In Search of Certain Earnings

Abstract

Sector composites that have highly stable earnings streams allow the portfolio manager or analyst to derive “earnings certain” sector risk premiums. ACE (approximately certain earnings) sectors represent such baskets. Because sector pricing is influenced by earnings variability, obtaining risk premiums from standard sectors is contaminated. With knowledge of an EPS stability measure, a composite engine, and a robust DCF framework, we can discover companies within each sector that exhibit highly stable earnings. In practice, ACE sectors can be used to derive current/historical “earnings certain” sector risk premiums, enhance sector rotation strategies, obtain sector-implied growth rates, make risk adjustments for present value modeling, and construct improved valuation benchmarks.