Contenders With Steady Earnings Rises Over Time May Turn Out To Be Best Bets

Money managers David Dreman and Terence McLaughlin don’t agree on much. But they do share one stock-picking strategy: Dull and plodding can be better than spectacular.

But both like one relatively little-used stock-picking method: They look for companies that have shown steady profit growth-no sudden soaring or collapsing. A company whose earnings grow 10 percent, then 11 percent, is a better bet than one whose profit gains 20 percent one year, 1 percent the next.

With most investment managers regularly failing to best the Standard & Poor’s 500-stock index, McLaughlin says, he isn’t trying to hit a home run on every pitch. He just wants to outdo the index.

With companies that show regular growth in earnings, he says, you should have a lot of confidence that they are going to get you from Point A to Point B over time.

But do steady growers really outperform volatile ones over long periods? Research done by James Floyd of Minneapolis-based Leuthold Group suggests that they often do.

Floyd analyzed the companies in the S&P 500 index, as if he were investing in them 10 years ago. First, he used a statistical technique to compare their annual earnings growth for the previous 10 years-1974 through 1984. That produced a number analysts call r-squared-the steadier a company’s growth, the closer the number is to 1.00.

Then he calculated stock-price growth for the decade through 1994. Lo and behold, the stocks with the highest stability, r-squared above 0.9, surged 246 percent. Those with jumpy earnings, r-squared below 0.2, rose only 169 percent. (Overall, the 500 stocks gained 229 percent.)

The message: All other things being equal, go for stable earnings growth and avoid the zigzaggers. This is a useful tool-especially when you come to questionable periods in the economy, as we are now, McLaughlin says.

However, he and other money managers caution that this isn’t a silver bullet; troubled Morrison Knudsen’s earnings stability has been well above that of AT&T’s, for example.

McLaughlin often uses it simply to check himself after he has found a company he likes. He recently invested in Sysco, a food distributor, and in Deerfield-based Premark, which makes Tupperware, because he liked their potential for strong earnings and return on equity. The earnings stability reassured him; without it, he says, he would have taken another look.

McLaughlin says that, knowingly or unknowingly, investors pay a premium for companies with stable earnings growth, to avoid surprises. That probably helps explain why such stocks often beat the market in the long run.

As long as you make sure you use earnings stability as one of several tools in your arsenal, its proponents say, it can help you make good guesses about the future.

McLaughlin, for example, tries to buy highly stable companies when they are temporarily down. He bought General Electric, now at $56.75, after it fell back a bit following news of Chairman John Welch’s heart problems.

Deborah Cashman Ohl of Ashland Management notes that earnings stability can be a useful indicator even for investors attracted to companies with variable earnings. For example, Schaumburg-based Motorola’s r-squared of 0.76 is low compared with Automatic Data Processing’s 0.99, but it is high for the technology sector.

One of Dreman’s strategies is to buy normally stable stocks that have taken serious hits, because they tend to rebound quickly.

In recent months Dreman has bought drug stocks, tobacco stocks, and financial stocks, all on the same theory. He bought KeyCorp, Banc One and PNC Bank after worries that derivatives could hurt bank stocks.

Right now, he says, the stock market is up so far that he isn’t buying anything new, thus illustrating a drawback of stable earners: Sometimes, cheap ones are hard to find.

One warning: Its supporters say the steady-earnings theory works in the long run, but not necessarily over short periods. So far this year, stocks in high-r-squared companies have tended to underperform the S&P 500, according to Baseline, a financial-data company.