Introduction
One of the greatest challenges that authors face when posting articles on financial blogs is how much information they should include and how much they should exclude. Space is limited, and many readers prefer a short write-up over long dissertations. Therefore, most authors (yours truly included) attempt to summarize their positions in the fewest words possible. However, this approach implies that readers will fill in the blanks between what is said and what is left out. Unfortunately, that is not what always happens.
In my own personal experience, the best example I can offer to illustrate what I’m talking about relates to comprehensive research and due diligence. I am a firm believer that all investing in common stocks requires comprehensive research and due diligence before your money is invested. As a result, I often provide articles on what I refer to as research candidates. Most of the time I am presenting candidates that I believe appear sound or attractively valued.
Therefore, my position is that a research candidate is offered as a suggestion to the reader that the company in question may be worthy of conducting a comprehensive research and due diligence effort. Because, and to paraphrase a comment Warren Buffett once made, “Investing without research is like playing stud poker and never looking at the cards.”
In this respect, I lay out the ingredients but expect the reader to do their own cooking. As I previously stated, I try to offer research candidates that might be worthy of the reader’s time and effort for conducting a comprehensive research and due diligence procedure. Nevertheless, I will often receive comments from readers pointing out important facts or considerations that I failed to mention about a given company. Even though I often stress the importance of comprehensive research and due diligence, I don’t do it in every article I write. Consequently, I understand why readers who are not familiar with my work might get the wrong or incomplete impression about what I’m suggesting or discussing.
Researching United Technologies: Here’s How I Do It
But even more relevant to the thesis of this article is another comment or question that I often receive asking how to conduct research and due diligence. On October 9, 2013 I published an article found here titled “What Is Due Diligence? Here’s How I Do It.” In that article I presented my general approach to how I personally perform research and due diligence, and utilized the company Medtronic (MDT) as a representative example to illustrate my process and procedure. However, several years have passed since I published that article, and in the comment thread of my most recent article I was asked the following questions as follows:
“Everyone talks about performing due diligence. Could someone give advice on what is entailed in that? Are there articles/web sites anyone recommends? Maybe this could be a good topic for Mr. Valuation?”
This reader’s questions inspired me to repost my approach to research and due diligence. However, in this article I will be sharing the due diligence I recently conducted on United Technologies Corporation (UTX), a company I have owned since late July 2010, and one that I consider attractively valued today. Also with this article I will be reposting excerpts from what I wrote in the previous article, however, I will not be applying quotations because the original work was mine.
The first step in my due diligence process is the determination of whether or not I believe a given business (stock) is worthy of the time and effort required for further scrutiny. Since my approach relates to investing in the business behind the stock, my initial investigation relates to the fundamental strength and health of the business in question. In other words, do I believe the fundamentals underpinning the business are strong enough and therefore worthy of my continued efforts? (Note: I purposely make it a point to ignore price or valuation with this first step).
As most regular readers of mine know, I developed F.A.S.T. Graphs™, the fundamentals analyzer software tool, in order to assist me in researching stocks deeper, faster and more efficiently. The following earnings and dividend graph on United Technologies since 1996 tells me a lot about the historical operating performance of this blue-chip dividend growth stock and provides insights into the quality and skills of its management team.
United Technologies is an industrial company in the subsector Aerospace and Defense. Both the Industrial sector and the Aerospace and Defense subsector are generally thought of as cyclical industries. In truth, many companies operating in this sector and subsector possess deep cyclical characteristics comprised of significant periods where earnings rise and fall from one timeframe to the next.
However, a careful review of United Technologies’ historical earnings and dividend achievements paints a different picture. Earnings growth has been very consistent with only the occasional drops or flattening of earnings results from one year to the next. Importantly, this blue-chip dividend growth stock remained very profitable during our last two recessions of 2001 and 2008. But best of all, the company has increased its dividend for 22 consecutive years and has paid a dividend every year since 1936. Therefore, this first step in my due diligence process suggests that this is the kind of company that I would like to be a long-term shareholder owner of.
Now that I am comfortable that this is the type of company I would like to be a long-term holder of, the next step is to check the company’s current valuation or price relative to its intrinsic value reference line. Therefore, I add monthly closing stock prices (the black line) to the above graph in order to check its current valuation, but also to analyze how the market has historically valued the company’s operating results.
The first thing that strikes me on the United Technologies’ graph after I bring price into the equation is how the market has had a long-term tendency to price this blue-chip at a premium to its orange earnings justified valuation reference line. However, I also noticed that its current price has fallen below its historical normal P/E ratio (the dark blue line) and its orange earnings justified valuation reference line as well. Additionally, I observe that reported earnings for fiscal 2015 fell approximately 8%, which perhaps partially explains the market’s current negativity towards the company.
For additional insights into my observation of the market’s penchant to apply a premium valuation, I next remove earnings and dividends from the graph leaving only price in relation to its historical normal P/E ratio. The most striking observation from this exercise is to notice how price has inevitably moved back to the normal P/E ratio range every time it fell below it in the past. At this level of my due diligence process, this gives me a modicum of confidence that it is a real possibility that this could happen again in the future.
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