The Three Ds of Investing: Due Diligence, Due Diligence, Due Diligence

Most of us are familiar with the saying. “The three L’s of real estate are location. location, location.” The same would be said tor investing, in which case, the term is due diligence.  The problem is that although most people know they need to invest, they don’t know where to start. For most, their investing journeys are a matter of trial and error. A common starting point i s often mutual fund sales. A person involved in this type of investing is not likely to get much direct or current feedback from a fund manager and will attempt or forgo due diligence by covering the spread, which is better known by the overused term, diversification, For the “do­-it-vourselfer … the Internet can be an unlimited source of opinon and information. Tools such as PALTrak, Morningstar, Market News, Squawk Box and News Wire can provide insight for investors. Information gathered from these sources can also be relatively subjective, due to the fact that what is happening in the management of any one fund could change without notice, The manager of the fund could leave for a better paying job, or be terminated, and you would have no warning as to any changes in your investment. Many investors will deal direct with a securities broker, in hopes of targeting more specific investment options.  In many cases, you will find brokers who focus their research on specific sectors, such as oil and gas, mining, agriculture, health and science or banking.

It is not uncommon to see a single mutual fund that has over 150 different securities. On the other end of the spectrum. you may find a security broker who only promotes twenty to thirty securities at any one time. Determining the option that suits your investment style can be difficult. A recent article I lead suggested that most brokers and fund managers could not beat the Standards & Poors 500 or other common Indices (Common Market Benchmarks).

It is important to note that if you are planning on dropping your investment dollars off at the bank, broker or advisor office. and are leaving the investing to them. you might not be happy with the outcome.  Chances are, you have already experienced this and are well aware of the result.

One of the issues investors may be facing is a lack of time t0 do a lot of research. If this Is you, as is the case for many busy Canadians. one possible strategy is to consider advisors that take a team approach.  It is far too much to expect great advice from someone who tries to be all things – investment advisor, financial planner, insurance specialist and customer, relations manager, all wrapped up in one. Don’t be afraid to ask, “who Is on the team and what do they do”? A team approach has become more common. These groups are likely to delegate and have specialists available for each task, such as research and customer service Insurance. Whether you are relying on your advisor or doing the due diligence yourself, some important questions t0 ask are:

  • How long have you been in business?
  • How long have you been in business?
  • What is the management structure?
  • What makes you competitive now and in the long term?
  • What do your flnanc.ials look like? Are they audited?

It will be difficult to get answers to these kinds of questions for a mutual fund invested in 150 different securities.  For the investor who is targeting specific sectors or a direct investment to a business itself, the answers are out there. When speaking with Ed So, President and CEO of Redstone. a Toronto-based bridge financing company. I asked him What their formula is for sound financial lending, In order to ensure a winning strategy. Ed said,

Ed So

“As an asset backed lender, our investors want to know who we lend to, for how much and for how long. Lending can range from $150,000 to $2,000,000. for one year and under.  There are three main criteria. First is a two to one ratio. A client looking to borrow $400,000 needs to post $800,000 in security. This could be comprised of commercial and/or residential property, Equipment & Machinery, Inventory and Accounts Receivables.  For Equipment & Machinery, we consider what the asset is worth as a “fire sale” scenario (when a property or asset is liquidated. usually by a creditor in a short period of approximately thirty days), not what the client paid for it, or even the appraised value. Receivables and inventory are also considered. but at a discount. In all cases we ask the borrowers to put up a personal guarantee as additional security for the debt. If a client is confident that they will repay the loan, then they should not have a problem with putting their name on it.  It is a show of commitment to their business and the debt obligation to Redstone.  ‘Redstone considers the worst case scenario just as the investors would, and will ensure that it has the ability to recover its loans for Redstone and investors. So every deal needs to be structured with the thought that the loan may go bad and how do we recoup capital. That said.  Redstone has not had a loan go into default.’  Redstone is not in the business of taking over businesses that over extend themselves. or else, we would have wanted equity from the beginning, or structured our business t0 be a merchant bank.  Redstone investors are looking for profit, so considerable consideration is given to analyzing cash flow and profitability and ensuring that our loans are successfully matched with the right candidate.  A client who is looking for a loan will typically have a “liquidity event.”  This Is an event that is certain to occur and ensures that the borrower will be capable of repaying the loan at a defined point In the future. Further to that. Redstone will not re-­leverage any investors· investments. All investors are equally in first position on the loans.”

