Wednesday, August 18, 2010 5 comments ++[ CLICK TO COMMENT ]++

Do profit margins have to mean-revert?

"If profit margins do not mean revert, capitalism is broken."
— Jeremy Grantham

How true is that? Do margins have to revert to the mean?

Sticking with the theme of exploring dissenting views (at least relative to my beliefs), let's consider one reason some people like me are very sanguine and bearish about the stock market. Namely, people like me have been concerned for a while that corporate profit margins are unsustainably high.

There are many measures of corporate profit margins and each data series is a bit different but the trend is generally the same. Here is one from Wiliam Hester of Hussman Funds, clearly illustrating how high profit margins have been in the last decade:

(source: "An Update on Valuation and Forward Earnings Assumptions" by William Hester. Hussman Funds. March 2010)

In the chart above, blue is the historical number while red is based on analyst forecasts of earnings and sales (this article was published in March of 2010.)

As you can see, even backing out the fictitious profits of financials 5 years ago, profit margins have been extremely high. The ironic thing is how badly the stock market has done in the last 10 years even though profit margins have been amazing. Imagine if margins were lower; how would the market have done then? In any case, that's a topic of another day.

The question, thus, is, whether the margins will fall back to their prior average. Now, why is this important? Well the author of the article gives one reason that encompasses investors like me who rely primarily on the P/E ratio:
These forecasted operating margins are important to investors who rely on using a P/E multiple based on forward earnings. Even with these forecasts for near-record profit margins, valuations on forward operating earnings are not favorable. The current multiple is about 14.8. As John Hussman has noted , the long-term average P/E ratio based on forward operating earnings is about 12. Taking the 14.8 multiple at face value implicitly assumes that the near-record profit margins assumed by analysts are now the long-term norm. Even a minor lowering of expected profit margins would cause the scale of the overvaluation to widen materially.
All this begs the question whether the profit margin has to mean revert? Have we seen systematic economic changes that may have permanently increased corporate profit margins?

Some Reasons Margins May Not Decline

Jacob Wolinsky, the blogger at Valuewalk, pointed me to a video segment by Morningstar's Pat Dorsey. Taking a page from philosophers, Pat Dorsey plays Devil's Advocate and presents some reasons margins may have changed (click here for original link to video.) I think macro-oriented investors should check out the link.

I'm not going to go over all the reasons but one of them is something I have never contemplated before. Dorsey suggests that it is possible that American corporations may have outsourced or completely eliminated low-margin businesses. If so, the businesses remaining in America would have higher margins. IANAE (I am not an Economist) but the logic makes sense.

For instance, if M is the mean margin or average margin, and X and Y are margins of different countries, then X+Y=M, where X margin can be higher than M, if Y is lower. If this were a closed economy (say only one big country) then X=M and therefore the overall margin must equal M (i.e. must mean revert in the grand scheme of things.) But if X can get rid of lower margin economic elements then X can clearly be higher than M if Y is lower than M.

So the concept is sound. However, it's not clear if this can be accomplished in the real world. A good check would be to see if companies in Great Britain in the 1800's and early 1900's saw their profit margins increase given how they outsourced or got rid of most of the low margin business to America (the fact that there were big wars in that period makes the analysis difficult). I don't have time to look up that line of thinking but someone with time to kill and interested in this topic may want to look up what happened a hundread or hundread and fifty years ago.

Just to be conservative—and also because I don't like supporting arguments in favour of paradigm shifts or big structural changes without solid proof—I'm maintaing my bearish outlook for corporate profits. I think profit margins will fall. Even if the above scenario of outsourcing low margin businesses were true, I think those regions with the low margin businesses will, eventually, try to take away the high margin business; it is also likely that the other two competitors, government and labour, will try to take away some of the profits, hence lowering margins.


5 Response to Do profit margins have to mean-revert?

August 18, 2010 at 8:27 PM

寂寞又無聊 看到你的BLOG 加油喔!!..................................................

Parker Bohn
August 19, 2010 at 1:41 AM

You've had some good posts lately.

I agree that equities don't look attractive right now.  I don't know if I would call myself 'bearish', but I don't think investors will get anything like the long-term average return over the last 100 years or so (unless equities decline and push dividend yields up).

I have a theory that this is actually intentional.  A large purpose of stock and bond investment is as a means of generational wealth transfer (ie handing off wealth between decades).  By lowering interest rates, governments have inflated the price of both bonds and stocks, and made the generational transfer of wealth more expensive.  This makes current consumption more attractive compared to savings, which stimulates the economy.

Another way of saying this, is that I think that all forms of savings have become more expensive.  Government bonds are expensive (in the US, perhaps in bubble territory).
Corporate bonds are expensive.
Stocks are expensive.
Cash is non-productive, and faces inflationary threats in the medium to long term.
Gold and commodities are non-productive and speculative.

So what's an investor to do?
What's your strategy?

Sivaram Velauthapillai
August 19, 2010 at 8:02 PM

Thanks for the compliments. Sometimes I wonder if anyone even pays attention to some of the stuff I write. I think a lot of people read the stock-specific stuff but not so sure about the macro-type stuff. Anyway...

I don't know about your 'generational transfer' theory. It sounds like theory that attempts to explain something completely unrelated. For instance, I don't think policymakers are sitting around thinking of ways to alter generational transfer of wealth. Instead, I think they are just trying to prevent a total collapse. In this scenario, that requires trying to shift savings/investment into spending. So, although what you described is happening, I don't think it's a purposeful strategy driven by transfer of wealth or lack thereof.

It's really hard to say what is happening or what caused all this--investors 50 years from now will still be talking about it--but one possibility is a savings glut, as Ben Bernanke theorized. If there is "excess" savings, returns on assets may end up being low.

The savings glut theory seems hard to believe--do we honestly have too much capital?--but if you consider how China is actually an exporter of capital, which is rare for a developing country, it sort of suggests excess savings.

I'm not really sure what is happening. I'm waiting to see if there will be more debt destruction (i.e. I'm not sure if we are seeing fictitious wealth or if it's real) and then I'll form a more solid opinion.

Whatever the cause, I think we both can agree that investing is going to be extremely difficult this decade. I wasn't investing back then but the dot-com bust makes it seem like that was a terrible period (99 to 2003) for investing but one could have avoided bubbly areas and don't quite well. Right now, as you allude to, there is nowhere to hide.

Sivaram Velauthapillai
August 19, 2010 at 8:10 PM

As for my strategy, I'm just sitting tight for now. I'm researching stocks but haven't encountered anything worthwhile yet.

Do note, though, some investors, such as Jeremy Grantham, is predicting fairly high (7% real) returns for high quality US stocks. Maybe that's the place to be, assuming one can figure out what "high quality" means.

I'm more bearish than Grantham (mostly because I'm really concerned about China whereas Grantham even goes so far as to say one should invest there because it will do so well) so even those "high quality" US stocks may come nowehre near a 7% real return.

No one can predict the future so who knows if it will be as bad as I imagine but if one does feel bearish, the ideal scenario is to pursue market-neutral (or even short) strategies or strategies that are uncorrelated with the market and the economy (e.g. risk arbitrage, liquidations, etc).  But these strategies require a wholly different skillset.

August 21, 2010 at 6:01 AM


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