Qualitative Checklist Part 3 of 3 + Trade Alert

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Welcome back to Part 3, the final part of our qualitative checklist series. Let’s waste no time!

11. Balance Sheet

These next two are pretty straightforward. First, I like to see a positive net cash position. I’m fine if the company wants to use debt if its stock isn’t richly valued but I feel better if there is more cash than debt on the balance sheet. I’m not really looking for management to optimize the balance sheet. That’s for companies with a super deep moat and few reinvestment opportunities. Ample cash is like slack in a system. Sometimes it’s healthy because it provides a cushion when unexpected things happen. For example, I’d much rather a company hold a bunch of extra cash on the balance sheet and then buy a big slug of stock in a huge sell-off rather than just offset dilution. Likewise, it’s awfully hard to go out of business if you’re making cash and you don’t have any debt. In fact, it’s really hard to do! If we can chop off the left tail just like that, I’m all for it.

There are small things to watch out for here as well. Lease accounting can be confusing but it’s important to think through the dynamics there. For example, a retail store wouldn’t be able to operate without its lease on its buildings so that it can function like debt. Further, if there are things like pension liabilities and tax liabilities, those should be added to the debt load. Some companies are so stable that they can juice the return on equity by taking on more debt. There isn’t necessarily anything wrong with that but just make sure the company has plenty of cash to service its interest expenses. I would say at least three years but that’s probably conservative. Investing is risky enough – investing in companies with strong balance sheets typically takes bankruptcy risk off the table completely.

12. Profitability

This one is incredibly important. My biggest investing mistakes have involved either buying unprofitable companies or buying companies where demand wasn’t as sustainable as I thought. The easiest way to lose money in investing is to buy companies with negative free cash flow. If the company itself can’t even make money, how do you expect to make money as a shareholder? It really is almost that simple.

Now, there are degrees of profitability. A company can be free-cash-flow positive but GAAP EBIT-negative because of stock-based compensation. Conversely, a company can be free-cash-flow negative yet GAAP-profitable because of working-capital dynamics or heavy capital expenditures. It’s incredibly important to understand the ins and outs of the financial statements and arrive at a normalized earnings power. This is what Buffett called “owner earnings.” A simple version is to start with net income and adjust for working-capital dynamics—e.g., if a company has a lot of deferred revenue from upfront subscriptions, that would boost owner earnings.

I like this approach because depreciation and stock-based compensation are real expenses, and you obviously need to account for large capital expenditures. Depreciation is often a decent proxy for maintenance capex, which is what you’re really after to normalize earnings power. There are two types of capex: maintenance and growth. Ultimately, you’re trying to understand how profitable the business could be if it weren’t growing so fast. That gives you a cleaner view of underlying profitability. If you want to get more sophisticated, you might even strip out some sales and marketing costs that are purely for growth rather than customer retention. Working capital can also swing widely based on timing, so it helps to look over a multi-year period. Normalizing earnings is an art and a science, but getting to core profitability is crucial—if the business model can never work, you’ll likely never make money on the stock.

Companies that can’t get to profitability either don’t have a good enough product, face too much competition, or aren’t executing well and keeping costs low. Any one of those raises your risk as an investor. While it’s true some companies reinvest every dollar back into the business, the truly great ones are often profitable very early. Look at the IPO documents from Microsoft, Google, or Apple—you’ll be surprised how profitable they were in the early days. Companies like Uber popularized a scorched-earth “spend to scale” approach, but that’s the exception, not the rule. As I’ve gained experience, I have less tolerance for investing in unprofitable companies. That may cause me to miss some opportunities, but the lower risk helps me sleep better at night.