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On page 386 it lists 5 criteria for stock selection for the enterprising investor. #2 is earnings stability - it reads "Earnings stability: No deficit in the last five years covered in the Stock Guide.

Does this just mean a company can't have negative earnings in any of the last 5 years, or is this something completely different?

Thank you for your time.

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Yes - this is exactly what it means. No losses (negative earnings).

With today's accounting methods, you might want to determine whether you view earnings including or excluding extraordinary items.

For example, a company might take a once-off charge to its earnings when revising the value of a major asset. This would show in the "including" but not in the "excluding" figure.

The book actually has a nice discussion in Chapter 12 "Things to Consider About Per-Share Earnings" which considers several additional variables to consider here too.

Note that this earnings metric is different from "Stock Selection for the Defensive Investor" which requires 10 years.

PS - My edition (4th edition hardback) doesn't have 386 pages so your reference isn't correct for that edition. I found it on page 209 in Chapter 15 "Stock Selection for the Enterprising Investor".

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    Graham actually talks extensively about identifying the accounting tricks that allow manipulation of reported earnings with the "extraordinary items". Since then, GAAP, and especially IFRS are dealing with this issue, so IFRS-compliant audited reports are much better than what was common at the time of his writing. But still, especially in the US (where IFRS is not yet required by SEC), companies are still able to do manipulations. – littleadv Apr 28 '15 at 4:21
  • Personally, I think that "not using IFRS" is more of a red flag than "had a loss in the last 5 years". The latter is a quantifiable risk. – MSalters Apr 28 '15 at 10:55
  • Do companies in Canada use IFRS? Thank you for your answer, by the way - it was great! – Kelsey Apr 28 '15 at 18:18
  • I think he was referring to dividend payouts – Pepone Apr 30 '15 at 20:43
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Please note that the following Graham Rating below corresponds to five years:

Earnings Stability (100% ⇒ 10 Years): 50.00%

Benjamin Graham - once known as The Dean of Wall Street - was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.

Buffett describes Graham's book - The Intelligent Investor - as "by far the best book about investing ever written" (in its preface).

Graham's first recommended strategy - for casual investors - was to invest in Index stocks. For more serious investors, Graham recommended three different categories of stocks - Defensive, Enterprising and NCAV - and 17 qualitative and quantitative rules for identifying them. For advanced investors, Graham described various "special situations".

The first requires almost no analysis, and is easily accomplished today with a good S&P500 Index fund. The last requires more than the average level of ability and experience. Such stocks are also not amenable to impartial algorithmic analysis, and require a case-specific approach.

But Defensive, Enterprising and NCAV stocks can be reliably detected by today's data-mining software, and offer a great avenue for accurate automated analysis and profitable investment.

For example, given below are the actual Graham ratings for International Business Machines Corp (IBM), with no adjustments other than those for inflation.

Defensive Graham investment requires that all ratings be 100% or more. Enterprising Graham investment requires minimum ratings of - N/A, 75%, 90%, 50%, 5%, N/A and 137%.

International Business Machines Corp - Graham Ratings

Sales | Size (100% ⇒ $500 Million): 18,558.60%

Current Assets ÷ [2 x Current Liabilities]: 62.40%

Net Current Assets ÷ Long Term Debt: 28.00%

Earnings Stability (100% ⇒ 10 Years): 100.00%

Dividend Record (100% ⇒ 20 Years): 100.00%

Earnings Growth (100% ⇒ 30% Growth): 172.99%

Graham Number ÷ Previous Close: 35.81%

Not all stocks failing Graham's rules are necessarily bad investments. They may fall under "special situations". Graham's rules are also extremely selective. Graham designed and backtested his framework for over 50 years, to deliver the best possible long-term results. Even when stocks don't clear them, Graham's rules give a clear quantifiable measure of a stock's margin of safety.

Thank you.

  • Hi Serenity and welcome to the site. Thanks for the very detailed explanation. You might make sure that it specifically answers the question - I am not sure it does, but I'm not familiar with the Graham method at all so I might just not fully understand. Thanks again for the detail though and we hope to see you around the site! – Joe Apr 30 '15 at 20:29
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    I don't think that when Graham was alive there were index stocks - I certainly don't recall any mention of them in my 2000 edition – Pepone Apr 30 '15 at 20:43

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