Buffett has a line I keep coming back to: only when the tide goes out do you discover who's been swimming naked. 🌊
For most of the last few years, the tide has been in. Money was cheap, lenders were relaxed, and almost any business with a decent story could borrow what it needed.
That's changing. The Fed just raised rates for the first time since July 2023, with the stock market sitting near a record high. Meanwhile, lenders are still charging riskier companies close to the smallest extra interest we've seen since 2007. Rising rates and relaxed lenders are a classic late-cycle mix, and that fits where I believe we are in the 18.6-year cycle.
So this week I'm not hunting for new stocks. I'm stress-testing the ones I already own.
Here are the 7 questions I'm asking of every one of them. Save this email, because you can run them on anything you own. 👇
1️⃣ When does its debt come due?
Debt on its own isn't the danger. The danger is debt that has to be refinanced at the wrong moment.
In April 2009, General Growth Properties, one of America's biggest mall owners, filed for bankruptcy with about $27 billion of debt. Its CEO said the core business was "sound and performing well, with stable cash flows." The malls weren't the problem. The credit markets had frozen, and the company couldn't refinance loans that were coming due.
🔍 What I check: the debt maturity table in the annual report. How much is due in the next two to three years, and what rate would it cost to refinance today?
2️⃣ Could it still pay its interest if profits fell by a third?
Interest coverage tells you how many times operating profit covers the interest bill. Today's number isn't the real test. The test is what happens when things go wrong.
Operating profit $100M, interest $20M: covered 5 times. Looks fine.
Profit falls by a third to $67M: now covered about 3.3 times.
The debt is refinanced at double the rate, so interest becomes $40M: now covered about 1.7 times.
Two ordinary late-cycle events, and the same company goes from comfortable to fragile.
3️⃣ Does it fund itself, or does it need someone else to stay generous?
Some businesses generate more cash than they spend. Others rely on lenders and investors to keep writing cheques to pay for growth, dividends, even share buybacks.
That works until it doesn't. In March 2008, Bear Stearns lost access to the short-term funding it relied on. Within about a week, JPMorgan rescued it in a deal eventually worth $10 a share. A year earlier, the shares had traded above $170.
🔍 What I check: does operating cash flow cover capital spending and dividends? If the gap is being filled with new debt or new shares, I want to know why.
4️⃣ How much of its revenue depends on the good times continuing?
Some customers keep buying in a recession. Others disappear.
US new home sales hit a record 1.28 million in 2005. By 2011 they had fallen to 306,000, a drop of about 76%. Every business selling into housing, from builders to timber to furniture, felt it.
🔍 What I check: who the customers are, and whether the purchase is a need or a nice-to-have. Revenue tied to housing, credit, advertising budgets or big corporate projects is usually the first to be cut.
5️⃣ Can it raise prices without losing customers?
This one comes straight from Buffett: "The single most important decision in evaluating a business is pricing power." He added that if you need a prayer session before raising prices by 10%, you've got a terrible business.
Late in a cycle, costs creep up: wages, materials, and now interest. A business with pricing power passes those costs on. A business without it absorbs them, and its margins shrink.
🔍 What I check: has it raised prices over the last few years while keeping its margins steady, and did its customers stay?
6️⃣ What happens to profit if sales fall 20%?
This is where most investors get caught out. Profit doesn't fall in line with sales. It usually falls much faster.
A company has $100M in sales, $40M in fixed costs (rent, staff, equipment) and $40M in costs that rise and fall with sales. Profit is $20M.
Sales drop 20% to $80M. The costs that move with sales fall to $32M, but the fixed costs stay at $40M. Profit is now $8M.
Sales are down 20%, but profit is down 60%. 📉
🔍 What I check: how much profit fell compared with sales in the last downturn, in 2008–09 or 2020 if the company was around.
7️⃣ Am I paying a price that assumes nothing goes wrong?
This ties back to last week's issue. Great businesses are easy to find right now. Fair prices aren't.
The real danger isn't just earnings falling. It's earnings falling at the same moment the market stops paying a premium.
A stock trades at 30 times earnings.
Earnings fall 30%.
The market now values it at a more ordinary 18 times earnings.
The share price falls about 58%, even though the business is still making money.
🔍 What I check: if earnings dropped and the valuation returned to normal, would I still be comfortable owning it at today's price?
🧭 What I do with the answers
I don't sell a stock because it fails one question. Almost every business has a weak spot somewhere.
What I'm looking for is a stack of them. A company with debt due soon, thin interest coverage, customers who vanish in a downturn and a high price tag is fragile in four ways at once. I'd much rather find that out now, while markets are calm, than in the middle of a sell-off.
The businesses that pass give me something just as valuable: the conviction to hold them when prices fall and everyone else is panicking.
💡 The takeaway
Late in a cycle, the question changes. It stops being "how much can this grow?" and becomes "what happens if things go wrong?"
The businesses that come through a downturn tend to have little debt, fund themselves, and have customers who can't do without them. Those are the ones I want to own when the tide goes out.
Hit reply and tell me which of the seven you'd never thought to check. I read every reply.
This newsletter is general information only and not personal financial advice. It doesn't take your objectives, financial situation or needs into account.
Ace
Tools I use
Sharing with you the tools I’m using at the moment.
🔎 My Value Stock Analysis and Research Platform - Smart X Terminal → https://smartxterminal.com/
📚 Books I read: https://smartxcapital.com/books