The real cardinal sin is when leadership can’t admit to its mistakes and fails to make adjustments needed to meet changing market conditions or to right a wrong. Unless there’s a change the bad news will just keep on compounding until it eventually overwhelms the company’s strengths, and the business fails.

In contrast, market history is full of examples of well-managed companies surviving even the greatest boondoggles by recognizing their errors and correcting them in a timely way. Shareholders may suffer in the near term as the extent of their mistakes is realized by the market. But ultimately--as long as management stays on target with its new course and is willing to adapt when conditions warrant--recovery is often extremely rewarding.

One great example in recent years is the phoenix-like story of ERICSSON (NSDQ: ERICY), the Sweden-based maker of communications equipment. Like others in its business, the company thrived in the late 1990s boom time, as scores of communications players sprouted up globally in both broadband and wireless markets and placed huge orders. Adjusted for the myriad stock split and reverse splits over the past decade, the company’s American Depositary Receipts reached a high of $188.36 per share on March 10, 2000, about the time the overall US market hit its all-time high.

Then came the Great Telecom Crash of 2000-02. Overcapacity and more than $100 billion in junk debt pushed virtually all of the new entrants out of business in the US and orders dried up. By the time WorldCom was filing Chapter 11 and going to zero, Ericsson shares were in freefall, reaching a low of $3.40 a share on October 4, 2002.

Management, however, never took its eye off the ball. Cutting its losses in the bombed out US market, the company continued to focus on high growth emerging markets, particularly China. Rather than pull back from the march of technology, management embraced it and forged new ventures, such as the enormously successful Sony Ericsson. Earnings stabilized and as the overall stock market crash subsided, the shares began to slowly climb, reaching the low 30s last year, and holding them despite a vicious downturn for technology stocks in recent months.

Today, the company is by far the healthiest player in the communications equipment industry and continues to seek and find profitable new markets. Second quarter profits took a slight 2 percent hit, almost entirely due to the cost of integrating the recent acquisition of Marconi. Sales rose 15 percent and earnings came in ahead of Wall Street expectations. Moreover, the Sony Ericsson handset venture continues to tear up the track. And the company’s credit rating outlook is rated stable to positive by all major raters.

In stark contrast is LUCENT TECHNOLOGIES (NYSE: LU), which appears to have resumed the dramatic fall it began back in early 2000 as the telecom crash began. The company still owns Bell Labs, the inventor of everything from the microchip to the cell phone. But its technological prowess has continued to decline in recent years as the research dollars have dried up in management’s furious effort to improve its financial results for Wall Street.

Lucent is almost entirely dependent on a handful of major US telecoms, which have been increasingly willing to go elsewhere for their equipment. Management’s grand plan in the 1990s of being basically an arms merchant in the upstart telecoms’ war on Baby Bell incumbents has been entirely abandoned, due to the lack of Winstars and Global Crossings to sell to.

Meanwhile, whatever earnings Lucent has are basically from an over funded pension plan. The stock’s current price is only about $2, compared to its 2000 high around the century mark. And even its bailout merger with France’s Alcatel looks a lot less attractive than it once did.

Why did Ericsson succeed in the new decade while Lucent failed miserably?

The answer is management. While Ericsson was able to shift gears--and even management teams--during its recovery period, Lucent remained stuck in neutral. Its legendary ability to create revolutionary new products was consistently exceeded by competitors.

It was beaten to new markets again and again. And its strategy of pulling back to serve only the big has been undone by the latter’s merger wave and newfound ability to can go elsewhere for its needs.

Shareholders who bought at the 2000 top and stuck with Ericsson all the way down still aren’t whole. But those who took some profits at the top and bought back in near the bottom made out like bandits.

And with the company continuing to grow, more gains are almost surely ahead. In contrast, those who believed Lucent would pull it together have been disappointed again and again. The only solace is the company hasn’t actually declared bankruptcy, though that’s a distinct possibility if the Alcatel merger should somehow fail.

Assessing management, then, is a critical part of stock picking. And there’s no better time to size up how things are being run than earnings season.

As second quarter results continue to come out over the next few weeks, there will be myriad metrics for assessing the performance of those running companies we own. One that we’re likely to see a lot of is comparisons of quarterly share market gains with executive compensation.

In my view, this information is always worth noting. Certainly, there are a number of CEOs who are being compensated richly while their shareholders are getting scrap.

I’m far more interested in whether or not companies are becoming more valuable as businesses over time. Since my primary interest is dividends, my key question is: Are cash flows and therefore dividend-paying power increasing, or is this company just barely keeping up payments, hoping it can put off an eventual day of reckoning--i.e., a dividend cut?

Exhibit A is always the payout ratio. For corporations, that’s the annual dividend rate as a percentage of recurring and sustainable earnings per share. For Canadian income trusts, real estate investment trusts (REITs), limited partnerships (LPs) and other flow through entities, it’s recurring and sustainable distributable cash flow.

