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of several other “accounting factors” that can distort reported earnings. One is “pro forma” or “as if” financial statements, which report a company’s earnings as if Generally Accepted Accounting Principles (GAAP) did not apply. Another is the dilutive effect of issuing millions of stock options for executive compensation, then buying back millions of shares to keep those options from reducing the value of the common stock. A third is unrealistic assumptions of return on the company’s pension funds, which can artificially inflate earnings in good years and depress them in bad. Another is “Special Purpose Entities,” oraffiliated firms or partnerships that buy risky assets or liabilities of the company and thus “remove” those financial risks from the company’s balance sheet. Another element of distortion is the treatment of marketing or other “soft” costs as assets of the company, rather than as normal expenses of doing business. We will briefly examine such practices in the commentary that accompanies this chapter.

* Northwest Industries was the holding company for, among other businesses, the Chicago and Northwestern Railway Co. and Union Underwear (the maker of both BVD and Fruit of the Loom briefs). It was taken over in 1985 by overindebted financier William Farley, who ran the company into the ground. Fruit of the Loom was bought in a bankruptcy proceeding by Warren Buffett’s Berkshire Hathaway Inc. in early 2002.

* Graham is referring to the provision of Federal tax law that allows corporations to “carry forward” their net operating losses. As the tax code now stands, these losses can be carried forward for up to 20 years, reducing the company’s tax liability for the entire period (and thus raising its earnings after tax). Therefore, investors should consider whether recent severe losses could actually improve the company’s net earnings in the future.

† Investors should keep these words at hand and remind themselves of them frequently: “Stock valuations are really dependable only in exceptional cases.” While the prices of most stocks are approximately right most of the time, the price of a stock and the value of its business are almost never identical. The market’s judgment on price is often unreliable. Unfortunately, the margin of the market’s pricing errors is often not wide enough to justify the expense of trading on them. The intelligent investor must carefully evaluate the costs of trading and taxes before attempting to take advantage of any price discrepancy—and should never count on being able to sell for the exact price currently quoted in the market.

* “Mean figure” refers to the simple, or arithmetic, average that Graham describes in the preceding sentence.

aThree-fifths of special charges of 82 cents in 1970 deducted here.

* Graham appears to be using “earnings on capital funds” in the traditional sense of return on book value—essentially, net income divided by the company’s tangible net assets.

* See pp. 299–301.

† Recent history—and a mountain of financial research—have shown that the market is unkindest to rapidly growing companies that suddenly report a fall in earnings. More moderate and stable growers, as ALCOA was in Graham’s day or Anheuser-Busch and Colgate-Palmolive are in our time, tend to suffer somewhat milder stock declines if they report disappointing earnings. Great expectations lead to great disappointment if they are not met; a failure to meet moderate expectations leads to a much milder reaction. Thus, one of the biggest risks in owning growth stocks is not that their growth will stop, but merely that it will slow down. And in the long run, that is not merely a risk, but a virtual certainty.

1 For more on how stock options can enrich corporate managers—but not necessarily outside shareholders—see the commentary on Chapter 19.

2 All the above examples are taken directly from press releases issued by the companies themselves. For a brilliant satire on what daily life would be like if we all got to justify our behavior the same way companies adjust their reported earnings, see “My