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Hi Hewitt, I enjoyed your book and I like you thesis about how earnings can be manipulated and why we need other ways to measure earnings to help us as investors. That being said, I am a member of Hidden Gems, and it seems to me that many of the companies that come up through that service do not/may not meet the criteria you are suggesting through your earnings power chart. This is just a gut instinct, for I haven't done a lot of detailed calculating on other than a few of their stocks that I actually own. I calculated a few PIV/ER's on some of my stocks and they didn't seem to have the safety factor that you may be looking for. What do you think of that and how do you look at those companies when they don't meet your guidelines(you mentioned recently that you missed on a few because of this - Blue Nile, FMD, etc.)? Is Hidden Gems something outside of the realm of the earnings power chart ? I know there are many different ways to be successful in picking stocks and investing, but these two ideas/methodologies don't seem to mesh very well, am I wrong about that ? If not, how do you think the two can be used together ? Thanks again for your help and insights. Bob
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After reading IETC I had the same experience. Applying it to a few of my favourite hidden gems didn't give very good results. The way I explained this to myself is that it's most likely due to the fact that HG tries to identify companies early in their development so the power staircase pattern hasn't been established yet. But hopefully it will in the future.

One question is, once a company shows a power staircase pattern in its earnings, is it still a good time to invest in them?

And another: what are the statistics of companies that did show early signs of developing a power staircase but that turned out to be bad investments anyway?

I think the importance of the book is that the concept makes common sense. So applying the principles when looking to invest in a company seems like a good idea as part of your valuation toolbox. But to use it as a general guidance for complete portfolio construction I'd need to see a bit more substantiation that doing so leads to superior results. A lot more than just showing how good the picture looks for a few obviously successful companies. I have been meaning to look at this in more detail but simply have been lacking the time to do so.

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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.

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