We’ve gone over all the things we want to know about a business – its basics, its numbers, its valuation, and the minutiae. We’ve gone over where you can find this information, ranging from official filings to message boards and local news reports. That begs a more direct, crucial question – what qualities do I look for in companies and stocks I want to buy?

I’m a big believer in the importance of skin in the game. I want my convictions to be transparent and in the open, and to practice what I preach. In this post, I present what I look for when I buy a stock, i.e. shares in a company.

It’s not a strict checklist, and some stocks or companies will fit certain aspects more than others. And it’s not for everybody – part of knowing your investment style is knowing which sorts of investments you’re comfortable making.

Here I share the 4 qualities I like to see when investing in a company. Because price also matters, in my next post, I’ll discuss what I look for in a stock specifically.

Restating my Investing Style: Value but towards the future

One of our first posts was about the importance of finding your investing style. The key point – you have to find a strategy that makes sense to you. That strategy should make sense or have some track record behind it. Buying stocks that begin with the letter G is probably not going to hold up over the decades. But many strategies can work. You just need to make sure you stick to what works for you.

I consider myself a value investor with an appreciation of growth. I like cheap stocks and I look good companies. Those are often mutually exclusive conditions, but every now and then they overlap, and that’s what I’m looking for.

There’s some disagreement among investors over what’s easier to find or understand, cheap stocks or good companies, and which offers better returns. Value investors, stereotypically, gravitate towards cheap stocks, while growth and quality investors gravitate towards good companies. But I think it is possible to find both the cheapness and the quality in a stock and company that makes for good long-term returns.

Revenue Growth

A company growing its business is a sign that its service or product is in sufficient demand that it is either finding new customers, selling more products/services to existing customers, or able to raise prices on existing customers without losing them. It’s a basic sign of quality, that the company is offering something in real demand.

When I use screeners, I will include a revenue growth component. This is a cleaner metric to start with than earnings. I can then drill in to make sure the revenue growth is organic and sustainable, and that it is translating to the bottom line. If it’s not translating, I’d hope to understand why the company wouldn’t be growing its profitability. It might be reinvesting to build its advantage, for example.

Source: Photo by Simon Kadula on Unsplash

My screening will be backwards looking, but I also want the company to have continued room for growth. I don’t trust myself to see far in the future, but I should be able to find reasonable grounds to believe the company can continue to grow. Spotify, which I own shares in, needs to continue to grow paying subscribers. I can argue they will by pointing to their growing active users base, thinking about their conversion strategies, about their pricing power (after they just raised prices), and how they might grow their ad business alongside the subscription. Spotify only makes sense as an investment if they grow revenue at more than 10% a year for a few more years yet.

Again, this is the first sign of ‘quality’ for me – if a company isn’t able to sell more of whatever it sells year after year, either it or its industry is unlikely to be attractive for investment.

A business I can understand

I want to understand in a simple manner what a company does to make money, and how it might get better or worse. This is something like the “explain it to me like I’m 5” test – if I can’t do that, I may not have a good handle on the business.

Part of this is understanding what the key variables are that will drive a company’s success. I don’t need to know the ins and outs of Spotify’s algorithms or even its marketplace for artists business, so much as knowing what the key metrics are that will tell me whether Spotify is making progress.

There are industries I avoid because I can’t figure this out. Commodity companies (energy companies, etc.) for example. I can’t really tell why one commodity company is better than then the next. I also don’t know what the price of a commodity will be in the medium, let alone long term. Biotech is another I avoid, because I have no expertise on understanding how drug trials will go. Healthcare too, because those companies are very reliant on government reimbursements and regulations, which can be unpredictable. I like to invest in retail companies and always seem to lose money.

Circle of competence vs. circle of interest

We’ll talk about the “circle of competence” concept later, but it more or less echoes this quality. It’s best to invest in companies you can understand.

That can be on an industry level or a business model level. I understand written media, which helps me consider companies in that industry. (Unfortunately, it’s not a strong industry).

I also understand subscription models. I invested in Arlo Technologies, a maker of security cameras, when I recognized the progress it was making in selling a subscription for the camera recordings. Having worked in subscription businesses, I could understand their model better than I could other companies. I could see how the subscription model was transforming the business due to how they changed their free trials.

A circle of competence is useful, but it can be limiting. I think you can always learn about new models and industries, just don’t dive in blindly. I like the idea of a “circle of interest”: spend times researching businesses you are curious about. That will make it easier and more fun to understand their businesses.

A business that controls its destiny

We’d all like to control our own fate in life, right? It’s not fun to depend on others.

