Rev Shark Is All Wet About Fundamental Investing

To disprove DePorre's assertion, I want you to accept the premise that while earnings drive stock prices, not all earnings are created equal. Why?

Because the generally accepted accounting principles (GAAP) income statement found in every annual report, 10-K and 10-Q has four structural limitations. As a result, a profitable company does not always possess authentic earnings power. These four structural limitations are:

1. Investment in fixed capital is ignored, so when capital spending is greater than depreciation, the resulting net outflow of cash goes undetected.
2. Investment in working capital is ignored, so when working capital assets, such as receivables and inventory, grow faster than working capital liabilities, such as payables and accrued expenses, this use of cash is not an expense, even though liquidity has worsened.
3. Intangible growth-producing initiatives are expensed, so R&D, marketing and advertising and employee education penalize earnings, even though these outlays may boost future sales or operating efficiencies.
4. Stockholders' equity is free, so the more retained earnings a firm employs as a percentage of total capital, the less profitable it is after adjusting for opportunity cost.

The Earnings Power Chart, which I developed, fixes these limitations by using two alternate income statements. The "defensive" statement makes sure the business can fund itself, and the "enterprising" statement tests whether management is creating value. These two ledgers measure corporate performance from opposing perspectives, and strength in both is required for a company to enjoy authentic earnings power.

Benjamin Graham, the father of security analysis, inspired this two-dimensional approach. The chief aim of the defensive investor, as Graham wrote in The Intelligent Investor, is to "avoid serious mistakes or losses." The primary objective of the enterprising investor is to own a security "that is both sound and more attractive than average." The GAAP income statement found in every annual report, 10-K and 10-Q does not adequately meet the needs of either investor type, however.

In 2000, Enron seemed to have earnings power, as net income had risen in nine of the last 10 years. But when we look closer, the luster fades.

There is a three-step process to check if a company has authentic earnings power.

Step 1: Build a defensive and enterprising income statement. In 2000, Enron lost money on both counts, as we see below. The GAAP income statement is sandwiched between our two alternate versions to emphasize that it is too enterprising (shrewdly optimistic) for the defensive investor, and too defensive (pessimistic) for the enterprising investor.

Step 2: Use the Quality of Profits chart to check the correlation among the GAAP, defensive and enterprising earnings. The tighter the fit, the better. In Enron's case, we find a loose fit in 2000, signifying poor earnings quality. More troubling, Enron's poor results went back to at least 1996, as we see below.

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Step 3: Plot the intersection of defensive and enterprising profits (losses) in the Earnings Power Chart. The best box is the upper-right; businesses here generate free cash flow and high returns on capital. Shun lower-left box companies like Enron unless you have a compelling reason -- even if they are profitable on a GAAP basis.

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I explained how the Earnings Power Chart unmasked Enron's low-quality profits in my 2002 debut column for RealMoney, and also in my book It's Earnings That Count (McGraw-Hill, 2004). The Earnings Power Chart also raised red flags concerning many other highfliers of that era that later crashed, including Lucent Technologies, WorldCom and HealthSouth (HLS - commentary - Cramer's Take).

Besides controlling risk, the Earnings Power Chart can help you find great stocks. Garmin (GRMN - commentary - Cramer's Take), as we see below, has authentic earnings power, since the navigation device-maker is situated in the Earnings Power Chart's upper-right box. What's more, Garmin keeps moving in an upper-right direction every year to forge an "Earnings Power Staircase," so-named because this distinctive chart pattern resembles the profile of a staircase. An Earnings Power Staircase is the hallmark of profitable growth -- the company is getting bigger and better. A $10,000 investment in the navigation device-maker grew to $44,000 during 2003-2006.

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DePorre is a good writer, and he has a compelling personal story. Further, Invest Like a Shark is packed with lots of valuable tips to improve your stock market results. Just ignore page 129, because when it comes to fundamental investing, RevShark is all wet.

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At the time of publication, Heiserman had no positions in stocks mentioned, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit Earnings Power.

Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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