U.S. Corporate Profit Margins, A Bottoms-up Analysis: Déjà Vu All Over Again1
By Baijnath Ramraika, CFA® and Prashant Trivedi, CFA®
"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly." - Jeremy Grantham, Barrons
"You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well." - Warren E. Buffett2
As U.S. corporate profit margins have made it to record highs, a debate has raged between those who place their hopes in the idea of a new paradigm and those who believe in capitalism's efficiency and the consequent tendency of profit margins to revert to the mean. Notable amongst those pointing to high profit margins and their susceptibility to mean reversion include John Hussman3, James Montier4, Albert Edwards5, Jeff Gundlach6 and Jeremy Grantham7.
Most of the analysis concerning U.S. corporate profit margins has focused on national account data compiled by Bureau of Economic Analysis. below shows the ratio of corporate profits (NYSE:CP) to gross national product (GNP). Clearly, corporate profits margins are way over norm. The series depicts a very strong mean reversion tendency confirming the effectiveness of the capitalistic system.
It is important to note that the term corporate profits after tax refers to profits of all corporations resident in the U.S. whether the profit is earned domestically or in a foreign country. GNP is the market value of goods and services produced by U.S. residents, regardless of where they are located.
This Time is Different
Notice that the corporate profit margins as shown in above have stayed close to +2 SD levels (two standard deviations above the mean) for much of the last ten years. Pointing to this behavior of profit margins, those on the new paradigm hopium suggest that something has changed this time around. It is suggested that productivity gains achieved and technological progresses made over the last couple of decades mean that corporate profit margins have arrived at a permanently higher plateau.
Another reasoning offered for higher profit margins is that service businesses like IBM, which have much higher profit margins, now account for a larger portion of the total corporate revenues and thus the high corporate profit margins.
In an interview with Matt Koppenheffer of Motley Fools, Professor Bruce Greenwald9 said, "I think Jeremy has been wrong about the reversion to the mean for about eight years now - and I think that there are structural reasons to believe that profits at or near this level may be more sustainable than he's giving them credit for." Greenwald then compares the profit margin deltas of Apple and IBM over the last few years suggesting that increased contribution from businesses like IBM mean profit margins could be sustainable at the higher level as he said, "In contrast, if you look at IBM, IBM is also at historically high margins. If you look seven years ago, it's at 14% operating income to earnings. You look today, it's at 20.5%." He concludes by saying, "To the extent that the market is moving away from the Apple direction, away from manufacture …… into these very much more differentiated service markets, these much more fragmented service markets, it looks like the profits may be more sustainable than people are giving them credit for."
A Bottoms-up Analysis of Corporate Profit Margins
At Multi-Act, we routinely go through historical financial statements spanning over more than a decade for every company we cover. In our own experience of going through these statements of several hundred companies annually, profit margins in case of a large number of businesses have moved in the wonderland. With our self-professed leanings towards the mean-reversion camp, we find this development troubling and are of the opinion that there is a non-trivial risk to profits from a decline in profit margins.
In the rest of this paper, we analyze profitability of the S&P500 Index on a bottoms-up basis. Much as the U.S. corporate profit margins in , we find that S&P500 profit margins have reached out to new highs. Further, digging through the components of these profits, we show that some of the contentions of those hoping for a renaissance of corporate profits margins are outright incorrect.
Data and Methodology
Our data sample consists of 1,079 companies that were members of the S&P 500 index between 1989 and 2013. Given that we are performing our analysis utilizing the components of the S&P500 index, there is some noise in our calculation introduced as a result of inclusions and exclusions of companies in S&P500. All data including fundamentals and price data are from Factset Global data feed.
We have excluded the Financials sector from our analysis given the significant differences between the income statements of financial businesses vs. other businesses, i.e., the analysis performed is for the S&P 500's non-financial components. This exclusion means that the yearly average number of companies in our analysis at 408 is less than what would otherwise have been the case10. For every calendar year, we utilize the fundamental data of all non-financial companies that were a part of the S&P 500 at the beginning of the year. Data reported anytime in a calendar year is assigned to that calendar year.
All calculation are performed on an unweighted basis. For example, instead of calculating profit margins for every company and then applying a weighting process (e.g., equal weighting or market cap weighting), we calculate total sales and total profits of the index and derive index's profit margin using these totals.
S&P 500: Net Profit Margin
below shows net profit margin of the S&P 500 non-financial stocks. As can be seen, the trajectory of net profit margins of S&P500 is very similar to U.S. corporate profit margins shown in .
shows the net profit margin of consumer discretionary stocks within the S&P500 index. The trend in profit margins of the consumer discretionary sector is very much in line with that of the broader index as well as that of the overall U.S. corporate profit margins.
shows the net profit margin of consumer staples stocks within the S&P500 index. While not as extreme as that of the broader index, consumer staples sector margins are close to their previous highs recorded in 2007.
below shows the net profit margin of the healthcare sector. Interestingly, Healthcare sector's profit margins are ruling towards their lows.
shows the net profit margin of the technology sector. Not surprisingly, at about 16%, this sector has the highest profit margin of all the sectors. Interestingly, much like the broader index, technology sector's profit margins is in uncharted territory as well.
shows the net profit margin of the industrials sector. Clearly, profit margins of industrials sector are in the wonderland as well.
shows the net profit margin of the energy sector. In this case, margins have retained their mean reversion tendency and have reverted to their mean.
shows the technology sector's net profits as a percentage of the total net profits of S&P500's non-financial stocks. Interestingly, tech sector's contribution to overall profits has flat-lined over the last few years.
