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Due diligence: What information do you need to make a good investment decision?
October 06, 2021

It’s World Investor Week, backed by the Financial Markets Authority (FMA), here in Aotearoa New Zealand. The theme for the week is ‘Investing FOMO – take a mo’ after the FMA’s recent report showed nearly a third of retail investors were making investment decisions based on the fear of missing out. The FMA are urging investors to take a moment by considering the 5 D’s of DIY investing:

1. Do your due diligence
2. Drip feed your investments
3. Diversify
4. Don’t freak out if markets go down
5. In doubt? Talk to a financial adviser

While it’s important for investors to consider all 5 ‘D’s, here at Catalist, we thought we’d dive a bit deeper into the first ‘D’ – due diligence. What information do you need about a business to make a good investment decision?

What is due diligence?

We’ve written another blog post on doing your due diligence and why it’s important but essentially, due diligence is the process of investigating or researching a matter before making a decision or entering into any form of agreement or contract. In an investment context, it’s making sure you’ve thoroughly understood a business and read all the information provided to you, before investing in it.

Where can I find the information I need?

When considering an investment, this should always be your first question – though the answer will depend on the type of investment you are looking at.

For example, for a KiwiSaver fund, you should review the Product Disclosure Statement, which can usually be found on the relevant fund’s website. This is a standardised document that allows you to compare the risks and investment strategies of the different funds.

When considering investing in a business listed on a licensed stock exchange, such as the NZX or the Catalist Public Market in New Zealand, the ASX in Australia, or Nasdaq in USA, you can be confident that all the information you need is available through the stock exchange itself. This is one of the benefits of a licensed stock exchange – there is a legal requirement to make all relevant information available to investors. The information provided may include documents such as financial statements, annual reports and a product disclosure statement or information memorandum. Investments on other unlicensed platforms, or private investments, may not provide you with all the relevant information and you won’t have the same legal protections.

Even on a licensed stock exchange, in many markets it can be hard to sift through all this information. Rather than compiling information in a single document, every time there is information that needs to be disclosed to investors, it is released. You may need to go back through multiple information releases to get a good picture of the business, which is why many investors rely on financial advisers or third-party research providers to give them an up-to-date view on each business. To make it easier for investors, for every business listed on the Catalist Public Market, there is a single page to access all the information you need to make your investment decision, including key documents such as an information memorandum (IM), also known as an investment memorandum. An IM is a comprehensive overview of the business, their objectives, terms of the investment and any risks associated with the investment.

It’s important to note that many businesses put out IMs, but not all IMs are subject to the same standards. So, whenever you’re relying on an IM, first make sure you understand whether the business is listed on a licensed stock exchange and whether the information is required to be comprehensive. When you know the standard of information to expect, what should you look for in the IM?

Five key things to look for in an information memorandum before you invest:

1. Business proposition and strategy

You should be able to understand how the business makes money and what their Unique Selling Proposition (USP) is. Put yourself in the shoes of a potential customer and ask yourself, why would you buy their product or service, rather than buying from someone else? This could be, for example, a unique product that is protected by intellectual property (IP). What’s the strategy for growing the business and is it convincing?

2. Team

The people are the most important assets in any business. You don’t need to look at CVs for every employee, but an IM should describe the skills, experience, and background of each of the key people involved in the governance and management of the business. Directors should be there to steer the overall direction of the business, so ask yourself whether the skills and experience of the directors and senior managers are aligned with the business-growth strategy they have described?

3. Performance

You don’t have to be an accountant to look at the past financial performance and ask yourself whether any future forecasts look realistic. What was the revenue (money coming in from sales of goods and services) in previous years, for instance? If the forecast says revenue will go up in future years, do you understand the assumptions behind that forecast?

Historic financial performance isn’t the only performance to consider though. Has the business achieved a milestone that means they can be more profitable in the future? For example, a business may spend several years researching and developing new products, during which time they may not be able to sell much. If they now have a product that they’ve demonstrated others will pay for, you might expect revenues and profits to start growing – but they may first need an additional injection of cash to help them deliver enough product to match consumer demand.

4. Investor rights

A key part of any investment is to understand what you are investing in. Are you buying standard shares, which would usually allow you to have a vote on appointing the Board of Directors and an entitlement to a proportion of any profits that the company decides to distribute. Or, does your investment simply entitle you to repayment of your money plus an agreed interest rate?

5. Risks and opportunities

A good IM will outline the things that could go wrong in the business and may even provide examples of how the business has dealt with the difficulties that have come its way so far. This should help you weigh-up whether the potential returns from investing in that business are sufficient to justify the potential that things could go wrong

The flip side of every risk is that there are also opportunities for a business that can successfully navigate a path through those risks. A business that can survive the bad times then has the opportunity to thrive in better times. So, ask yourself how well-prepared the business is to face potential risks.

So overall, we encourage investors to embrace the five Ds of DIY investing this World Investor Week and beyond. Take a moment to have a think about how your emotions or FOMO dictate your investment decisions – and take your time to consider all the information that’s available about an investment.

As a licensed stock exchange, the Catalist Public Market has been designed in a way that encourages (and legally requires) the disclosure of quality information. Rather than continuous trading and continuous information disclosure (as is the standard with markets like the NZX), Catalist uses periodic auctions, meaning information is disclosed at each auction. This means investors can get all the information they need to make a good investment decision, without overburdening the small and medium-sized businesses (SMEs) who are disclosing the information. Periodic auctions also mean investors have time to consider all the relevant information, without the ‘fear of missing out’ to those who make faster decisions and without feeling overwhelmed from continuous information overload.

We will shortly be launching our first public listings (mini IPOs), which will allow investors to diversify their existing investment portfolios to include a portion of SMEs. If you want to introduce some SME businesses into your wider portfolio, make sure you’ve signed up for a Catalist account and opted in to our newsletter. We’ll be sending out updates on IPOs and investment opportunities in the coming weeks. We already have a small number of opportunities open to wholesale investors. If you would like more information contact us.

By Michelle Polglase