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.