Down to the Last Drop of Profit Growth (in Barron’s)

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The following article was published in February 4th, 2008 issue of Barron’s.  It is revised, updated partial excerpt from my book Active Value Investing: Making Money in Range-Bound Markets STOCKS ARE ALLEGEDLY CHEAP NOW, at 17 times 2007 earnings. And they are cheap by historical standards. Only seven years ago, they were at price/earnings ratios double today’s; they are even cheaper if you compare their forward earnings yield of 6.7% to Treasuries’ yield of 4.25%. They are cheap, cheap, cheap! Or so we’ve been told.

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.

Many disagree that the profit-margin reversion will take place. Here are the most common arguments against it, and some food for thought on why “common” doesn’t necessarily translate as “wise.”

Who said that margins have to revert to a mean; why can’t they just remain high?

Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, too, so they fly in and start cutting into these above-average margins. This always has happened in the past, and it will happen again and again in the future.

What about the billions of dollars U.S. companies poured into technology — weren’t they supposed to make these operations more efficient and bring higher profit margins?

The billions of dollars did not go to waste; companies are more productive now than ever before. Efficiency gains stemming from productivity were a source of competitive advantage and higher margins when access to proprietary technology was a competitive advantage.

For example, Wal-Mart’s rise in the retail industry was achieved through a very efficient inventory-management and distribution system that passed cost savings to consumers and drove less-efficient competitors out of business. Today, however, that same — or even better — technology is available off-the-shelf to retailers like Dollar Tree or Family Dollar, whose outlets are about the same size as a couple of Wal-Mart bathrooms put together. Oracle or SAP will gladly sell state-of-the-art distribution/inventory software systems to any outfit able to spell its name correctly on a check. Increased productivity didn’t and won’t bring permanently higher margins to corporate America — the consumer is the primary beneficiary of lower prices. If profit margins didn’t respond as they do, Wal-Mart’s net margins would be 25% today, not 3.5%.

Over the past 70 years, growth in corporate earnings and gross domestic product haven’t differed significantly. On the other hand, there has been a permanent benefit from increased operating efficiency: It lets companies hold less inventory and adjust more quickly and precisely to changes in demand. This has led to less volatile GDP.

Shouldn’t average profit margins be higher now, as the U.S. economy has transitioned from an industrial (low-margin) economy to a service (higher-margin) economy?

It is not as much of a change as we might think. In 1980, services represented about 48% of GDP. After 27 years and a lot of changes like outsourcing, services have increased to 58% of GDP. If we assume that the service sector has double the margins of the industrial sector (a fairly conservative assumption), increases in the service sector should have boosted overall corporate margins by about 40 to 70 basis points above their 27-year average — between 8.9% and 9.2%, but still far below today’s 11.9% margin. Thus, if we adjust corporate margins to reflect the transformation toward a service economy, corporate profit margins are still 30% above their long-term mean.

Shouldn’t globalization allow U.S. companies to increase margins?

A larger portion of U.S. companies’ profits is coming from overseas than ever before. However, globalization is a double-edged sword — U.S. companies are expanding and will continue to expand overseas and capitalize on new opportunities. But as the world flattens, they also face new competition at home and abroad. For example, Motorola-a company that used to represent American might in the telecommunications arena — has been marginalized in the U.S. and around the world by companies whose names we didn’t recognize 15 years ago — Finland’s Nokia and South Korea’s Samsung.

Although Wal-Mart is rapidly expanding overseas, it will soon face a new breed of competition. U.K. retail giant Tesco recently entered the American market. U.S. companies may get a larger portion of their earnings from overseas (the weak dollar will only help), but they’ll have to fight to defend home turf.

International expansion doesn’t guarantee fatter margins, quite the opposite: We are about to face competition from countries that may be more concerned with increasing market share, even at the expense of short-term profitability.

High oil prices are here to stay, so maybe multiyear high margins in the energy sector are here to stay as well.

This would be the case if energy companies sold their products to customers in another galaxy where somebody else bore all the costs of high-energy prices. Petroleum products are consumed by corporations and individuals. The profit margins benefiting the energy sector are achieved at the expense of lower margins for companies that consume their products-which really is the rest of the corporate world, in various degrees.

