Written by Mike Schellinger follow me at MicroCapClub Twitter

 

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One of the things I have learned through my years of investing is that there are limits to the usefulness of research and there is a point of diminishing returns.

No matter how much due diligence you perform on a company there will always be blind spots and risks. Even the CEO can’t know and predict everything. Some risks and facts are knowable and others just aren’t.

As an investor, I think it is important to be cognizant of these limits and to know where the boundaries might be. I don’t want to spend too much time researching a company when my efforts might be better spent researching another company or another investing activity.

Let me illustrate my point with some examples:

  1. Companies are involved in lawsuits. It is impossible as an investor to know the details of every business relationship a company has had and whether any of them might lead to a lawsuit. You can even have a competitor or totally unrelated company that sues a company for patent infringement. While reading the legal section of the 10-K can give you some clues here, it is not uncommon to be blindsided by a lawsuit that significantly impacts a company.
  2. Competition can often have an impact on the financial future of a company. You can research competition to know the company’s competitive position but it might be difficult to guess moves competitors might make. A company in a seemingly good competitive position today might not be in as good of a position tomorrow. For example, a competitor could drop prices by 20% tomorrow but it is hard to predict that. Sizing up competition is a valuable part of the due diligence process but it can only go so far.
  3. Often, government regulation can impact a company. I avoid companies that have significant government regulation but virtually every company has some risk here. Sometimes something comes out of the blue.
  4. Companies can occasionally lose customers through faults that are not their own. You can assess how strong a company’s bond is with their customer and look at customer concentration, but beyond that it is hard to know when they might lose customers.
  5. Quality issues with a company’s products occasionally happen. Even a good management team can be tripped up by quality issues.

Don’t Buy & Forget

As you can see from the above, there are risks that you just can’t avoid and often large amounts of due diligence will do little to mitigate the risks. Let me be clear by saying that I’m not advocating small amounts of research or buy and forget. I’m simply saying that beyond a certain amount of due diligence you are often wasting your time. I’m reminded of a famous Warren Buffett quote:

“You should focus on what’s important and knowable.” – Warren Buffett

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While there are limits to what you can learn by research, having the right management team in place at the company and knowing that they are trustworthy will go a long way to mitigating many risks.

A good management team will know how to take steps to mitigate risks and will also be adept at steering the ship when the waters get choppy. Companies are not just assets and liabilities and are run by people.

How good those people are will greatly impact how the company performs.

Is The Management Trustworthy?

One of the key steps in due diligence of a company is determining if management is trustworthy. When you buy a stock you are hiring someone to manage your money.

It is no different than hiring an electrician or anyone else that provides a service for you. You want someone that is trustworthy.

There are a few aspects of being trustworthy.  I think there are two basic categories to examine.

First, you want to know if management has the right ethics and is looking out for your best interest.

Second, you want to know if management has the skills for the job so you know if you can trust that they will make the right moves. I’m going to focus more on the former than on the latter as I think the later is a much more involved and complex subject.

On the later it might be better to read a book like the Intelligent Fanatics Project or some other book on management.

How to Determine Trustworthiness

There are lots of different ways to determine if management has the right ethics and is looking out for your best interest. The main key is to look at past actions. Below I list a number of things I evaluate and some tips to determine if management is trustworthy.

  1. Is management compensation reasonable and does management own a significant amount of stock? Reasonable compensation and heavy ownership of stock isn’t an indicator of ethics but it does help to know that management is aligned with shareholders and is likely going to look out for them rather than just worry about themselves. If management takes a small salary and has a significant ownership interest you can bet that they value increasing shareholder value more than their salary. See this article for more thoughts on the subject.
  2. Has management treated stock like gold or have they issued shares like candy? Poor utilization of stock currency often leads to bad investment results. It is important to pay particular attention to stock awards to management. If they give themselves large amounts of stock be very wary.
  3. I like to look at past press releases of the company. If the company made forward looking statements such as guidance, did they come true? I want management that follows through on their statements. Often things happen that impact whether forward looking statements come true so a few things that don’t happen or don’t happen in the time frame projected will not turn me off. However, if I see a pattern of promises that never come true then it is really hard to trust management.
  4. Talking and meeting with management is a great way to learn how trustworthy management is. Often how they answer questions will give you great clues into their trustworthiness. One particular thing that sets off five station alarms is when management is evasive in answering questions that they should be willing to answer. It can mean that they are hiding something that isn’t particularly good. Adam Epstein does a great great job of covering management discussions in his blog 10 Lessons Learned from Interviewing Hundreds of MicroCap CEOs.
  5. When I read SEC filings I make note of things that don’t make sense. Even little things like math errors in the filing really turn me off. Some of my worst investments have come from situations where there were errors or problems with the filings. In fact, one turned out to be a fraud. Their reports had many errors and the biggest ones
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