In Exhibit 1 we see three types of profit for each year from 1996 to 2001. The first profit figure, accrual profit, is the proverbial bottom you see in every company's annual report, 10-K and 10-Q. Next is free cash flow, or what I call "defensive profit." This is what a company earns after expensing investment in fixed and working capital, two uses of cash that are omitted from the accrual ledger. The last type of profit, enterprising profit, is arrived at by converting R&D and other intangible growth-producing initiatives from operating expenses to capital assets, and by expensing the opportunity cost of stockholders' equity.

The Wrong Kind of Profit

So what does the quality-of-profits chart tell us? As we see above, HealthSouth generated accrual profits every year. Moreover, it was profitable on a defensive basis in four of six years. Crucially, however, HealthSouth was profitable on an enterprising basis only once, and that was back in 1996. Since then, the company produced a torrent of red ink.

Because the accrual income statement has four major limitations, I focus on the relationship between a firm's two alternate profits and losses. Specifically, I look to see which box its defensive and enterprising profits (losses) intersect. The best companies intersect in the upper-right box, or Earnings Power Box. Moreover, that point keeps moving in an upper-right direction, forming an Earnings Power Staircase, or staircase for short. If you're a cautiously greedy buy-and-hold investor, you should try to find a few staircases and ignore all the other companies.

As we see in Exhibit 2, the only time HealthSouth was even close to the EPB was in 1996. The next year, in 1997, it moved to the upper-left box, signaling defensive profits but an enterprising loss. This is troubling, because remember that accrual profits in 1997 were higher than in 1996. One sure indicator of trouble is when a firm's accrual profits rise but its defensive and/or enterprising profits fall. In 1998, HealthSouth ended up in the lower-left box -- always bad news. In 1999 and 2000, the company was back in the upper-left box. It had defensive profits but enterprising losses.

Our study here offers two lessons. First, unless you know what you are doing, avoid growth companies that don't have staircases. Second, check your portfolio. As Charles Ellis, author of Winning the Loser's Game, has observed, you probably already own all the stocks that will cause you the most heartache in the next several months. So ask yourself: Do you have a HealthSouth lurking in your portfolio right now?

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