Beyond The Headlines
Kicking the Tires: The Future of Due Diligence
Kicking the Tires: The Future of Due Diligence
I remember sitting in a pilot seat of a massive Boeing 777 cargo plane. It was just me with no co-pilot by my side. I wrapped my fingers around the control yoke; I reached for the throttle with my right hand. In my mind, I was ready for takeoff. It wasn’t a dream! It happened almost a decade ago. As a small perk of my research work investigating companies, I got to visit the FedEx facilities in Memphis, Tennessee. I shook hands and exchanged pleasantries with the founder and CEO, Fred Smith. Then I joined a group of portfolio managers on a small bus to the airport. I love planes and airports; they didn’t have to ask me twice. We got to see a new Boeing 777. We were kicking the proverbial tires and doing our due diligence, and those were some big tires to kick! If you know the smell of a brand new car, I’ll tell you that a brand new Boeing 777 has a distinct smell, too.
This was also the very airport where Tom Hanks’ Cast Away character Chuck Nolan was welcomed back by the very same Fred Smith, who at first had some doubts about having FedEx featured in a plane crash movie.
Funny enough, I was in the process of getting my private pilot license at the time, which allows me to fly single-engine propeller planes, no big jets (maybe one day). To raise my instructor’s blood pressure, I had someone snap a photo of me in the cockpit of this big cargo plane, and I sent it to him saying I’m on my way and asking if he has room in the flight school’s hangar. Flight instructors don’t joke much, neither does Tom, but I think he appreciates my sense of humor now and then.
In my recent conversation with a dear friend and mentor – James (Jay) Hughes (who has spent a wonderful career working with prominent families around the world in his role of a true homme de confiance), we discussed the future of due diligence in the investment process. We talked about due diligence in the COVID and post-COVID era. What will the world look like, we wondered.
I might have researched thousands of companies in my career, I met countless CEOs, and I kicked a good number of tires, big and small. In flying and investing, I live by checklists. Before each takeoff, a pilot walks around the plane and actually touches and checks vital parts. Tom would jokingly ask: “Will it fly?” I never said it, but I always thought that a better question would be whether it will crash!
As investors, we have incredible access to disclosure that the listed companies are required to share with the public. It wasn’t always this way, but over decades, the amount of information and reporting frequency have improved. I still think that US-listed companies are among the best in the world on that front. This gives investors in US equities a great advantage and more comfort.
Outside of the US, it can be a bit of an adventure trying to get a complete picture of the business and knowledge of the local market, and access to local research might be very helpful. Otherwise, a US-based investor might be at a disadvantage. We often lean on outside resources to fill in the gaps in our due diligence.
We have a rich network of connections built over decades of experience. We are a Zoom call away from someone on the ground, almost in any significant economic hub in the country and the world. These are our proverbial boots on the ground; somebody can do the kicking for us. It has proven especially important when travel is almost impossible these days.
Speaking of international travel, early in my career, I hopped on the plane and took a red-eye flight to Brazil. It was a big adventure for a junior analyst. I spent a week with a few fellow investors visiting companies in Sao Paolo and Rio. I also met with local research firms that help outside investors navigate the markets there. I was a bit envious of their office views in Rio with vast beaches as far as the eye could see. I’m still in touch with some of them.
The last time I met with CEOs of some of our holdings was a little over a year ago, two short weeks before lockdowns in New York City. We talked, we mingled, we had coffees and lunches. This year, the same event was hosted exclusively online. The amount of disclosure and information was the same. We missed out on some of the in-person experiences.
When I think of due diligence, I think of the many investors I met in my career. Their takes on due diligence couldn’t be more varied. Some go almost as far as counting the bags of frozen peas in the freezers or measuring foot traffic camping out by the store entrance. Others insist on never meeting the management or visiting the company; they believe that’s the only way to preserve their independent think and avoid being influenced by a charismatic CEO.
I believe we belong somewhere between the two. I like to think it’s challenging to invest in a business without firsthand experience with the product or service or access to someone who has had such an experience. I do believe that some CEOs have a true gift for inspiring their troops and “seducing” shareholders, bringing everyone on board their grand vision.
I personally prefer those executives who underpromise and overdeliver and tell me how things really are. I like to have enough mental space and emotional distance to make up my own mind about the business without too much embellishing. After all, I always would rather have our CEOs grow and expand their businesses than spend too much time at too many investor events.
The more confidence I have in the disclosure I receive, the less tire kicking is necessary, in my opinion. As a rule of thumb, if any investment calls for excessive due diligence, I immediately think that we might be better off moving on to the next one. If it takes so much to convince us to buy it, how much more will it take to make us keep holding it.
Between my trip to Brazil and shaking hands with FedEx’s Fred Smith, I had many opportunities to meet talented executives running incredible businesses. At times, I’d meet the same CEOs who ended up managing more than one company we held. In a way, we followed them on to the next business. I only had a handful of encounters that convinced me not to invest in a company. I can’t say it was a surprise. The meeting confirmed what I already thought after a careful study of all the available information. There were maybe three that stand out. In a few short years, all three ended up with fraud, investigation, and a collapse of the stock price. I didn’t need to shake anyone’s hand or kick any tires to see it coming. If the story is too good to be true, it never is.
When it comes to due diligence, if I don’t feel comfortable with the investment after all my reading, the meeting won’t make me change my heart; it never has. On the other hand, if I like what I’m learning, studying all the materials, kicking the tires, and shaking hands or speaking on a call with someone close to the story can give me a bigger conviction. It is the latter, though, that can make more of a difference. A potentially small position in our portfolios can become bigger because of the extra mile we go with our due diligence.
Due diligence has been helpful not necessarily in eliminating bad investments or investment “crashes,” but rather in helping to make sure we own the stocks that have the ability to “fly”!
I can’t tell if handshakes will be around in the post-COVID era, maybe there will be elbow or fist bumps, but the due diligence will be around. I think some of it might be done over Zooms instead of in-person; maybe we’ll rely more on our network or resources with boots on the ground. One way or the other, we’ll still want to get to know our holdings and the people who run them. I believe that in-person occasions won’t completely go away, but they might be more rare and special, and they will be valued even more highly.
I don’t know if I will get to sit in the cockpit of a 777 anytime soon, but I’m looking forward to seeing the future of due diligence. It might be a less-discussed aspect of the investment process, but it’s crucial, and it may have to be redefined and adapted to this new, much more remote, and dispersed world we live in. Lastly, I had my own 2020 wedding with an all virtual audience (except for my in-laws and my bride); I think I’m ready to have my imagination stretched when it comes to many aspects of investing, including the post-COVID due diligence!
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