There has been so much talk about corporate margins reverting to the mean in recent years, so we've decided to investigate this issue further. Big names like Warren Buffett or Jeremy Grantham have argued that corporate profits, as a percentage of GDP, are at historically high levels. See the chart below. They argue that the "E" in the P/E ratio will compress as a result of profit margins coming down from their high levels, resulting in P/E ratios that would be unjustifiably high.
We decided to investigate the source of why margins have come up in recent years. There are two culprits: employees getting squeezed (i.e. lower labor expense, % of sales) and lower interest rates (i.e. lower interest expense, % of sales). We took the top 100 American companies by market value currently and figured out average levels for key metrics, which are summarized in the following chart.
We start by looking at the net margin, which is what we are concerned about. The latest year we have is for 2012, because all of 2013's data was not available at this time. The average net margin is about 22.4% higher than the average net margin experienced during this last decade. This is highlighted in yellow above. Companies are taking an additional $2.30, on average, off of every $100 in sales generated today (12.7%-10.4%=2.3). What is driving this?
Well, the operating margin is doing better, but not that much better. The operating margin is improving because companies are getting a better COGS %. The COGS % includes direct labor, such as factory workers. This may be indicative of getting more out of labor, but this is not the driving force behind improvements in the net margin. In fact, there has been somewhat of an offset by an increasing SG&A %.
The real thrust of the net margin growth has been after the EBIT line: interest and taxes. As a percentage of sales, both of these accounts are currently very favorable relative to the previous decade's average. The Interest Expense % is 20.3% less than its average, also highlighted in yellow. Notice also that total debt is 19.4% of total assets currently, a level that is the highest for the decade.
We can definitively say that the low level of interest expense, relative to sales, is driving the high net margin.
So When will Margins Revert?
It is tough to say. Just to maintain the E in P/E in a margin reverting world would require an offsetting increase in revenue. Will economic growth be large enough to grow revenues and offset declining margins? Maybe. To grow earnings would require significant economic growth to not only offset compressing margins but also to grow the top line. This is the reason why the likes of Jeremy Grantham believe that stocks are not likely to produce large returns from current levels over the next decade. The compression of margins will be such a large drag on earnings, that it will require significant revenue growth to post net positive growth. It is like one step forward and two steps back.
So back to the question at hand: when will margins revert? We have identified the interest expense being at such low levels that has driven growth in the net margins. Let's look at the term structure of interest rates.
The current yield on investment-grade corporate securities is about 3.68%. The term structure has been getting steeper since about 2012. What this means is that the market is expecting us to get closer and closer to higher rates. This makes sense. We have been talking about taper for 2014, and the economy seems to be making moderate progress towards increasing employment and growth. Growth is expected to lead to higher rates. Because rates are already so low, on a percentage basis, growth in interest rates will make a big difference. In other words, adding 50 bps to 3.68% makes a larger dent than adding the same 50 bps to 4.68% or 8.68%. Based on the yield curve, movement in rates could be anywhere from 1 to 3 years.
The price you pay determines your investment return. Based on our evaluation of the sample companies, we find that net margins are being driven higher mostly by the interest expense as a percentage of sales being at a historically low level. We find the lesser driving force to be labor expense. As rates rise, we expect net margins to revert downward to the mean, as articulated by the likes of Warren Buffett and Jeremy Grantham. This will compress the E in P/E, which is unlikely to be offset by the rising revenues of economic growth. As a result, we believe that the price you pay today for stocks in general may not lead to significant returns over this next decade.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.