Today’s show was inspired by something that happened recently. I was at a party and I met someone who said they knew who I was, but I didn’t know them. That happens often when you speak frequently as I do. She was asking me about the projects we have underway. She was telling me about the ideas she had for flipping houses in our local market, something she had never done before. The ideas she was suggesting sounded risky to me. The path to success is filled with land mines and she really would need to work with someone who has a lot of experience and help her avoid the many pitfalls along the path. At that point she offered to invest passively with me in some of my projects. Now I don’t know if she would even qualify to invest in our projects. That’s not the point of the story. The point is that it was clear to me that she had not developed a clear idea of what constitutes a good investment. The idea that she would part with large sums of money without having that clear criteria is the part I found disturbing. Sadly, I encounter this situation very very frequently.
So on today’s show we are talking about the importance of developing a clear investment criteria.
Making an investment decision requires discipline. It requires a formal due diligence process. I see of people making insanely rash and poor investment decisions all the time. Frankly it’s hard to stand by and watch it happen.
Due diligence requires a separate focus on three areas. These are:
- The local market conditions
- The people running the project
- The specifics of the deal itself.
The idea here is that you develop your own due diligence checklist. The step that most people miss in that exercise is to have some clear pass/fail criteria for each of the checklist items.
I look at the overall supply and demand situation to confirm that the market conditions are truly favorable for investment. If there is much more supply than demand, it’s going to be difficult to create value in the market. Business is all about solving real problems. If there is excess supply, whether it is because people are leaving or it has become overbuilt, the outcome is the same. If there is an excess of supply, there’s no reason to invest.
When it comes to the team, I look deeply at the people who are sponsoring the project. I look at their track record. I want to see projects that have experienced adverse situations to see how the team handled those situations. The deal itself also has to meet very specific criteria.
My own due diligence checklist consists of about 60 items. Your list doesn’t need to be excessive. But I believe a due diligence list of between 40 – 60 meaningful questions is about right.
The questions should be categorized by grouping. Within each subset list some questions can allow for some grayscale in the answers. Others will require a black or white binary pass or fail answer. If you color code the answers to the checklist you will be able to see in a couple of pages whether the deal is going to work or not. You will see if there are a few solvable problems, or if there are too many problem areas to overcome. If the problems are confined to a few areas. You may be able to have a meaningful negotiation with the deal sponsor. Maybe an additional piece of collateral, or an additional process step can eliminate a risk item. Ask other more experienced investors to review your checklist and provide both ideas and input.
It will take several iterations to develop a checklist that you feel truly confident in. You may refine that checklist over a period of months or years. That doesn’t mean you should wait until the checklist is perfect before you make an investment. But the simple act of having a checklist and a defined process for making decisions will put you ahead of the vast majority of investors.
