Due Diligence is a process in which analysis of stock investment takes place. This is an important aspect of fundamental analysis.
Know everything about Due Diligence here.
About Due Diligence of Investment
Due Diligence is one of the most basic practices to follow while making an investment decision.
Due Diligence is the act of investigation, wherein the investor tries to analyze the potential returns before investing in a company.
During this process, the investor might take into consideration the financial statements, the management statement, the recent changes that the company has witnessed, etc.
Apart from just looking at the financial statements of the company, the investment Due Diligence includes a lot of things. We will be discussing some of them in this article.
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Investment Due Diligence Process
Here is the step by step process of due diligence which a fundamental analyst does to do their research on a particular company. This is very important concept in fundamental analysis.
Generating a Stock Idea – 1st Step towards Due Diligence
The 1st Step towards Investment Due Diligence is to generate a stock idea.
There are a total of more than 6000 companies listed on the NSE and BSE, and while making an investment decision, it is nearly impossible to go through all of them.
The rational procedure of investing suggests making a checklist with investable attributes, and then short listing stocks.
Once you pick a stock, you need to analyze it against the checklist you made. But it is not possible to pick up every stock available and then analyze it against your checklist.
To help you in choosing the right stock, we have come with a list of factors which you should consider before picking a stock and comparing it with your checklist.
The list includes the following factors:
The first thing you can do while shortlisting the stocks for analysis is, picking them on the basis of general observation.
General observation simply means being aware of the trend in the market. You must keep your ears and eyes open to look for stocks that are being discussed in the market or news.
It is not necessary to buy a stock that the majority is buying, but you must always be aware of the existence of such stocks.
This will help you keep an eye on all the stocks that are being traded in the market. Apart from this, you should also be aware of your surroundings.
Keep an eye on the companies that you get to see on a daily basis in the form of hoardings, advertisements, etc.
Stock screener is basically used to scan and filter the stocks on the basis of a set parameter.
This means you need to put a certain criterion, and all the stocks that fulfill your criteria will be filtered for you.
For instance, if you want to select the stocks that have an ROE of more than 20% and PAT margins of 15%, you will have to put it in the screener, and the stocks will be filtered for you.
There are multiple screeners available in the market. However, google finance’s stock screener is one of the most reliable screeners we have ever used.
Keeping a look at the overall macroeconomic trend can also help you choose the stocks for the purpose of investing.
This is because the macroeconomic trends do not change or develop overnight, but you can see their effect in the long run. Therefore, keeping an eye on such trends can help you pick stocks.
For instance, if the government is planning to make use of renewable energy in the future, you must consider the stocks related to that sector.
If we take a look at the economy from a broader perspective, all the companies are divided into various sectors.
So, keeping yourself aware of the recent happenings in various sectors can help you in choosing the right stock.
For instance, take a look at the automobile sector. All the cars designed are mostly run of fuel, but due to an increasing hike in prices, a rational consumer would consider an electronic vehicle.
Therefore, you should consider the companies that are planning to design such vehicles in the future.
This implies that knowing about the recent happenings in various sectors and choosing the company which can benefit from the change can help in choosing the right stock
This criterion requires you to be pro-active about all the recent happenings.
You need to know about all the companies that are in the news lately and then analyze that news to make an investment decision.
Now, it is important to note that the news must be from a relevant source, and it should be based upon facts.
This is because sometimes you might read articles based on rumors that might lead to a wrong investment decision.
For instance, look at the timeline of Vodafone Idea stock. The stock became highly volatile on the day when the Supreme Court gave their verdict on AGR dues.
The stock first saw a major downfall on a day and then increased nearly 50% in a matter of two days.
Being aware of such news can help you choose the right stock for making an investment decision.
Circle of Competence
If you are a person who is employed in a particular sector and is usually unaware of other sectors, this can be one of the most suitable criteria for you.
Circle of competence requires you to choose a stock from your industry as you would be aware of all the recent and upcoming changes in that industry.
For instance, imagine yourself as an employee in a pharmaceutical company. Being an employee of such a company, your job would require you to be aware of all the recent happenings in that sector.
Therefore, you can use this knowledge in making an investment decision by choosing a stock that can favor such changes.
If you take a look at the stock prices of Glenmark Pharma, you would realize how the prices change on the basis of news.
The share prices of Glenmark Pharma increased when the news for the Covid-19 vaccine under development came into the market.
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Choosing a Right Stock – 2nd Step towards Due Diligence
The second step towards trading or investing is choosing the security carefully.
Before you make an investment in a company, you must be aware of the company you are investing in. Therefore, choosing a stock carefully becomes extremely important.
While choosing a stock, different investors would take different factors into consideration.
Some might invest in a stock based on the company’s financial statements, while others might invest based on corporate governance.
The factors based on which a person chooses a stock are commonly known as investable attributes. The investable attributes are subjective in nature and might vary from person to person.
Based on these investable attributes, a person should make a checklist and ensure that the security they choose fulfills the basic criteria.
It is important to note, whatever investable attributes you take into consideration should be backed by a logical explanation to make your checklist reasonable.
The Moat – 3rd Step towards Due Diligence
After picking up the stocks, you need to compare them with your checklist and choose the most promising ones.
The process of comparing the stocks with your checklist and making an investment decision is known as the Investment Due Diligence.
This is one of the most crucial processes, and therefore you should check the stock for all the factors mentioned in your checklist.
Economic Moat, simply known as the moat, is a term popularized by Warren Buffet. In simple words, moat means competitive advantage.
This implies that the company should be able to compete with the other organizations present in that sector. Doing so will help them make profits in the long run.
The companies with a recognized brand name, higher market capitalization, etc. tend to have a higher moat.
In the case of such companies, it becomes difficult for the competitors to overpower them in terms of market share as the company is sustainable.
Due Diligence – The Last Step
The core process of equity research for making investment decision requires three steps which are:
Understanding the business
Before making an investment, you must be aware of what you are getting into.
You must be aware of the company’s operations so that you know how it might perform under various circumstances. For this, you can refer to the company’s annual report.
It will not only give you an idea of the company’s operations, but you can also have a look at the financial statements to analyze the growth potential of the company.
Application of the Checklist
Once you have selected a company and read its financial statements, you need to compare it with your checklist.
While doing this, you will have to check the company based on all the factors you have mentioned in your checklist.
This process might not require much time, but you must analyze the company against all the factors mentioned.
This process requires the investor to analyze the price at which the security is trading.
Under this, the trader uses a DCF Analysis to check if the price at which the security is trading is the correct entry price or not.
The DCF model will be explained in further lessons.
Investment Due Diligence – Conclusion
The Investment Due Diligence is important as it helps the trader in making the right investment decision.
The process is not very complex, either as it requires you to make a checklist and analyze companies against it.
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