is the management? Do they have technical competence and personal integrity? What does public opinion say about them? Check Google and other websites. Many companies allow themselves and their products to be rated by Rating Agencies. The latter use professional indices and criteria to evaluate the company/ product and arrive at an appropriate rating. Investors may choose to use these as their criteria for choosing investments and avoid the tedious due diligence exercise. Stick with investments with BBB rating or higher (the highest ratings are AAA or A* depending on the rating agency). Confirm that the rating is up to date. It may be their latest one but if it is outdated, there is cause for alarm. Why haven’t they subjected themselves to a fresh appraisal?

When investing in small businesses SWOT and PEST Analyses are critical. SWOT stands for strengths, weaknesses, opportunities and threats. Do the investment’s strengths outweigh its weaknesses? Does it have opportunities for growth? Have its managers developed effective risks management strategies to counter the threats to the business? PEST stands for political, environmental, social and technological. Do government policies favour the business e.g. with agriculture based businesses? Does it generate wastes that create an environmental nuisance or hazard? How are these wastes managed? Is the business socially acceptable, or is in a pig farm in a sharia ruled state? Is it up to date with technological advances or would the business or its processes become obsolete in a short time?

For real estate investments, we need to ascertain the veracity of the title. Is the vendor the owner? If he is an agent, has he been given the authority to sell? Not only are we to conduct investigations into genuineness of titles in the appropriate government agencies, we should also check for the future plans of governments. Genuine owners with genuine titles have been known to fraudulently sell off properties they know have been earmarked for roads by their government. Some properties are yet to be registered at the state land registries, these require great caution. If in doubt, do not deal. Remember the 1st rule of investing.

Due diligence no doubt is hard work, but it has deliver great dividends to all who exercise it both in the world of investing and outside.