Due Diligence – Fundamentals and Beyond

The ASX Australian Investor Study 2020 corroborated a trend noted on multiple financial websites in the last several months. The COVID 19 Pandemic seems to have fueled further increases in new investors.

The latest study highlights some surprising trends, among them the following:

• The increase in new investors over the last few years has seen a marked shift in investor demographics, particularly among those who hold listed investments. Driven by the number of women and younger Australians actively investing, this trend looks set to accelerate over the next few years, as a new wave of investors intends to enter the market.
• The increase in new investors entering the market has seen a sharp rise in the proportion of women investing. Forty-five per cent of those who began investing in the last 12 months were female, up from 31% among those who started five to 10 years ago. It is a trend that looks set to accelerate, with women accounting for 51% of intending investors.
• The last two years have seen an influx of younger investors into the market. Among those who began investing on a securities exchange within the last two years, a quarter are Next Generation investors. This development looks set to continue, with 27% of intending investors (those planning to begin investing within 12 months) aged 25 or younger.

While some observers of this trend within the professional investment community expressed concerns about the need for investor education for these newcomers, the ASX study points to some who are eagerly looking for market knowledge.

If any of these young newcomers were about to buy a small business of any kind, it is hard to imagine them doing so without performing some kind of “due diligence.” A generic definition for due diligence is a comprehensive appraisal of a business undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential.

The most common due diligence method is financial ratio analysis. Ratios are readily available on many financial websites. However, they suffer from a major drawback – they represent a single moment in time. There are better, although more challenging, methods of financial analysis, using the financial statements released by a company in its legally required filing period.

Trend analysis is one form of analysis using these financial statements and they represent an excellent opportunity for new and old investors to identify trends in what a company does, what it owns, what it owes, and how much cash goes in and out its doors.

Company websites include the three major financial statements released annually, but often include only two or three years of reporting. Some financial websites, such as reuters.com/markets include five years.

There are three core financial statements for investors to examine:

1. Balance Sheet
2. Income Statement
3. Cash Flow Statement

The values used to create financial ratios come from these three statements, but as already noted, the ones you see on financial websites represent a single point in time.

A five year view of the three statements lets investors see the drivers of the company’s financial performance in its operational performance over time.

Upon first inspection, some investors – old and new – might be intimidated by the list of metrics, some in common sense language, others requiring translation services from a professional accountant.

However, there are core numbers most relevant to an investment decision. To illustrate, we turn to Reuters for the financials for Rio Tinto (RIO) and Fortescue Metals Group (FMG).

First, the Balance Sheet for Fortescue:

For each item Reuters simplifies the assessment process by providing a trend graph in the extreme right hand column. Retail investors should not be scared off by the seemingly endless list of items, many of which need definition. Instead, concentrate on these keys:

• Cash
• Total Current Assets
• Total Assets
• Total Liabilities
• Total Equity
• Tangible Book Value per Share

Most analysts will tell you Cash is King on the balance sheet, and Fortescue fares well with an upward trend, despite the dip between FY 2017 and FY 2018.

Assets, both current and total, are in an upward trend and liabilities are stable.

Investors willing to dig a little deeper would note the relative stability of long term debt.

Fortescue has seen impressive increases in its Tangible Book Value per Share, a figure that includes only liquid assets.

This quick and easily available review suggests Fortescue has shown strong financial performance over five years.

A walk through of the Balance Sheet for rival miner Rio Tinto (RIO) shows a similar pattern, with a few more ups and downs than Fortescue. However, for each of the most relevant items, the trend for Rio seen on Reuters is upward or positive and stable.

The Income Statement looks at a company’s revenue and expenses in a given accounting period, annual or quarterly. In some ways it is favored by retailers due to its more common name as the profit and loss (P&L) statement.

Most retail investors gravitate toward the Income Statement where they find the items of greatest interest – revenue and income. Operating expenses should not be overlooked as significant increases in expenses eat into income.

