Dimensions of Due Diligence

Due diligence is the infinite abyss of time and resources for asset managers — No investor can conduct perfect diligence — Multi-dimensional due diligence is required for a full understanding of a business.

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DIMENSIONS OF DUE DILIGENCE

Active investment managers perform three tasks: crafting an investment philosophy, conducting due diligence to identify businesses that fit this philosophy, and building portfolios of businesses that pass the due diligence test.

The due diligence process is the infinite abyss of time and resources for an investment manager. Given the vast number of potential research avenues, no investment manager can complete perfect due diligence.

An understanding of what is possible is essential to prioritizing work and ensuring the most crucial areas of diligence are performed.

Basic Diligence

First and foremost, the potential investment itself is analyzed. Typically, an investment analyst will understand the current business model and strategy, investigate competitive dynamics, and estimate the fair valuation of the business.

This research provides a linear view of the business; like walking down a hallway, this basic diligence analyzes the business in a single dimension.

Adding Dimensions

Still focusing on the target business, an analyst can examine historical performance, adding a time dimension and taking a longer-term perspective. Historical performance, particularly through business cycles, provides insight into downside risks inherent in a business model.

Another avenue is adding source material, moving beyond company filings and management meetings, to industry research and interviews with customers, suppliers, competitors, or former employees.

Expanding the time period and source material allows an analyst to understand the context in which the business operates, both historically and within its industry.

Exponential Diligence

An exponential leap is possible by expanding the research scope to include global competitors. This competitive benchmarking is invaluable to understanding the full potential of a business.

This added diligence dimension places an enormous burden on an analyst. Not only must basic business diligence be completed on all competitors, but expanding primary research to an industry-wide list of players becomes exceedingly time consuming and expensive.

Conducting industry-wide due diligence, including both a wide range of source material and historical analysis, allows an analyst to truly understand a business, its position within an industry, and its context historically.

Future Diligence

There is a final dimension of due diligence, often not available to investment analysts. This is the due diligence conducted during the ownership of a stock.

Management discussions become more powerful over time. Competitive dynamics evaluated through real-time challenges reveal themselves more completely. Decisions made by the board and management team are better understood when analyzing years of historical notes on the company – notes that wouldn’t exist without ongoing due diligence.

The Ideal

Few investors achieve an ideal level of due diligence on even one, let alone every investment in their portfolio, particularly when portfolios include hundreds of investments. Despite this limitation, understanding the full potential of due diligence provides a roadmap for investors to evaluate their research processes.

In addition, knowing where an investor lies on the due diligence spectrum is a key input into portfolio management decisions. The conviction to double down on a struggling investment may stem from years of business analysis, management discussions, and industry context. This conviction may be lacking for newer positions where an analyst has yet to conduct “future diligence.”

While the multidimensional explosion of research tasks can be daunting, it is also the most rewarding part of being an investor. The opportunity for continuous learning, across companies, geographies, and industries, ensures an analyst’s job is always interesting.