Friday, October 16, 2009

Due Diligence Is YOUR Job

Due diligence can mean different things to different people. But, as an investor, it is your job and responsibility to do it. Otherwise, it can be very costly. Don't count on anyone to do it for you. Some think that reading annual reports, proxy statements, and other documents filed with the SEC is due diligence. I don't think this is good enough, especially for small-cap companies. Remember that these documents are drafted in a way to make the company look as good as possible. If reading available information is not good enough, what should investors do? I believe that investors should call the management, industry experts, reporters, former employees, or anyone else who can answer their questions.

This year, I invested in FortuNet (FNET), a manufacturer of multi-game and multi-player server-based gaming platforms. The company has had very stable revenues and earnings. Earnings per share were $0.27, $0.28, $0.27, $0.18, $0.35, and $0.25 in Years 2003, 2004, 2005, 2006, 2007, and 2008, respectively. I paid $1.20 per share for FortuNet's stock, which is equivalent to a P/E ratio of 4.44 using the average earnings per share of $0.27. However, there was an issue - Aces Wired, parent company of K&B Sales Incorporated, was involved in illegal activities and was raided by Texas authorities who shut down its operations. K&B Sales Incorporated provides 36% of FortuNet's revenues. If K&B Sales Incorporated lost its distribution license because of Aces Wired's illegal activities, this would be detrimental to FortuNet's revenues. The stock price could take a huge beating. However, at a price of $1.20, I felt that this risk was already priced into FortuNet's stock price.

On one day in September, the price of the stock soared over 200% to almost $4.00 per share within minutes on no news. It finally settled around $2.00. After several days, a market participant enlightened everyone on the Yahoo message board that the reason for the stock's rally was that the Texas authorities had settled the case with Aces Wired and kept K&B Sales Incorporated's license intact. With this new information, the stock seemed a good deal even at $2.00 per share.

Before committing more money into FortuNet's position, I decided to confirm the new information about K&B Sales Incorporated. I called Bruce Miner, Licensing Services Manager from Texas Lottery Commission, a governmental body in charge of approving and revoking gaming licenses. He told me that the case is not settled. K&B Sales Incorporated's license is still under review. If the commission finds anything out of line, the license will be revoked. Now, it seems like the market is pricing FortuNet's stock as if K&B Sales Incorporated's license is safe. Even though I believe that FortuNet has a bright future, I am not willing to see my investment get cut in half because the market is misinformed. I think there is a good chance that K&B Sales Incorporated will lose its license. If this happens, the stock is likely to get punished severely, and I will be waiting to pick up some shares at incredible prices. As of now, I exited my position after making over 50%.

I think that investors can lose a lot of money by relying only on information that is contained in reports filed with the SEC. I passed on several companies this year that looked great on paper because after making several phone calls, I learned that the risks were too high. You never know what you might learn about a company after you speak with industry experts. You will not know until you call.

Disclosure: I, or persons whose accounts I manage, do not own shares of FortuNet at the time of this posting.

1 comment:

  1. Theirs always bargains stock somewhere you just have to look form them.