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Core of the Story

Equities are riskier than bonds because equity earnings represent what is left over after everyone else has been paid and thus are volatile. But what if you could make your equity earnings more stable? The stock in your firm should become safer and potentially a better investment. As the argument goes, if you can make returns on stocks in these companies that are comparable to what you would make on stocks in more firms with more volatile earnings, you could argue that you are getting the best of both worlds—high returns and low risk. There are three elements to this story.

  • Stocks with stable earnings are less risky than stocks with volatile earnings. For this story to work, you have to accept the idea that volatility in equity earnings is a good measure of equity risk. Luckily for those who use this story, that is not a difficult sell. The alternative measures of risk used in finance, such as stock price volatility or betas, are all market-based measures. To those investors who do not trust markets—they feel that markets are subject to mood swings and speculation, for instance—earnings stability or the lack thereof seems to provide a more dependable measure of equity risk.

  • Stocks with more stable earnings generate less volatile returns for stockholders. According to this argument, firms with stable earnings are less likely to roil markets with earnings announcements that surprise investors. The resulting price stability should make the returns on these stocks much more predictable than returns on the rest of the market, especially if the firm takes advantage of its more stable earnings to pay larger dividends every period.

  • Stocks with more stable earnings tend to be underpriced by markets. This is perhaps the toughest portion of the argument to sustain. One reason given is that companies with stable earnings are often boring companies that don't make the news and investors in search of fads and stars are not interested in them. As a result, stable earnings companies will be underpriced relative to companies with more volatile histories.


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