“They can’t touch me. I do my homework”
-John Boyd

How much investment due diligence is enough? How much is too much?

The amount of research an investor should do before making an investment depends on three factors: 1) Size of Position 2) Illiquidity of position, and 3) Contrary nature of position.

The Kelly Criterion is a good heuristic, although in real life we never know exact probabilities. Most investments will succeed or fail on one or two factors. The key is to identify those and understand them better then the person selling to us. Anything beyond that is just for fun. Indeed a lot of investors really like to dig. But the 80/20 rule applies. Think jiujitsu not powerlifting.

Position Size

Position sizing is part math and part psychology. The bigger a position, the more a person has to check and double check. This isn’t just a number in a spreadsheet. Conduct a premortem. What is the maximum pain you can take? The only way to survive a large position going against you is to have the confidence in your research.

Its critical not to get causation wrong here. If “concentration” is part of one’s identity as an investor, there is a major risk confirmation bias will takeover and more research will just make them more sure of a false idea. Remember smarter people are actually at greater risk of confirmation bias.

If the facts lineup, it might make sense to “go for the jugular”.

Illiquidity

For most individual investors, illiquidity is a secondary concern. Nonetheless an investor must consider it. An investor can easily sell a widely traded stock or ETF. But for illiquid positions, an investor needs to learn that information ahead of time.

Decisions that are easy to reverse can be made quickly. Decisions that are difficult or impossible to reverse require more analysis up front.

Contrarian nature

Markets are usually right. The more out of consensus a view is, the more data and analysis an investor must have to back it up. “Who is on the other side?” is probably the most important question in investing. I’m only comfortable if I understand the contrary position better than people who hold it.

Active investing requires active thinking.

With investment research an hour of active critical thinking is worth more than a week of passive reading

Techniques of due diligence depend on what’s available, and also on an individual personality. Some people are good at plowing through footnotes or analyzing sentiment data, others are highly skilled at interviewing industry experts. Since computers read 10-Ks the minute they come out, its essential to get creative with due diligence, but this does not mean digging for the sake of digging.

Example:

I was researching, a venture capital focused business development company (BDC) liquidation. Its investments holdings consisted of preferred stock in 11 venture stage companies, with most of the value concentrated in the top five holdings.

Although there was limited publicly available information on the financial condition or valuation of each individual holding, the filings disclosed the aggregate range and average of the metrics and assumptions used by the company in the valuation process to arrive at fair value of Level 3 Assets on the financial statements. My interest was piqued when I noticed that other public BDCs that owned some of the same asset were marking them at much higher prices. Nonetheless, I needed to verify the viability, and growth potential of the main underlying businesses.

I approached this issue from multiple angles:

One of the company’s largest assets was preferred stock in a company that operated a dating site. With permission from my wife, I set up a fake profile to see how the interface of the website and app worked, and to verify that there were indeed a large number real people using it in my area, and a few other cities I checked. This helped me corroborate information from user reviews I had read.

The company owned stock in a highly specialized medical testing startup. I reviewed the background of top employees on LinkedIn, university websites, and various scientific journals. Additionally I discussed the business idea with friends in academia. They verified that the idea had a reasonable chance of working, and would require an advanced degree to replicate.

Accounting rules gave management ample discretion on how to report the holdings on the balance sheet. I carefully reviewed everything they had disclosed about their valuation process, and tracked changes in language between different filings over time.

I also contacted the management of the BDC, and was able to reach the people in charge of the valuation process on the whole portfolio. They helped me understand the facts they were using to justify the valuations supplementing my careful reading of the public disclosure. The conversation verified that the BDC was indeed serious about liquidating its portfolio. Further they candidly reminded me how valuing the portfolio conservatively made the tax consequences of converting to a liquidating trust more favorable for investors(the management group was also a large shareholder).

I did a lot of unconventional work, but didn’t mindlessly dig for more info. It wasn’t a huge position but since its going to be locked up in a non transferable liquidiating trust, and it was an idea most people thought too ugly, a bit of extra work was justified.

The company already paid back most of my initial investment after selling one investment and the portfolio still has a lot of value. The true test will be in the final IRR when its all said and done.

See also: The hard thing about finding easy things