A measurement recognized by Generally Accepted Accounting Principles (GAAP), earnings per share (EPS) are standard, regardless of what kind of enterprise you’re looking at. EPS, however, can be temporarily inflated by one-time gains, or deflated by one-time losses. These can include weather (for utilities especially), a spike in commodity prices for producers, an asset sale, the write-off of a money-losing business, a gain or loss from hedging a particular market exposure or a thousand other items that may or may not recur.

Distributable cash flow in contrast is not a GAAP-sanctioned number, and as such is not necessarily uniformly calculated from company to company. To get around this, I make sure the trust or other entity is only including operating cash flow, less maintenance capital expenditures necessary to keep the business running. Even this number can be dramatically affected by one-time events, such as asset sales, weather, hedging gains or losses, etc.

That’s why when I sit down to calculate payout ratios for the corporations, REITs, LPs or Canadian trusts I cover, I factor out the one-time items as best I can. The resulting number is therefore the best approximation of how the real underlying business is doing when all the accounting adjustments are factored out. If that number is increasing steadily, management is growing the business. In contrast, if that number is stagnant or falling, the business isn’t becoming more valuable. Management isn’t doing its job.

If a company, trust, REIT or LP has been a consistent grower, I’m willing to forgive a stumble or two in a particular quarter. More than one or two, however, is a clear sign of trouble, and it’s time to move on to another dividend-payer whose management is doing its job.

MARKET MAYHEM

As it turned out, last week was a good one to take a vacation from the market. As I was basically in the wilderness until Saturday, I spent the weekend digesting the market news by reading each day’s edition of The Wall Street Journal, starting with Monday.

Each day had its share of drama. Early in the week, the action was mostly negative, continuing the downtrend of the prior week. Then the trend changed dramatically and by Friday even most battered from previous days had rallied strongly. The result: not much change from the prior week.

That’s been the trend in these choppy markets for the past few months. Massive selloffs have been immediately followed by huge gains that have wiped out the red ink, and vice versa. Then, the whole pattern has repeated itself.

Those who panicked on the down days and sold have been slightly burned in some cases. Also, about midweek last week when the market was hitting its low, I received a slew of e-mails from investors who purchased recommendations below my recommended buy targets and were wondering if they should sell. These inquiries tapered off later in the week when prices rallied. But those who followed their fears are the poorer for it.

The only real losers in the choppy market, however, have been investors in companies with flagging businesses. Ford Motor (NYSE:

F), for example, has continued to crash and burn, and may have cut its last lifeline by abandoning its hybrid vehicles program.

In the US utility arena, even the weakest are still squarely on an uptrend. The differentiation, however, is becoming far starker among the Canadian trusts. Simply put, the small and stretched have to replenish shrinking reserve bases by buying new properties at outrageously high prices. We’ve already seen a half-dozen dividend cuts in the sector and--despite the recent surge in natural gas prices--we’re likely to see more in coming months.

That’s in dramatic contrast to the biggest and strongest oil and gas trusts, most of which are again pushing all-time highs as they produce from rich reserves. But the need to separate the strong businesses from the week has never been greater. No matter what industry you’re talking about, the strongest players are certain to come back from the market’s ups and downs. The weak have no such assurance and if they do falter, investors’ losses are going to be huge.

As I look out at the market for the rest of the summer and into the potentially critical months of September and October, I see a generally benign big picture. The US economy appears to be slowing a bit, reducing the danger of overheating. A stirring of inflation appears to have given the Federal Reserve a little more room to maneuver, and possibly call a halt to its relentless upward push on interest rates.

Most important, earnings are coming in strong for a host of key companies. And while there have been some disappointments, the outlook seems to be for more good results to come.

This is obviously what the market has reacted to in recent days, given last week’s big upmove and the drop in the benchmark 10-year Treasury note yield back under 5 percent. And, despite the mild retrenchment on Monday for the big averages, we’re still seeing some solid gains in income stocks.

On the other hand, there is huge event risk for this market. The biggest concerns the massive flare-up in Arab-Israeli violence and the flaccid US response to it, which is threatening to create another huge rift in US-European relations. Two potential immediate impacts are a breakdown in talks to limit Iran’s nuclear program and a continued tilt in Arab countries away from US-based super oils in favor of those from other nations. But the potential geopolitical implications are staggering, particularly the growing power of Russia at our expense.

Also on the subject of oil, the war in Iraq continues to take one ugly turn after another, with no end in sight. Venezuelan President Hugo Chavez has become increasingly belligerent regarding his country’s supplies. Cuban oil is being opened up to foreign-based companies, even as US supers are excluded. And the post-election protest rallies in Mexico City on behalf of leftist candidate Lopez Obrador appear to be growing larger and more impassioned.

In the face of this almost daily stream of bad news on oil, it’s no wonder black gold is stubbornly hanging in the 70s. And now natural gas supplies are apparently tightening in the face of record summer heat, which has boosted demand for electricity, sending prices markedly higher.

In short, there are a lot of things that could trigger a lot more chop in this market. But again, the good news is as long as your companies are becoming more valuable as businesses, your portfolio will ride out whatever storms lie ahead.

You can’t foresee every event. But even in this market, as long as you do your homework this earnings season, you can take a week off and let the market do its thing, secure in the knowledge that your portfolio will be whole when you return.