It is important to note that not all lenders operate this way.  Some will raise capital then go back to a bank and leverage that money for more lending power and will consequently put the bank in first position and the Investor is left holding the bag with no way of recapture. This is what happened In the past when people refer to Asset Backed Commercial Paper in the U.S. Not only are the answers out there, there are companies that do nothing but analyze businesses that are looking for Investor dollars. One such company in Calgary, AB Is ExemptAnalyst and Global Stock IQ. founded and managed by William McNarland. William’s clients range from Exempt Market and IIROC (Investment Industry Regulatory Organization of Canada). dealers who offer products, a U.S. pension firm and independent family offices.  All who are looking for these types of specialized advice. For the past sixteen years. William has focused his attention or asset management, analysis, investment banking and private equity.  With nine professional designations and extensive global equity experience. he is an expert at separating the wheat from the chaff, as they would say in the West. In a recent interview with William McNarland, we discussed the relevance of his service and had this to say: “Our due diligence focuses on four key areas:

  • Models and expected rate of return
  • Show how that model compares to other opportunities
  • If management will have the ability to execute successfully on the plan
  • To make a qualified judgment on their overall investment.
William McNarland

There are warning signs that a business is a questionable investment. The number one red flag we see is that the management does not do what they have outlined in their business plan. An example of this is where a company will have planned for twenty per cent to cover costs and fees and the remaining eighty per cent is to be Invested. yet when you review the audited statements, only forty or fifty per cent has been invested because some unexpected costs have come up. A solid business plan will have safeguards to protect against going off course.”

The general public can access this information from our clients. who make annual and semi annual reports available to their clients on an ongoing basis. It is imp0rtant to note that some firms will not do any form of reporting to clients, after the initial offering memorandum.  This means that you might have no idea what is being done with your investment in the future. We will track the performance of a company two times per year. We will review first when the yearly accounting audit is done and then six months in between. Canadian Securities Administrator’s (CSA) National Instrument has turned the wild, wild, West into the wild West. People were able to refer or sell products with a imi ted knowledge, now they need to take a course and be registered with a dealer. The hope is the dealers will select better than average products and the representatives selling to the consumers take proper sustainability into account.
The bottom line is time. Our research strives to weed out fraudulent or unnecessarily risky opportunities and identify those opportunities with attractive risk-adjusted returns. Our average report Is forty to fifty pages per company. This requires considerable time and effort. Unless this is something you can dedicate yourself to full time. it would be too overwhelming.·
Depending on your accountant’s area of expertise or business savvy, they may also be a source of advice. Louis Sapi, CA, MBA and Managing Partner and CEO for one of Toronto’s most highly regarded accounting firms, HS & Partners Chartered Accountants has been offering such advice for nearly three decades. Louis’ main role is in Mergers and Acquisitions, corporate finance and business consulting. and as such, must always have a due diligence focus.

“The key to due diligence is not just the numerous checklists and formulas one can apply but how you apply them … in short one needs to approach each file and each question with a professional skepticism. We need to recognize and apply our years of experience, and increasingly refined intuitive sense, to due diligence process. You can receive an answer on a ‘checklist question’ that satisfies the question – but is it an honest answer?  What lies below the answer? Do other related answers correspond or contradict the first answer? We often seek an answer by asking several differently worded questions to see ii we get the same result. Frankly. our clients need this from us. Our skeptical philosophical approach to due diligence is to say, “we do not want to approve you for our clients’ investment… prove to us we are wrong.”

It’s a bit of a “guilty till proven innocent” way to look at things, but in the current days of technological advancement, we need to take a tactical approach. It is this kind of thinking that creates safe guards for you. the clients. The important thing to consider. When looking ai Where to Invest, Is that you find a company that matches your personal investment philosophy and not just a promised rate of return.

It’s a bit of a “guilty till proven innocent” way to look at things, but in the current days of technological advancement, we need to take a tactical approach. It is this kind of thinking that creates safe guards for you. the clients. The important thing to consider. When looking ai Where to Invest, Is that you find a company that matches your personal investment philosophy and not just a promised rate of return.

Colin Keddy

Colin Keddy is a Registered Financial Consultant and President of Equitable Financial Inc.  Equitanle Financial Group [EFG].  Colin provides fee for Service Financial Analysis as well as Estate Planning and Investing Advice.

Colin can be reached In Otrawa ar 1-613-225-3515 or the GTA and central Ontario at 1-855-225,3515. E-mail Colin at: ckeddy@equitablefinancial.ca