"What will move margins next…Our best guess? Gravity." - Leuthold Weeden Capital Management
In a recent Insight entitled Is Bernanke Blowing A Bubble, we unpacked the key drivers behind the recent, prolific rise in the global stock market (NASDAQ:ACWI). Although earnings growth and dividend yield have aided in the rise, the lion's share of the gains have come from multiple expansion. Multiple expansion or contraction is primarily a product of sentiment shifts in the market with the most recent shift pushing the historical upper bounds of bullishness. Investors are more confident in the quality and potential growth of the stock market's underlying earnings today than they were a year ago. They are therefore willing to pay a higher price for those underlying earnings, which has put upward pressure on stocks and led to higher P/E ratios, particularly here in the U.S. (NYSEARCA:SPY). Even with the rise in P/E ratios around the globe, a cursory look at the current P/E level would indicate that markets are only trading at a slight premium to historic averages and are nowhere close to bubble levels. This may be true, but one aspect that is overlooked in this type of short-cut analysis is the quality and sustainability of the earnings (E) in the P/E ratio.
Earnings in their simplest form are sales less expenses. They can grow by either increasing sales or decreasing expenses or a combination of the two. Because earnings tend to fluctuate to a much greater degree than sales, some analyst argue that valuation metrics should be based on sales rather than earnings. This type of analysis isn't without its flaws as earnings are what owners in a business put in the bank and classic value investing teaches that the "fair value" of a business is the present value of its future earnings stream. That being said, price-to-sales can still be thought of as one arrow in the valuation quiver and they tell quite a different story than the P/E ratio. The price to sales ratio, which doesn't reflect any gains in productivity, is flashing signs of an overbought and expensive market. In a recent letter to his investors John Hussman wrote;
"…if one examines the stocks in the S&P 500 individually, the median price/revenue multiple is actually higher today than it was in 2000." (emphasis by Hussman).
But as mentioned earlier, business owners don't bank sales, which is why earnings are the most common valuation tool. The ratio of earnings to sales is the profit margin. Historically, profit margins have tended to mean revert over long periods of time due to natural supply and demand forces in the open market. The chart below shows the ratio of US corporate profits to GDP, which can be thought of as a proxy for sales.
What is clearly shown in the above chart is that profit margins are currently at record high levels versus their historic average. In fact, they are now 72% higher than their average level of 6.4% going back almost seven decades. Some market pundits will point to efficiency gains in production through automation and outsourcing as reasons to justify the "new normal" or permanent paradigm shift in profit margins. In other words, they are making an argument for why this time is different and profit margins shouldn't mean revert as they have so many times in the past.
There is some truth in this argument as technological advances have been dramatic over the past several decades, but economics 101 teaches that gains from cost reduction are temporary as outsized profit margins attract more competition and are eroded away by capitalistic competitors bringing goods and services to market at lower prices. Although gains in efficiency make for a nice story, they have not been the primary factor behind the increase in profit margins and are at best a tail wagging the dog. The chart below breaks down the change in profit margins here in the US from the tech bubble profit margin peak in 1997 versus the third quarter of this year. What is interesting to note is that the margin on operating earnings is very similar (15.1% vs. 15.3%). The expansion in the net profit margin has been almost entirely driven by a reduction in interest and tax expenses, which account for 2.6% of the 2.8% increase in net profit margins (7.3% vs. 10.1%).
Intuitively, this makes sense as interest rates are at historically low levels and companies have become more creative in their corporate structure to minimize taxes. But the big takeaway form this analysis is that the gains in profitability are being driven by financial engineering ((dog)) rather than operating efficiencies (tail). Therefore a belief that "this time is different" and new record high profit margins are here to stay is a belief that interest rates will remain at current low levels and corporate tax rates will not increase. This story is a harder pill to swallow, which is why we still believe that profit margins will continue to be cyclical and will eventually mean revert. This is the biggest risk to using short-cut valuation metrics like 12 month trailing or forward P/E ratios, which is why we like to monitor the Cyclically Adjusted Price-to-Earnings ((NYSEARCA:CAPE)) ratio pioneered by Professor Robert Shiller of Yale University. High profit margins are not reason enough to underweight the target to equities in a well-diversified portfolio, but do give us pause about "pressing the bet" on equities.
Disclosure: I am long ACWI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Transparency is one of the defining characteristics of our firm. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments or its principals. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.