Delving deep on due diligence

March 4, 2024

Peanut butter and peanuts on the wooden table

Balance sheets can teach you a lot about a company, but nothing beats getting on a plane to see the business for yourself.

A balance sheet offers (at most) a high-level insight into a business: the revenue flowing in (or out), debts and liabilities, personnel and other key factors. These are important to know, but you can learn only so much by reading an annual report or modelling things on a spreadsheet.

Visiting a factory or making the rounds of the company’s locations is not just crucial, it can be fun, rewarding and challenging. It is an opportunity to connect the dots between what you see on paper and what makes a firm unique. You get a sense of how a core business might be responsible for generating the outsized returns and competitive advantage that attracted you to it in the first place.

Getting hands-on at a target company isn’t optional. It’s pass/fail. Due diligence is about overturning every rock you can find, lest you miss a crucial piece of data. It’s about understanding the fundamentals of a business so you can make a good investment decision and buy at a price below its intrinsic value.

That’s the art of investing, right? Buy low, sell high. That sounds straightforward, but there’s some nuance to this maxim, according to superstar investor Waren Buffett. He said the two most important rules to investing are: “Rule number one, don’t lose money. Rule number two, see rule number one.”

What did he mean by “don’t lose money”? Buying a stock at $315 and watching it go to $10 is frustrating, but not if you know the company’s underlying value. There’s a chance that if the underlying assets are still strong, the investment is still solid despite the stock price.

“Losing money” is much deeper than that. Buffett’s rules refer to a situation where you buy a stock at $20 but only later discover that it is worth $15. That’s the sort of mistake that can get you fired – or wipe out your net worth. If it happens, it means you’ve miscalculated the intrinsic value of the target company.

In his book The Intelligent Investor, Ben Graham explained the concept of intrinsic value as what a knowledgeable buyer would pay for an asset in its entirety in cash.

For example, if you’re shopping for an antique table, how do you know a dealer’s price is right? You will need to see the prices for similar tables at other stores or compare it to what others have paid for similar tables in the past. If the dealer’s antique table is worth $1000, and you see it at another store for $995, maybe it’s an ok deal. But if you see other tables priced at $800 or $600, maybe those are the better deals instead.

But why do you think these are better deals? Because you might have been wrong in your analysis about the intrinsic value of antique tables. Your goal is to buy an antique table at a price lower than what you think it’s worth. That gap is called the margin of safety.

The same is true when buying businesses. Only after learning a company’s intrinsic value is it possible to buy it within the margin of safety. And the only way to discover this margin of safety is to touch, taste, smell and see the business, for yourself, on the ground.

Let’s invent a company to illustrate this. We’ll call it Bob’s Peanut Butter.

On paper, Bob’s Peanut Butter had good margins, decent returns on capital, a growth business and it allocated capital wisely. Even better, customers are willing to pay a premium. Your task is to figure out why people like it so much. So, you board a jet for a look around.

It turns out you’re the first non-employee in twenty years to be allowed into Bob’s Peanut Butter factory. After talking to the staff surrounded by cluttered whiteboards and PowerPoint presentations, you learn that the founder’s grandfather invented a process called graffing.

Graffing is the process of spinning the contents of a vat in circles while an arm rises up and down in a pattern. The workers pour in the raw ingredients and the graffing continues for 12 hours.

Slowly, the process agitates the contents by creating tiny bubbles to result in a uniquely smooth texture. The process always takes 12 hours and cannot be sped up.

When you taste other peanut butter and compare it to Bob’s Peanut Butter, the difference is immediate and obvious. Bob’s Peanut Butter is the ambrosia of sandwich spreads, and that’s why the company can charge a premium for it.

There was nothing in the books about why everyone loves Bob’s Peanut Butter. It required a visit to the factory to see how the company had identified something it was good at and worked hard to fortify this market position.

Its management team was laser-focused on finding new growth opportunities in the core business and thinking up clever ways to pursue those opportunities.

As they say in the military, time spent on reconnaissance is seldom wasted. The value of Bob’s Peanut Butter was in its intangible assets that couldn’t be accounted for by accountants.

There really is no substitute for getting your hands dirty when it comes to due diligence.