“A prudent question is one half of wisdom.”
— Francis Bacon, Sr.
Due Diligence Question #4: How Does This Investment Make Business Sense?
Investing is ultimately about business, so every investment must make business sense.
What that means is the earnings, valuation, and return on investment must be congruent with the competitive advantage and barriers to entry possessed by the underlying business.
Let me clarify this idea with a little bit of Economics 101.
The world of business and finance is competitive. Above market returns and excessive valuations can only be supported if a significant competitive advantage coupled with barriers to entry for future competitors exists.
Otherwise, the high valuations and returns will attract competition until returns and valuations are forced down to market level. In plain language, that means your investment loses money – which is a bad thing.
For example, when the NASDAQ indexes were selling at over 200 times earnings in 2000, it didn’t take a genius to figure out this made no sense. How could a broad equity index representing a claim on the earning power of many companies in competition with each other be worth 200 years of earnings?
The truth is it wasn’t, and prices declined accordingly.
Similarly, when looking at various Southern California apartment deals in 2005, it didn’t take a genius to figure out they made no business sense when they were selling at prices so high you couldn’t service the debt with zero vacancy, no operating costs, zero taxes or insurance, and the lowest interest rates in the last 40 years.
There isn’t a valuation model in existence that can make business sense out of such inflated prices except the greater fool theory.
In summary, you can use the business common sense test to help you avoid dangerous investment manias and speculative bubbles that can lead to losses.
Investment Advice: How To Avoid Fraud With The Business Common Sense Test
But the business common sense test isn’t just limited to avoiding investment manias and speculative bubbles, because you can also use this same test to sniff out potential frauds.
For example, a common fraud I see is the classic Ponzi scheme where someone is offering you outrageous interest rates on your money and “guaranteeing” your principle to invest.
The business idea supporting the investment usually sounds plausible on the surface, but is often laced with techno-babble terminology to intimidate the novice from asking the following necessary and obvious questions:
1 How does it make business sense for the promoter to go through all the headaches of soliciting many small investors, when a legitimate business could attract all the capital needed from professionals with one phone call and at lower interest rates? (Answer: It probably isn’t legitimate, and a professional would figure that out with due diligence – amateurs don’t do their due diligence.)
2 How are the exorbitant returns being promised adequately earned by the underlying business, and what are the barriers to entry that will keep those returns from being competed away (assuming the business is legitimate)?
3 What’s really behind the “guarantee” and what’s really being guaranteed anyway? (Investment advice: the more somebody “guarantees”, the closer you should look at the guarantee and what you’re being guaranteed from.)
Knowledge is the nemesis of the con man, and an informed investor who’s willing to ask questions is his worst enemy.
The way you learn is by asking questions and listening – that’s what due diligence is all about.
Amateurs want to hope and believe they found an easy road to wealth so they don’t ask questions and don’t want to know the truth. The result is usually expensive.
I see investment fraud cross my desk with remarkable regularity. They’re out there, and if you invest, you must apply business common sense and do your due diligence to flush this stuff out.
I’ve saved many clients hundreds of thousands of dollars just by coaching them on how to ask the right questions … and I can help you, too.
“Just wanted to thank you for your advice about the (name withheld for legal reasons) investment. I recently cashed $220K out of his deals making over 20%. The money was over a month late but it arrived. A real estate lawyer thought it was the worst contract he had ever seen; from the first sentence he knew it was bogus. Working with you really helped. I got an education and learned to do my due diligence and let the numbers be the basis for my decision.”
— Name Withheld For Legal Reasons
(This scam was later uncovered by the S.E.C. – investors who didn’t get out early lost everything.)
Always remember that your investment represents a claim on either the assets or earning power of the underlying business. Whether it’s debt, equity, or real estate, you must ultimately be able to make business sense of the return you’re being promised.
If it doesn’t make business sense, then it probably isn’t real.
Remember, if it sounds too good to be true, then it probably is. That’s just common sense investment advice for a competitive business world.
Due Diligence Question #5: How Does This Investment Affect The Risk Profile And Mathematical Expectancy Of My Portfolio?
For the statistically or financially trained, what we are talking about here is efficient frontiers and modern portfolio theory. For the rest of us, I’ll try to translate into plain English.
You should never add an investment to your portfolio unless it either lowers your portfolio’s risk, or raises its return. Preferably, you should get both.
How do you do this?
Let’s say you have an investment strategy in stocks that returns 8% compounded over multiple cycles in the market, but loses money during bear markets. If you add an inversely correlated asset (something that zigs when the other asset zags) with a return expectancy of 12%, you’ll lower the risk of the whole portfolio while increasing the return.
Examples of assets with low or negative correlation to domestic stocks include commodities, gold stocks, real estate, and certain alternative investment classes like hedge funds.
All investments should first be analyzed for their risk profile (under what conditions they will zag), and their mathematical expectation (how much they should return over time).
In Summary...
In summary, the game of investing is won or lost on the due diligence battlefield.
You must ask questions until you have the answers you need to make an intelligent decision. A quick review of the five “must ask” due diligence questions follows:
1 How can I lose money with this investment?
2 How will this investment help me achieve my personal and portfolio objectives?
3 What’s my exit strategy?
4 Does this investment pass the business common sense test?
5 How does this investment affect the risk profile and mathematical expectancy of my portfolio?
My intention is for the above list of due diligence questions to serve as a basic starting point for your own due diligence process.
“The key to wisdom is knowing all the right questions.”
— John A. Simone, Sr.
I don’t pretend this list is exhaustive because a whole book could be written on the subject. Other due diligence questions to consider include:
1 How realistic is the expected