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Chapter 5. Stable Earnings, Better Investment?

Chapter 5. Stable Earnings, Better Investment?

Larry's Riskless Stock Strategy

Larry had always wanted to invest in stocks but had considered them too risky. Having thought long and hard about why stocks were risky, Larry concluded that the culprit was volatility in earnings. He was convinced that he could construct a portfolio of stocks with stable earnings that would deliver high returns without the risk. Without much effort, Larry was able to identify the companies that had reported the most stable earnings over the previous five years in each sector, and he put his money in the stocks.

Even as he bought the stocks, he found that many of them were pricey, trading at high multiples of earnings, suggesting that other investors had come to the same conclusion as Larry about the low risk and high quality of these stocks. Having bought the stocks, he also noticed that stock prices were volatile at some of these companies, even though their earnings were stable. One of the stocks in Larry's portfolio was a gold mining stock, and when gold prices jumped because of a crisis in the Middle East, Larry noticed that the company did not report higher earnings, even though other gold mining companies did. When he confronted management about this, they admitted they used gold futures contracts to hedge risk. While these contracts reduced their exposure to downside risk, it also reduced their upside profits. When Larry assessed the end results of his portfolio, he found that he had still been exposed to risk and had relatively little to show for it. Larry's search for a free lunch had come to an end.

Moral: No downside, no upside.


When you invest in a firm, you are exposed to the risk that the firm's underlying business or businesses may go through rough times and that the earnings and stock price of the firm will reflect these downturns. This will be the case even when a firm dominates its business and the business itself is viewed as a good one. To counter this, some firms diversify into multiple businesses, in the process spreading their risk exposure and reducing the likelihood of sharp downturns in earnings. GE provides a good example in the United States. In recent years, firms have also diversified geographically to reduce their risk from a downturn in the domestic economy. In the 1980s, Coca-Cola used this strategy to deliver higher earnings even in the midst of stagnant growth in the beverage market in the United States. The argument that diversifying reduces risk seems incontestable, but does it follow that investing in diversified companies is a good strategy? Some investors seem to think so.


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