The following article is based on a chapter from Aswath Damodaran's book Investment Fables.
Not many investors enjoy hearing that one of their stocks has dropped because the company surprised the market by missing its earnings target. It takes an iron stomach not to bolt for the door during those times, which is why many investors are drawn to stocks with stable and predictable earnings. The argument is that if you can find companies with stable earnings that generate similar returns to their more volatile brethren, you are getting the best of both worlds -- good returns with limited risk. But does earnings stability really translate into superior performance? Let's look at a couple of different ways firms can create stable earnings and see if there is any payoff.
The only game in town
Utility stocks have long been praised as the best investments for the risk-averse because of their steady earnings and dividends. These companies usually act as regulated monopolies, providing nondiscretionary products and services to a steady customer base. In return for operating a recession-resilient business with no competition, utilities agree to give all pricing power over to a regulated authority. Although deregulation has changed the game a bit over the last decade, there are still some companies that operate under this structure, including the utility arm of Hidden Gems recommendation Otter Tail (Nasdaq: OTTR ) .
The question for investors is not whether utility stocks have greater earnings stability, but whether they make better investments and outperform the market. Sadly, history has shown that utility stocks have lagged the overall market by an average of 2% per year from 1928 to 2002. Utility stocks are the belle of the ball during recessions thanks to their guaranteed rates of return. But in the long run, markets rise as economies grow, and unregulated businesses generate higher returns on their capital.
A finger in every pie
Some companies diversify their risk by owning businesses in more than one sector of the market. These companies are known as conglomerates, and no one is a better example than General Electric (NYSE: GE ) . By spreading its revenues over multiple sectors, GE creates earnings stability that is not overly exposed to the success or failure of any single business unit.
Logically, the market should value conglomerates at a premium compared to the sum of their individual parts because of the diversification benefit they provide. Oddly enough, this is not the case. The evidence seems to indicate that conglomerates trade at a 5% to 10% discount compared to their individual pieces. This is because conglomerates usually pay a heavy premium to acquire various businesses, which drains more shareholder value than the diversification creates. Also, many times companies like these will suffer from lack of focus and will underperform their stand-alone competition.
The world is my oyster
Sector risk isn't the only threat companies are exposed to -- they also face the broad-market risk of a recession. One way to reduce this risk is to expand operations to a global scale, creating diversification across different economies. Stock Advisor pick BorgWarner (NYSE: BWA ) is a perfect example of this type of business. Several years ago, BorgWarner committed to diversifying its operations internationally to combat the slumping domestic auto industry. Only 37% of projected 2007 revenues are expected to come from the Americas, compared to the 66% share back in 2000. This strategy has been paying off, as BorgWarner continues to grow at a much faster pace than the broader auto industry.
This is only one isolated example, and it can't be used to define an entire market segment. But there is evidence to support the idea that geographical diversification does in fact increase the value of a firm. However, the effect was found to be small, and unfortunately, most of this benefit is realized when a company first transitions from domestic to international operations. Therefore, investing in firms that are already geographically diverse generally yields little in excess returns for the shareholder.
The bottom line
There are other ways to stabilize earnings besides the ones mentioned here, including financial hedging and managing earnings with accounting choices. But do any of these things add value for the shareholder? That depends on your definition of risk and your overall investment objective. If you can't bear to see your portfolio shed 25% or even more without heading for the nearest exit, investing in companies with stable earnings may be your best bet. But keep in mind that this stability may come at a price -- a reduction in your expected returns.
That is why the long-term investor should concentrate less on quarterly earnings fluctuations and more on the sustainability of operations well into the future. Some of the advantages of stable earners -- including sector and geographic diversification -- can be accomplished by the individual investor. By holding a diverse portfolio of quality stocks spread over a variety of different industries and staying focused on the goal of long-term capital appreciation, investors truly can have the best of both worlds: market-beating returns, with less risk.
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Fool contributor Elliott Orsillo lives in sunny California with his wife and his basset hound, Lola. He is a happy BorgWarner shareholder, but owns no other companies mentioned in this article. The Motley Fool has a disclosure policy.