When the corporations in which we invest clients’ money record a profit, the managements of those companies are expected to:

1) Pay out some of that profit in the form of dividends, and
2) Reinvest the remainder of the profit back into the business.

Reinvested profits are the engine of growth for the future – helping companies expand their business and acquire new assets. In fact, many people believe, quite accurately, that a capital expenditure decision is the most critical decision management must make.

Our responsibility

As investment managers, we monitor and measure a corporation’s success in spending shareholder money wisely. One measure is relatively high profitability, either return on equity or return on capital. Another is “Earnings Purity,” which measures earnings realized over the past 3 years after so called “non-recurring” charges are subtracted.

Earnings Purity is a new concept in earnings analysis developed by Baseline Financial Services that measures how much of a company’s reported operating earnings are “pure” and not clouded by write-offs or other financial engineering tactics.

Long-term memory

Companies take write offs when their investments have failed, and sometimes managements like to pass off failed investments as non-recurring charges, hoping investors will quickly forget about them.

However, the Earnings Purity measure does not forget. A perfect 100% score means that all the earnings of the past 3 years have been realized (i.e., no write-off). A less favorable 60% score means 40% of profits have disappeared through write offs.

High scores here

At Midwest Investment Management, stocks we own in client portfolios have a relatively high average Earnings Purity score of 88%, compared with 63% for the S&P Index. This means the managers of companies whose stocks are in our client portfolios have been relatively good custodians of shareholder wealth.

By comparison, some well-known companies have Earnings Purity scores ranging from 0% to 20%, meaning they have written off 80% to 100% of their past 3-year earnings. Examples include Goodyear, Ford, Georgia Pacific, J.C. Penney, Schlumberger, Sun Microsystems, and AOL. Not surprisingly, their stocks have suffered.

Of course, a high Earnings Purity score doesn’t mean things can’t change for the worse. It only means that probabilities are in your favor, just as an “A” student is unlikely to become an “F” student overnight.

The likelihood that stocks in company portfolios maintain a high Earnings Purity score is one of the factors we analyze in our ongoing investment research process.

Our use of Earnings Purity score analysis offers tangible benefits for clients with managed accounts at Midwest Investment Management. If you’re not a client, consider the positive impact this new concept in analysis could have on your portfolio. For more information, contact me at (216) 830-1133 or email: elm@mimllc.com