Everything else being equal, steadier earnings growth compounds more reliably than the same average growth rate achieved with high year-on-year variance.
For example, earnings growth at critical life-saving technology specialist Halma has averaged around 12% over the last decade, which is close to its compound annual growth rate (CAGR) of 12% a year. This implies that annual growth was consistent, rather than jumping around.
Contrast this smooth performance with clothing retailer Next, where annual earnings growth has also averaged 12% over the last decade. Here, the average masks a bumpier earnings trajectory, including some negative years, which reduces its CAGR to only 4% a year.
To illustrate how this works, let’s say earnings grow 50% in year one and fall 50% in year two. The average growth is zero (50 plus minus 50) but the CAGR is (100 x 1.5=150 x 0.5 = 75) minus 25%.
Other advantages of earnings stability include the ability to pay regular and progressive dividends, in contrast to companies which skip or shrink their dividend in bad years.
Nasty earnings surprises are less likely at companies which have stable earnings growth, which means they are more likely to maintain their dividends.
Halma is on track to for its 47th consecutive year of dividend increases of more than 5%. Reinvesting dividends is a key ingredient to growing wealth and the ‘flywheel’ effect which drives compounding of investment returns.
Companies with reliable earnings can be attractive for investors looking for steady income as well as those seeking capital growth.
Consistent earnings growth doesn’t happen by chance
Companies which demonstrate reliable earnings do not do so by accident, but because they possess entrenched competitive advantages or operate in industries with more stable demand characteristics.
What are the different types of competitive advantage?
Brands, intellectual property and trademarks provide pricing power, high switching costs and network effects create stickier revenues while economies of scale generate cost advantages.
A competitive advantage highlighted by investor Chris Hohn who manages The Children’s Fund are irreplaceable physical assets such as airports, railways and toll roads.
Durability of a competitive advantage is more important than anything else, because it implies higher barriers which are harder to break down, protecting profitability for longer.
However, competitive advantages are always influx and eventually they weaken and disappear.
For example, despite possessing several competitive advantages, the Blackberry phone disappeared as customer behaviour and technological disruption (Apple’s iPhone) impacted what looked like a previously unassailable position.
How did we create the list of stable earnings?
Using data from ShareScope we analysed a decade of earnings per share from the UK’s largest 350 companies excluding investment trusts and property companies.
We calculated annual growth rates for each company before sorting the companies by how much their earnings growth deviated from the average each year (shown as the variability figures in the table).
By this measure (also known as standard deviation in statistical language) Halma has exhibited the most stable earnings growth over the last decade. It operates in niche non-discretionary safety and compliance end markets which have regulatory-driven certification and approval barriers.
Imperial Brands/ British American Tobacco
Regulation is a threat for most industries, but for tobacco firms, advertising bans and enforced plain packaging protects the incumbents from new challenges and new entrants.
However, the same dynamics are shrinking the underlying market with volumes declining every year. Imperial Brands and BATS benefit from addiction-driven inelastic demand (people smoke whatever the price) allowing these firms to consistently ‘outrun’ volume declines with price increases.
These characteristics have resulted in resilient earnings while the companies save money on advertising and capital expenditures, boosting cash flows, which are then used to pay dividends and buyback shares.
BAE Systems has benefited from the recent turmoil in geopolitics and rearmament of UK and Europe military forces. It is the only company among the four largest defence contractors with deep roots in both the UK and US.
BAE operates long duration contracts which provides a high degree of revenue visibility which is rare outside of regulated utilities.
Relx faces AI challenges
Despite getting caught up in the crosshairs of February’s AI-related sell-off in software companies, data analytics company Relx arguably has the hallmarks of several competitive advantages.
Its vast proprietary databases across legal (LexisNexis) and scientific publishing (Elsevier) which have been curated over many decades, make it difficult for competitors to replicate.
Recurring subscription fees (over half of revenues) and high renewal rates provide revenue visibility and contribute to stability in earnings. The question investors have is whether Relx can successfully embed AI into its products to enhance the customer proposition.
Value-added distribution company Bunzl supplies essential products and everyday consumables that companies need to run their businesses. It operates at scale in a fragmented market which means small independent distributors can’t easily replicate Bunzl’s purchasing cost advantages.
Martin Gamble: Shares and Markets Writer
Martin Gamble is Shares and Markets writer at AJ Bell. He was previously the Education Editor of Shares Magazine. He has been with the business since 2019.
Martin graduated from the University of Kent in...