Due Diligence: Five "Must Ask" Questions Before Making Any Investment (Part 2)

(Editor's Note: This is a two-part educational series on investment due diligence. Part 1 is at Due Diligence Part 1 )

Due Diligence Question #3: What Is My Exit Strategy?

You should always have your exit planned before acquiring any investment.

Why? No investment is appropriate forever. Times change and your objectives change. You have a reason for acquiring an investment, and when those reasons are violated it is time to exit without delay. By knowing your reasons in advance there is no confusion or hesitation in the sell decision.

The reason it is important to sell is because your portfolio is a living entity. Selling is to your portfolio what pruning deadwood is to a tree – it makes room for new growth to occur. It is healthy.

You should never marry your investments. Polaroid was once a darling blue chip stock that got decimated by technology changes. The rust belt was a real estate boom at one point, and the railroads were the king of transportation … but not anymore. Everything changes, and you must change your portfolio to be congruent with the times.

My investment advice is that there is no such thing as a "permanent investment." I've never met an investment I wouldn't sell given the right circumstances. My job as the manager of my portfolio is to understand what those circumstances are so that I'm ready to take action when conditions warrant.

I must know the assumptions and premises under which I enter an investment so that I can exit as soon as they are violated. Wherever possible I must pre-define exit points in terms of price to control losses when things go wrong.

For example, I was a partner in a company that invested in real estate tax liens. We developed an entire business model to acquire valuable real estate for little more than back taxes … and it worked. We actually purchased valuable real estate free and clear for pennies on the dollar of what it was really worth.

However, despite it being profitable we exited the business because we learned how a legal assumption critical to the success of our model was simply wrong. Once we uncovered the false premise of our model we exited with our profit and moved on to greener pastures. We knew the reasons behind our model, and we knew when that model was invalidated. Some would question our logic because the model had previously been profitable, but we knew it was just a question of time until the invalid assumption would bite us in the rear.

Similarly, when I enter equity positions I pre-define the point at which I will exit based on price behavior that would prove my decision was incorrect.

In summary, you must always pre-define your exit strategy because the first loss is usually the best loss. You should conserve capital so that you are prepared to invest in the next opportunity. By consistently pruning your portfolio of troubled investments you are making room for new growth to occur.

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 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 during due diligence 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 is not 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 is really behind the "guarantee" and what is really being guaranteed anyway? (Investment advice: the more somebody "guarantees" the closer you should look at the guarantee and what you are being guaranteed from.)

Knowledge is the nemesis of the con man, and an informed investor who is willing to ask questions is his worst enemy. The way you learn is by asking questions and listening – that is 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 are out there, and if you invest you must apply business common sense and do your due diligence to flush this stuff out. I have saved many clients hundreds of thousands of dollars just by coaching them on how to ask the right questions … and I can help you also.

Always remember that your investment represents a claim on either the assets or earning power of the underlying business. Whether it is debt, equity, or real estate you must ultimately be able to make business sense of the return you are 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 is 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 will 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 15% 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 17% you will 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). Only add an investment to your portfolio if it lowers the risk of the overall portfolio and/or raises the return.

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 is 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. 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 return?

(2) What are the assumptions and drivers behind the expected return?

(3) How dependent is the historical return on the time period analyzed?

(4) What are the tax consequences of this investment?

(5) What is the background and history of each principal involved?

(6) And many, many more.

My goal with this article was to arm you with some of the more important due diligence questions that can help you avoid the most obvious and expensive errors on the road to retire early and wealthy.

I hope it helps you.

Related Articles:

• Due Diligence: Five "Must Ask" Questions Before Making Your Next Investment (Part 1)