World Wide Margins: Outstanding or Out of Whack?

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Includes: DGT, DIA, EFA, IOO, QQQ, SPY
by: Benjamin Hacker

A large focus for many professional and amateur investors alike is the determination of the appropriate level of valuation of the stock market. While often times you will hear some folks dismiss this topic as unnecessary when hunting for superior individual stocks, I do believe that the discussion should merit at least a modest amount of focus.

Without a rough estimation of what the 'fair value' of a market may be, it (I believe) is speculation to dip too big of a toe into any individual equities that are encompassed by it. A prime example of where this may have gotten an investor into trouble was in 2000 in the U.S market. Investor enthusiasm for all technology issues distorted the valuation on many names to the point where the aggregate S&P500 was pushing up over 30x earnings. An investor specializing in large U.S equities, and technology names in particular would have done well to at least contemplate the underlying economic assumptions that a 30x multiple implies about a market.... and then immediately realize the lunacy that was taking place.

More importantly I think, are those investors/speculators who follow a so-called asset allocation investment model where decisions are more driven by overall valuations of an entire market as opposed to individual equities and bonds. These investors may be more keen to understand the level of valuation more, since individual valuations bear no weight on their decisions.

One of the rallying cries that have been made by myself and many other investors for the last few years has been that the aggregate profit margin level for the U.S stock market on a whole has been ominously high. Meaning simply that the portion of our economic output [GDP] that is flowing to capital (i.e., shareholders) is (too) high, and the portion going to labor is contracted. History has shown this is of significance because this margin level has been very consistently mean-reverting over the years, and the level has averaged to be ~6-7% over many economic cycles.

There are some interesting arguments as to why a rise above the mean may be sustained (it's different this time right?), but the two key ones that I think are relevant are:

  1. The entry of additional labor markets from India and China (read: globalization) have shifted the balance of power toward capital for an extended (perhaps permanent) period of time
  2. The U.S market cannot be taken in a vacuum as many high margin businesses with strong brands count toward the U.S figures but make much of their money abroad

The key conclusion for those who disagree with the above is that the current margin of the US (8.25%) is above trend, and is bound to mean revert. So the P/E of the market, is overstated by ((8.25-7.00)/8.25=) ~15%. Needless to say, if the net earnings of the S&P500 would drop tomorrow by 15%, the market would be lower than it is today.

While this line of reasoning has always resonated with me; it has always rung a bit hollow from the mouths of its vocal proponents because of an obvious omission. I have heard critics and pundits use the mean reverting profit margin argument probably over 100 times to argue that the US market is overvalued... but I've not seen a single article, blog, or speech by someone using the inverse reasoning to argue a bullish case for an asset class. As Charlie Munger says "Invert. Always invert."

It is often stated that the bearish case is easier to deliver because it makes one sound 'smart'. I fully agree that is the case, but I often believe that people are subconsciously effected by that truth. The reason in this case is simple. The reason margins get high is because everything is going right. Productivity is up, GDP is growing, unemployment is down. As a bear, you can always point to the profit margin and say "Be careful, the good times won't always be here..." Maybe some folks think you are an idiot, but you don't lose money by not buying... or better yet you can still be buying, but just voicing caution at the same. This is a prudent course of action.

On the flip side of the coin, you see Japan in its ultimate economic funk, with <2%>

a) Either one market has superior characteristics (regulation, ease of capital flow, strong human capital) AND those reasons provide a superior level of profitability at the expense of other companies from other countries.

OR

b) You believe that in the end, companies profit margins will revert to the mean as the global landscape for competition will push all returns to the mean.

So is the US strong because Japan is weak (simplistically speaking)? Or has the U.S just had a good run that can't last, and Japan has just had a bad run that can't last?

I personally believe that their may be a bit of truth in both, but I want to perform a little data reconstruction to see what the statistics show the market to believe. The following data set is from the S&P / Citigroup Global Indices (from 11/30/2007):

Immediately, you notice a few things:

  1. The U.S isn't even in the 25th percentile in terms of profit margin.
  2. The U.S is on par with the 'world' weighted profit margin (the implication is that the largest components of the index are toward the bottom, and the higher margin countries in this data set tend to be smallish)
  3. Emerging Market profit margins are >11%!!!
  4. Japan is dead last
  5. Peru, Egypt, Hong Kong and Iceland are all up at 20% or above

The astonishing thing to me is that there continue to be people who not only claim that U.S equities are overvalued (they may be), but many times they are the same people who are advocating that you diversify out of the U.S and get foreign exposure without bringing up the same basic data point (net margin) with respect to foreign markets. Blind asset allocation won't help us!

I do believe that many educated folks do already understand this, and are acting on this knowledge already. Buffett for instance has made various overtures stating that the U.S markets are slightly to fairly overvalued... he has even offered up (in the past) his own valuation metric for the U.S market which is a price/sales ratio of 0.8x+ (and presumably rising based on his comments). By using a price/sales ratio Buffett is implying that there is a normalized profit level for the U.S market. On other occasions, Buffett has noted that he sees bargains in South Korea which is the second lowest country on the list in terms of margin level. Buffett has also actively made negative comments regarding Japan which implied that he took a long hard look at the companies there and just didn't find anything he liked.

Aside from Buffett though, there are many other who continually beat the 'mean-reverting margin' drum against U.S equities but don't seem to discuss the topic for any other markets. These pundits appear to have lost their way, or be parroting 3rd party research which they don't fully comprehend.

Of course there can be many explanations for some of the data points above (emerging markets tend to have much higher weight to metals / mining / energy companies which are currently generating substantial profits is just one explanation) but suffice to say that I don't ever see the data above shown much less explained. There just seems to be a lack of intellectual honesty about these things. Or perhaps they are just dumbing it down for their audience, i don't know.

I don't mean for this post to provide conclusions on which of these countries is a good place to invest. This list is only a starting point based on one piece of data, but it is instructive to always try to dig to the next level of data to understand what the masses are saying... and more importantly, what the masses are saying that is wrong.