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Parkite,

Charlie Munger's latticework theory is based on his belief that to solve a problem, you have to study it from as many angles as possible. Further, the more life experiences you have, the easier it will be to solve that problem. Munger says the latticework approach works for investing, as well as the many other challenging aspects of every-day life. Robert Hagstrom covered this topic in one of his books; also, a Google search of "Munger & Latticework" will yield lots of useful material.

Now, as for the Earnings Power Chart approach that I advocate when looking for conservative growth stocks, let's recall the four substantive limitations of the accrual income statement found in every annual report, 10-K and 10-Q. They are:

1. Omission of investment in fixed capital
2. Omission of investment in working capital
3. Stockholders' equity is free
4. Intangibles like R&D are immediately expensed

No single income statement can deal with all these limitations. But who says we have to use just one P&L to gauge a firm's earnings quality. For reasons outlined in my book, I think you should use TWO ledgers. Which is exactly what the Earnings Power Chart does--it combines the advantages of a defensive and enterprising income statement under one roof, as it were. That's your latticework.

Also, as a bonus, here's my checklist for finding companies I hope to own for many years without taking on undue risk:

Revenue:
Revenue growth > 8% a year last 3 years?
Opportunity to sell to world market rather than single neighborhood, city or state?

Earnings quality:
Company forging Earnings Power Staircase?*
Gross margin minimum 50%; operating margin minimum 10%
Dividend payout long-term upward trend?
Consistency of earnings. A decline in one year out of five, or two out of 10, is OK.

Balance sheet:
Positive stated, tangible book values
Cash + marketable securities > 5% assets
Working capital assets > working capital liabilities
Cash + marketable securities > LT debt + equivalents
Debt repayment period < 5 years
Equity-debt ratio > 200%

Management:
Return on greenest dollar > 15% each of last 3 years*
Insiders own at least 10% of company
CEO, CFO each own at least 2x their salary in stock they bought
Stock-based compensation < 20% accrual profits
Share dilution less than 2% a year
Write-offs < 2x last 10 years
No restatements last 10 years
Plain-vanilla financials
Share count reduced > 15% last 5 years

Employees:
Worker-owner culture (e.g., no history of strikes, employees own 10% of company via ESOP, etc.)
Minimal labor requirements (fewer employees the better)

Liquidity:
Daily dollar volume > $1 million
Shares short < 10% of float
Average daily trading volume more than 100,000
Institutional:
Institutional stockholders < 40%

Technical
Relative Strength > 50

Competitive position:
Dominant (i.e., > 50%) market share in niche industry
Minimal government/industry regulations
"Inelastic" demand; i.e., people/companies need/desire product/service almost regardless of price
Product not easily substituted or copied due to copyrights, patents, etc.

*see my book "It's Earnings That Count (McGraw-Hill, 2004) to learn more



Hewitt
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