The discussion above dispels both the misconceptions that higher profit margins are driven by services businesses that typically carry higher margins and the profits from such businesses have increasingly become a larger part of the U.S. economy. While profit margin of the technology sector is indeed the highest of all sectors, technology sector's contribution to total profits have stayed pretty much the same over the past few years. Further, what the data clearly shows is that profit margins are high in a variety of sectors including consumer discretionary, consumer staples, and industrials. In fact, they are close to their highest level in the technology sector as well.
Of Technological Progress and Productivity Gains
As we discussed earlier, one of the reasons offered for the structural shift upwards in profit margins is that technological progress we have made over the last couple of decades and the productivity gains achieved have lowered costs. If this were to be true, we should see a significant improvement in gross profit margins as cost of production per dollar of sales should decline. below shows the gross profit margin of S&P500's non-financial stocks. What a contrast!
plots depreciation expense as a percentage of sales. Interestingly, depreciation expense as a percentage of sales declined while gross profit margins were stagnant, i.e., minus this benefit, gross profit margins would have declined.
Another place where impact of technological improvement should show is in fixed asset turnover. shows the fixed asset turnover for all S&P500 non-financial companies. Instead of going up, fixed asset turnover ratios went down.
Choosing Short-term Gains (Read stock price increases) Over Long-term Competitiveness
While profitability has stayed stagnant at the gross profit margin level, there has been substantial improvement in operating profitability as shown by .
Looking at the behavior of gross profit margins and operating profit margins, it should be obvious what is happening here. As is seen in below, SGA and other operating expenses as a percentage of sales have persistently declined over the last two decades. Apart from other expenses, included in SGA and other operating expenses are marketing expenses, advertising expenses, R&D, software development costs, and product promotion expenses.
Central Banks and Helicopter Drops
The central bank largesse has been another factor contributing to higher net profit margins as borrowing costs have been suppressed ever lower. As is seen in the chart below, corporate borrowing costs have dropped well below their mean. Our calculations suggest that increase in borrowing costs to mean will reduce corporate net profits by 11% while an increase in borrowing costs towards +1 SD (one standard deviation above the mean) will cut corporate net profits by 22%.
Accountants and Politicians
It seems that no story about fundamentals and macroeconomics can ever be complete without the involvement of accountants and politicians. shows the effective tax rate for S&P500's non-financial components. Clearly, effective tax rates have trended lower over the last couple of decades with the decline catching a sense of urgency in the past few years. Now, some of this decline is related to foreign profits that are taxed at lower rates. However, our guess is that some of it is also a result of creativity of accountants and will likely attract increasing attention of politicians.
While profit margins are setting new records, sales have been trailing below trend. plots the total sales of S&P 500 non-financial stocks and the trend sales using the full period data on a logarithmic axis. Clearly, sales have failed to move above trend over the past five years.
A bottoms-up analysis of S&P500 profit margins confirms that profit margins have moved to new highs. However, a deeper dive into the details rejects the hypothesis that much of that improvement is a result of structural shifts towards a service driven economy. Instead we find that much of the improvements in profit margins have come from the so called low hanging fruits; costs that are easy to cut and where associated negative impacts do not show up in the short-term.
We venture a guess that as the world moved increasingly towards the idea of shareholder value maximization11, time horizons of both the management and the shareholders have shortened. As Montier shows, the average lifespan of a company in the S&P500 in 1970s was about twenty seven years and is down to about fifteen years now. In tandem, the average tenure of CEOs is down from about ten years in 1970s to about six years now. Combine this with the incentive systems prevalent today (think stock options), it is only logical that a CEO who is going to be around for about six years and is going to get a large chunk of her rewards in stock options will want to see higher stock prices. Cutting SGA expenses and postponing capital investments, actions that carry positive short-term earnings impact at the expense of business's competitiveness in the long-term, look promising to managers whose payoffs depend on stock prices in the short-term. Not surprisingly, the renters (there are hardly any owners any more) clamor for just such actions.
The problem with this thinking is that the long-term eventually shows up. And when it does, profit margins may have no choice but to remember their long forgotten tendency to revert to mean.
Prashant Trivedi, CFA, is a partner at MAEG and is the founding Chairman of Multi-Act Trade and Investments Pvt. Ltd. He is a B.Sc (Econ.) graduate from Wharton.
Baijnath Ramraika, CFA, is a partner at MAEG. He earned his MBA from the Darden Graduate School of Business, University of Virginia and is a Chartered Accountant from The Institute of Chartered Accountants of India. He resides in Pune with his wife and two daughters. Contact him at Baijnath.Ramraika@Multi-Act.com.
1 "It's déjà vu all over again." - Yogi Berra
2 From Warren Buffett's speech at Allen & Co.'s Sun Valley, Idaho bash for business leaders in July 1999. The full speech can be accessed at http://archive.fortune.com/magazines/fortune/fortune_archive/1999/11/22/269071/index.htm
3 "The Coming Retreat in Corporate Earnings", John P. Hussman, Weekly Market Comment, December 16, 2013
4 "What Goes Up Must Come Down!", James Montier, March 2012
7 "Danger: Children at Play," GMO quarterly letter, August 2011
8 Data Source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Corporate Profits After Tax (without IVA and CCAdj) [CP] and Gross National Product [GNP]; Bureau of Economic Analysis; accessed October 28, 2014.
10 Without the exclusion of financials, this number would have been 500 as there were 500 companies in the S&P500 index in each one of the years between 1989 and 2013.
11 Shareholder Value Maximization: The World's Dumbest Idea, James Montier at European Investment Conference on October 17, 2014. The presentation is available for viewing at http://new.livestream.com/livecfa/EIC-Montier
© November 2014 MAEG. Reprint with permission only.