A common saying in the property market is ‘buy the worst house on the best street’. Why would you want to do this? Simply put, there is a greater potential for upside and reduced risk of downside, which makes sense. Looking at the role of due diligence in the decision-making process, we see that investors tend to apply higher standards of due diligence when buying property than shares.
Buying a property involves a thorough due diligence process
Due diligence when buying a property typically starts with a limited understanding of the local market and multiple inspections. This helps the buyer determine whether the property is suitable for their desired purpose. These inspections reveal information such as the number of bedrooms and bathrooms and the proximity to schools and transport. From there, the buyer can launch a more detailed investigation by engaging professionals, including:
A real estate agent
A building inspector
A land surveyor
A pest inspector
An electrical engineer
Once the buyer has all the necessary information, the negotiation process can take place with the vendor to agree on a price. The final piece of the due diligence puzzle is to engage a conveyancing solicitor to assist with the settlement, which ensures that the buyer receives the property as agreed. This approach is commonplace and considered prudent when buying property.
Investors tend to buy shares they know
When we compare this approach with the approach people follow when buying shares, we see some startling gaps. When it comes to choosing shares, investors often make selections with little research or methodology. They generally favour the companies and brands they think they know. The reasoning behind these decisions is often as simple as: ‘I know that name’. Often very little or no time is spent on due diligence or valuation to gain a better understanding of the share. In fact, hundreds of thousands of dollars may be invested with little more care than choosing a popular horse or trainer in the Melbourne Cup!
Why don’t we treat the purchase of shares with the same degree of diligence as when we buy property? Why do we gravitate toward the most popular or expensive shares available to us?
If we consider the time spent in orchestrating all the pre-purchase inspections when buying property, it is unlikely that the average investor will be in a position to conduct the necessary due diligence on a share they would like to buy.
Think of buying shares as buying the company
Instead of thinking that you are buying a share (often at a price that has little to do with the true valuation of the business you are buying), imagine you are buying the entire company without the option to sell. Only when you have an understanding of the company, should you continue your investigation. For the due diligence process, you can then engage the services of some of the following professionals:
A financial adviser
A business analyst
This process will raise a number of questions that investors should always ask, but rarely do. By asking the right questions, you are ensuring you will be making an informed decision, reducing the potential for failure in the process.
Questions to ask when buying shares
The following questions are not just randomly selected. These questions should be part of the investment decision-making process. These questions have proven to provide an increased level of accuracy when selecting stocks for portfolios:
Do I understand what the company does?
Will I get my money back plus a decent return?
Am I comfortable holding this company as a potentially illiquid asset for an extended period (7 to 10 years)?
Why does the person I’m buying from want to sell?
Extracted from Gray Matters. Commentary by Sam Benjamin, Relationship Manager at Allan Gray Australia Pty Ltd