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No. of Recommendations: 9
I want to be very clear about this: Just because a company forges an Earnings Power Staircase does not mean you automatically buy the stock.

In addition to checking earnings quality (criteria 1), you also need to consider the nature of the firm's competitive advantage (criteria 2) and also whether it trades at a discount to intrinsic value (criteria 3). The second and third criteria are more speculative than the first criteria, but you use the Earnings Power Chart and various ratios for guidance here. For those that read my book, you will recall that Wrigley earned passing grades on criteria 1 and 2 but failed criteria 3. If you bought Wrigley when I wrote that chapter, you know the stock has sharply underperformed the S&P 500.

Two other points. First, you can make good money buying companies in the upper-right box but that are not forging an Earnings Power Staircase. I have. Second, the best stocks in terms of maximum total returns may well be those in the lower-left box that are working their way to the upper-right box, as is Apple's story over the last 5-6 years. My only advice here is to make sure you know what you are doing; Enron was a lower-left box company for several years before it filed for bankruptcy.

In my research, the Earnings Power Chart has almost always revealed something wrong with a company before the red ink shows up in the GAAP income statement. Sometimes you get false signals, however. In other words, the business doesn't look so good on either alternate metric but GAAP earnings and the stock continue to rise. But this is okay. Our goal here is to be picky. When you study the characteristics of great investors, they tend to have concentrated portfolios and low turnover. Companies that pass the Earnings Power Chart and our other criteria are probably the kinds of companies that will appeal to picky investors.


Hewitt
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