Due Diligence and Portfolio Management Decision-Making

We manage portfolios for other investment advisors and consultants in addition to individuals, families and trustees. A bank recently interviewed us to manage international stocks for their clients. The process, known as “due diligence,’ consists of statistical reviews along with manager interviews. Our performance statistics are available through databases such as Morningstar which compiles returns from numerous investment managers. The bank’s goal in selecting a manager is to try to determine whether the investment managers have a process in place that is repeatable and will most likely lead to superior investment performance in the future.

Before we invest in a stock, we spend quite a bit of time researching the underlying business ofthe company. We study its products and services to understand whether there is a growing market for its offerings. We also research the competitive landscape to ensure that the company will maintain or grow its market share in the face of determined competitors. We focus on companies with leading brands or market niches that are defensible.

Most of our time is spent trying to figure out what could go wrong with a particular investment. Our first goal is to avoid losing significant amounts of invested capital. Limiting these impairments produces superior returns over a market cycle.

Aside from researching the business and assessing risks, we also determine a fair value for the stock. We will only buy or hold investments that we believe are worth more than the market price for that stock. Similarly, we sell any investments that we believe are worth less than their market prices. After this valuation step, we develop a thesis to buy or sell a stock for a set of reasons. If our thesis or underlying analysis is wrong, we will change course and sell a holding that is in the portfolio.

While knowing a company thoroughly is important, the ultimate decision to buy or sell that stock is the most important factor in investing. Superior research analysts are not necessarily the best portfolio managers since the skills are different. The portfolio manager must distill the true signals from all of the noise that has no influence on whether or not an investment will succeed. Analysts also focus their efforts on limited market sectors and a small number of companies, but the portfolio manager must assess the entire portfolio and determine how to position the portfolio to perform well in the market. The manager must then execute his or her decision with confidence that the odds favor each specific trade and will improve the portfolio’s structure as a whole. This ultimate decision-making process is the most vital, but also the hardest to assess.