No man is an island though, and no company is either. When I talk about controlling one’s destiny, I mean two things.

Financial control

I want the companies I invest in to not need to raise money from the markets in the next couple years. I want this to hold even in extreme times – say, when it seems like the world may be shut down for months due to a novel pandemic.

This means I like to invest in companies with strong balance sheets, and that are generating positive free cash flow. They have more cash than debt on their balance sheet, or at least any debt is reasonable for their business and doesn’t carry a high interest rate; positive equity value showing that the company has more assets than liabilities; no near-term imbalance in liabilities that could be a problem; and no major obligations that could crimp the company’s longer-term future.

Positive free cash flow* means their operations generate more cash than what it costs them to reinvest in their business.

* Operating cash flow minus capital expenditures > 0 when you look at the filings.

A company that has positive free cash flow and a strong balance sheet won’t need to raise money in the near future. They can pay off any debt, generate money to add to their balance sheet, and invest in their business. If they have a bad year, it shouldn’t cripple them.

In a climate like September 2023’s, where interest rates are as high as they’ve been in 15 years, and the stock market is also rewarding, at least to some degree, profitability more than it had in the last two years, this is no luxury, but instead a must.

Imagine a company that isn’t yet generating positive free cash flow. Its stock is likely to be trading lower than two years ago. If the time comes for it to raise money, it has to either issue expensive debt or issue new shares that will raise less money per share. That means it will dilute shareholders – their shares will count for less of the company ownership. This can cause something of a doom loop as the company keeps raising money from less excited shareholders. But even in less drastic situations, it’s a bad deal for existing shareholders.

Operational control

Operational control is harder to prove, and easier to see in the negative case. A company with one customer who accounts for 30%+ of its business might have limited control over its fate. A company reliant on showing up on Google’s search engine holds its breath every time Google changes its algorithm.

When studying a business, I look to see where its money comes from, and how susceptible that revenue source is to outside changes. Sometimes those will be changes in fashion or taste – it’s probably why I’ve struggled so much investing in retail companies.

Business exists in a changing, volatile environment. This is the hardest element on this list to be sure about when researching a company. But it is worth thinking through, whatever your investing approach is.

Efficiency

All things equal, I want to invest in businesses that have high margins and low capital expenditure needs. This isn’t a magic bullet. But the higher margins are and the lower capital expenditure requirements are, the more each sale is going to reward shareholders when all is said and done. With our other qualities are already factored in, this efficiency is the last sign that the company has its stuff together and is running smoothly.

The reason this isn’t always a good thing is that high margins attract competitors. Jeff Bezos’s famous saying is “your margin is my opportunity.” Part of our job in studying a company is to understand whether the margins are defensible and why; in other words, to understand the company’s competitive advantage or moat.

Low capital expenditure requirements mean that anybody could quickly spin up a new business to compete with the company in question. Software companies rarely require capital expenditure, certainly not in the early stages, and competition can be quite fierce as a result, with competitive advantages coming from less concrete things like ‘network effects’ or ‘switching costs.’

I own shares in Charles Schwab, which is asset heavy; it’s basically a bank wrapped inside a brokerage. This got the shares into trouble this year with the regional bank crisis. It is also what enabled Charles Schwab to cut commission costs to zero, damaging TD Ameritrade’s business to the point that TD Ameritrade agreed to be bought by Schwab. Your assets can be, well, your assets, part of a strong balance sheet and a competitive advantage.

Wrapping it up

As in anything, there are exceptions and corner cases to all of these rules and preferences. I gave a reason you don’t want the most efficient business in the world. Take the old saying “When there’s a gold rush, don’t dig for gold, sell picks and shovels.” The picks and shovels sellers still depend on the gold rush. There are slow growing or not growing companies worth investing in, and companies who have, let’s say, ‘improving’ balance sheets that are worth considering.

My ideal business has all of these traits – efficiency, financial health and operational control, growth, and a business I can understand. These are the qualities I’m looking for when I want to invest in a company. And yet, there are cases where a company checks all these boxes, but I don’t invest. What gives?

In our next post we’ll discuss what I look for in a stock. There’s another piece of the puzzle, one many investors ignore – the price we pay now and what that means for our hopes of a return in the future. I’ll break down the qualities I look for in a company’s stock. Later, we’ll tie these two parts together with some examples to conclude the how to buy stocks course.

Disclosure: As of this publication, I own shares in Spotify (SPOT), Charles Schwab (SCHW), and Arlo (ARLO) in my account or accounts I manage. Positions may change at any time.