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Looking at the Evidence

There are a number of ways in which firms attempt to make earnings less volatile. Some firms have stable earnings because they are in predictable and safe businesses, with little or no competition. Others seek stable earnings through a strategy of diversifying into multiple businesses, hoping that higher income in some will compensate for lower income in others. In a variation of this theme, firms also diversify geographically, with the intent of balancing higher income from some countries against lower income from others. Still other firms use the wide range of options and futures contracts that are now available to reduce or even eliminate their risk exposure. Finally, there are firms that use accounting devices and choices to smooth out volatile earnings; this phenomenon, called earnings management, acquired quite a following in the 1990s. The consequences of each of these approaches to reducing earnings volatility for stock prices and returns is assessed in this section.

Stable Businesses with No Competition

For several decades, utility stocks (phone, water and power companies) were prized by risk-averse investors for their steady earnings and high dividends. In fact, these firms could pay the high dividends that they did because their earnings were so predictable. The reasons for the stable earnings were not difficult to uncover. These stocks were regulated monopolies that provided basic and necessary services. The fact that their products and services were nondiscretionary insulated them from overall economic conditions, and the absence of competition gave them secure revenues. In return for the absence of competition, these firms gave up pricing power to the regulatory authorities.


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