The statement shows how the revenues the company generates get translated into net income (profit) or loss. Key items in the statement include:

• Total Revenue
• Total Operating Expenses
• Operating Income
• Net Income After Taxes
• Diluted Normalised Earnings per Share (EPS)

Here is the Income Statement for Rio Tinto:

Rio’s Total Revenues (cash and credit) have been trending upward for the last five years. Both operating income and net income after taxes took a hit between FY 2018 and FY 2019. Another benefit of trend analysis using financial statements is seeing how a company responds to a down year. Rio’s income rebounded in FY 2020, while still not matching the boom year of FY 2018. One explanation for what happened can be found in total expenses, which increased between 2018 and 2019. The company reversed the trend in FY 2020, a good sign.

Diluted EPS includes preferred stock and bonds that can be converted to stock (convertible bonds), with Rio reporting steady improvement

A review of the Income Statement for Fortescue shows the revenue and income dip coming between FY 2017 and FY 2018 with the company rebounding strongly in FY 2019 and into FY 2020.

The Cash Flow Statement is a recent introduction to financial reporting, first used in 1987. This statement takes information from the other financial statements to produce an accounting of the transactions that move cash into and out of a company’s banking ledger. There are five items for retail investors to consider:

• Net income
• Operating cash flow
• Cash flow from investing activities
• Cash flow from financing activities
• Final cash amount.

Here is Rio’s Cash Flow Statement history from Reuters.

Net Income as reported does not include accounts receivable, unpaid expenses, depreciation and other adjustments that do not involve cash transactions.

Cash from Operating Activities is the key metric since it tracks the difference between cash received from customers and cash paid out in expenses. For Rio, the trend is positive. A review of Fortescue’s Cash Flow Statement shows an upward trend interrupted between FY 2017 and VY 2018 followed by strong upward movement in FY2019 and FY 2020.

Both Rio and Fortescue show negative Cash from Investing Activities, an unsurprising result since the number represents cash paid out in asset purchases and acquisitions. Cash paid out is offset somewhat by dividends the company earns if it holds share in another dividend paying stock.

The same is true for Cash from Financing Activities. Cash paid out includes dividend payments to shareholders and bondholders, share buybacks, and loan repayments. Cash in comes from loans, bond issuances, and other sources of outside capital.

In the eyes of most financial experts, due diligence by the numbers alone, regardless of ratios or financial statements as the source, falls short of what investors need to make informed purchase decisions on a stock.

Due diligence goes beyond the numbers in several ways.

First, the market in which the company does business is arguably the most important consideration in doing due diligence beyond the numbers. Key issues include:

• What does the company make or do to generate revenue?
• Who buys the products or services the company offers?
• What is the size of its market?
• Is demand for the products or services growing, stable, or declining?
• Who are the company’s competitors?
• Can new technological developments disrupt the company’s business model?

Fortescue is a pure play iron ore miner while Rio is a diversified miner whose primary revenue source is iron ore, but also mines aluminum, copper, and derivatives of both.

Due diligence beyond the numbers requires reading and the ability to sort relevant news from irrelevant news. Company websites are good starter sources. Investors with time can dig into annual reports which offer the highs and lows of the year in question with an outlook statement for the future.

Financial websites like thebull.com.au provide daily market news updates for a specific company where investors can find the highly relevant information gleaned from financial releases. The CommSec Daily Report here on thebull.com.au often contains relevant information for a stock of interest.

Some financial sites allow users to set up alerts for company news for stocks of interest. In the past month there have been multiple articles commenting on the demand for iron ore in China, a principal customer for both Rio and Fortescue.

For investors who feel the due diligence by the numbers for Rio and Fortescue fails to provide a clear winner, Fortescue has announced plans for a major expansion of its business model. The company is launching a project to produce “green” steel here in Australia, replacing coal as a fuel for firing steel producing furnaces with hydrogen.

Electric Vehicles (EV’s) require 30% more aluminum than traditional internal combustion engine (ICE) powered cars.

Further due diligence beyond the numbers uncovers an article from global research and consulting firm Woods Mackenzie stating that EVs can use up to three and a half times as much copper when compared to an internal combustion engine (ICE) passenger car, with copper demand further enhanced by its use in EV charging stations and electrical grid infrastructure.