Today’s stock valuation is a lot higher than it appears if you normalize earnings to lower profit margins. And while it’s hard to tell when earnings will embark on a fateful journey to seek their historic mean, it should happen sooner than later. Earnings will either decline or grow at a slower pace than GDP.

Depending on the industry structure, companies that don’t have a sustainable competitive advantage will not be able to keep competition at bay, and will face margin compression, along with lower earnings growth or declining earnings. Look at your portfolio: Can the companies whose margins are hitting all-time highs sustain them?

VITALIY N. KATSENELSON is a portfolio manager at Investment Management Associates in Denver, and the author of Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007)

P.S. The following two charts really tell a great story about profit margin compression overtime.   Due to readers request I created one based on GDP and one based on GNP.  As you can see there is little difference between them as GDP (domestic product) and GNP (national product) are very similar.   An additional point: margins don’t have to revert and stop at the mean, historically they went below the mean (that is how mean is created).  

 

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12 Comments

  1. Mr. Vitaliy,

    Thank you for showing the graph with GNP as well.

    One other question. Why start at 1980? In the 1960s I believe profit margins were at levels such as the current ones.

    Also, the integration of China/India into the global economy could be providing an excess supply of workers that will take a protracted period to efficiently make use of. This could keep worker wages down and slow down the process of profit margins returning to historical norms.

    Finally, S&P 500 dividend yields are 65 bps above real government bond yields. Corporate profit margins better collapse quickly or you can’t justify buying bonds over stocks for the medium-term. (Of course one could argue that it will be a low return environment going forward for all assets.)

    I like your site and just ordered your book.

  2. This is definitely a very interesting persective on overall corporate earnings. I’ve never quite understood how the stock market as a whole returns 9% compounding over the last century vs a GDP growth of ~3%. How exactly has that been possible under this mean-reverting math?

    Also, what do you think about the prospect of accelerating progress due to technology to keep things “propped up” if you will with respect to your 8.5% mean margins? Do you not think this is a significant effect enough to justify high projected future profits?
    Thanks! I just ordered the book, would be very interested to hear your response to my questions.

  3. Excellent job Vitaliy. I was just going to write something on this myself. I’ll excerpt liberally if you don’t mind, and add in a few things.

    Ryan,

    The reason the stock market has returned more than 3% is a combination of things. First, GDP has been adjusted for inflation, while stock market returns have not. The real return (above inflation) has been about 6.5%.

    Dividends from stocks account for the majority of the rest (a small amount at todays valuations and payout ratios @ 1.8%. Historically @4.5% of the return) About .9% a year has been the increase in P/E’s and the remainder has been real earnings growth. As you can see, long term real earnings growth has been around 1% above inflation if you do the math. Real earnings have historically grown slower than GDP. That is what you should expect moving forward as well.

  4. Thoughtful piece.

    I recently read Leon Levy’s “Mind of Wall St.” and it in he brings up a salient point about the relationship between corporate profitability and the savings rate. Generally, a lower savings rate should produce higher corporate profitability, all else being equal. Because businesses have fixed costs (labor, real estate…), every incremental portion of my income that I spend instead of save should flow through the corporate P/L at a higher incremental margin than operating margins, hence raising margins. As the savings rate inevitably increases from its present 0.2%, it seems inevitable that this must help push margins back down to their historical average.

    Caveat: I’m not a macro guy, but Levy’s argument intuitively makes sense to me.

  5. Profit margins for the S&P500 do not appear to have grown as much. They are still about 8.5% which is what you say is the historical norm. How do you explain the difference in the profit margins for the economy as a whole and the profit margins for the companies in the SP500?

    I would be more concerned if the profit margins for the SP500 sky rocketed and then reverted back to the mean.

  6. Hi, I just finished your book and think its a great piece of work, very thorough and well backed up with facts. I don’t mean to sound like a stickler though but I have looked at your investment firm’s website and your performance appears to be 50% below the market index over the past 15 years or so. How do you account for this considering such good ideas that you have now?
    Thanks!

  7. Great book. However, I think I’ve found a slight flaw with your P/E approach to valuation.

    You use the dividend yield and add it directly to the “expected P/E” based on growth rate. But, if the stock price falls then the div yield rises, and so will the fair value P/E you predict (i.e. the stock’s value based on P/E will rise just because the stock price has fallen).

    Why would the expected/fair value P/E rise if the stock price fell and nothing else (like growth, risk, etc.) changed?

    Thanks.

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