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Margin Shrinkage – It Can Happen to You
Profit margins are a tick away from all-time highs and are creating the impression of cheap equity valuations. But that impression is a mirage, because today’s generous margins are destined to shrink. Stocks are allegedly cheap now, at 15.7 times 2010 earnings. And they are cheap by historical standards. Only 10 years ago, their price/earnings ratios were double today’s; they are even cheaper if you compare their forward (2011) earnings yield of 7.3% to the 10-year Treasury yield of 3.40%. 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 close to an all-time high of 13.3% (the all-time high was 13.9% in 2007), almost 58% above their average of 8.4% 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 15.7 to 24.9 times trailing earnings. Many disagree that profit-margin reversion will take place. Here are their most common arguments, and some food for thought on why this supposed common sense doesn’t translate to sensible logic. Who said that margins have to revert to a mean; why can’t they just remain high?
“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” – Jeremy Grantham
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, so they fly in and start cutting into these above-average margins.
What about the billions of dollars U.S. companies poured into technology – weren’t they supposed to make their operations more efficient and bring higher profit margins?
Those 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 and Family Dollar, whose outlets are about the same size as a couple of Wal-Mart restrooms put together. Oracle or SAP will gladly sell state-of-the-art distribution/inventory software systems to any company 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 GDP 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 51.3% of GDP. After 30 years and a lot of changes like outsourcing, services have increased to 65.3% 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 80 basis points above their 30-year average – to between 8.8% and 9.2%, but still far below today’s 13.3% margin. Thus, if we adjust corporate margins to reflect the transformation toward a service economy, corporate profit margins are still 45% 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. (It’s very interesting how much the smartphone industry has changed in three years: Apple, a company I did not even mention in my 2008 article, has transformed the industry. Motorola, which was almost dead then, is coming back to life. Nokia is becoming irrelevant very quickly, and LG and HTC are important players.)
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 (Cisco Systems has been successful in Asia, but its home turf has been attacked by the Chinese company Huawei.) U.S. companies may get a larger portion of their earnings from overseas (the weak dollar will help), but they’ll have to fight to defend home turf.
International expansion doesn’t guarantee fatter margins; quite the opposite: We are facing competition from countries such as Korea and China that may be more concerned with increasing market share, even at the expense of short-term profitability.
Higher oil prices are here to stay, so maybe multiyear higher 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 benefits of higher profit margins to the energy sector are achieved at the expense of lower margins for companies that consume their products – which is the rest of the corporate world, to varying degrees.
Today’s stock valuations are 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 their historic mean, competitive forces will make that happen sooner than later. Earnings will either decline or grow at much slower pace than GDP.
Companies that don’t have a sustainable competitive advantage will not be able to keep their 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, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
P.S.
Robust (above-average) earnings growth from the depth of a recession creates a false appearance, usually reflected in forward earnings estimates, that earnings can and will grow at a faster rate than the economy for a long period of time – but they don’t (see chart below, the growth of $1 of earnings and GDP from 1950 to 2010). For earnings to grow at much higher rate than the economy (GDP) for a long time, profit margins have to keep expanding, and as I’ve discussed in the past, capitalism (i.e. competition) doesn’t allow that to happen.
I first wrote about this in January 2008, and here is an update to that article. All I had to do was to update a chart and the numbers in the article and add a few comments – all of them are italicized.
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#USA corp profits
where do you take USA corp profits SIR? from BEA/NBER.. well its BULLSHIT.. why ? here's reason..
accoroding BEA recently USA corp profits just made all time HI..
is it true? NOT A CHANCE
if profits are all time high, well 'USA FED CORP TAXES' (aka money that can be verified) MUST BE ALSO ALL TIME HI? right??
well 12 month rolling sum of 'USA FED CORP TAXES' is 50% below of PEAK in 2007-2008.. so my guess BEA/NBER lied about corp profts by factor 2..
so ANYBODY WHO BELIEVE IN ANY BIT OF GOV PROPAGANDA IS AN IDIOT..
thats why just choosen ones run real money , rest of like you write JUNK ABOUT SIDE WAY MARKETS..
hey genious sp500 is in range market since 2000 .. you dont need to have PHD in rocket science to figure out
alx
ZH duplicate fuck-up
ZH duplicate fuck-up
Terrific post as usual from Vitaliy. Yeah with this latest natural disaster in Japan and surely 1 or 2 surprises before the end of the year, the next 9 months should be interesting.
The US is a series of government supported monopolies. I think they can maintain margins. I don't like it. But that is just the way I think it works here.
hrrmmmm....hrmmmmm he said shrinkage.
Vitaliy's scenerio shows no vitality for employment. If unemployment can not be reduced when corporate profits are above norms, then no hope when profit margins are reduced. In fact one can argue that current higher profits are at expense of employment in an effort to seek higher productivity by corporate sector utilizing outsourcing, temps and more worker efficiency.
This strategy is good for short term but eventually leads to consumer demand destruction and lower profits especially if also facing commodity inflation. Sounds like stagflation
its buyflation where wages decrease and commodity prices rise. apparently due to scarcity of commodities. we have globally already mined the easiest ore, oil, used up the best fertile land for food, etc...
What we aren't seeing is complete degredation in those margins yet. As a result, absent external shocks (Japan perhaps), we can't say that the market will collapse as sellers are still outweighed by buyers. We saw almost 10-15% of the SP500 (50 - 75 companies) showing very poor margins in Q4:2007, before this flowed through to other companies and the market fell rapidly. We are only seeing margin collapses at 5 - 10 companies in the SP500. When we see it happen to 50, we can solidly say that the market is moving towards a correction.
However, the number of true buyers may be masked by the Fed's efforts.
apparently the cure for any downtick in the market is to crush the dollar. as evidenced today in it's non stop freefall since the opening bell.
ain't the "free market" grand?
PPT 'To Do' list
4:00 pm: Buy dollars
9:30 am: Sell dollars
rinse, repeat
Interesting to see Chart 1 plotted vs. the unemployment rate.
that's a 2010 chart. In 2011 unemployment doesn't exist any longuer.
Much better than shinkey dinkage.