For some time we’ve been focused on the defensive
characteristics of client portfolios because of what we view as an environment
of higher-than-average risk. Many of
these risks are fairly obvious such as the slow pace of economic recovery from
the recession, the Fed’s aggressive use of quantitative easing, and the high
and growing levels of government debt in developed economies around the world. However, one of the larger risks to the stock
market comes from a much more subtle source: unusually high corporate profit
margins.
One of the reasons this risk gets overlooked is
because, on the surface, high profit margins are a very good thing. Indeed, one of the markers of a strong
company is robust profitability. While
high profit margins are positive in the short run, in the long run they are
very difficult to maintain, let alone grow.
In a free enterprise system, high margins attract increased competition
(think of the explosion of cheaper smart phones to compete with Apple’s very
high margin iPhone), which eventually brings margins down, just as low margins
cause firms to exit markets, eventually bringing those margins up. In other words, there’s a natural
gravitational pull bringing high margins down and low margins up. This gravitational pull applies to the entire
corporate sector just as it does to individual companies. In statistics this tendency to return to the
middle of a range is called “mean reversion,” and profit margins have
historically had a particularly strong tendency to revert to the mean. In the
graph below, one can see the modern history of corporate profit margins. At the end of the third quarter of 2013,
margins exceeded 11%, while the average or mean over this history has been
between 6% and 7%.
There
are a number of ways to measure corporate profit levels. Common metrics include comparing gross
profits to revenues (operating profit margin), net profits to revenues (net
profit margin), or corporate profits as a share of the US gross domestic
product (as shown above). Whatever the measuring stick, the results are the
same; corporate profits are at or near record levels. It’s also apparent in the graph above that
profit margins ebb and flow with the economic cycle. In the current cycle, margins have had a
sharp cyclical rebound from the lows of the last recession to a level above
past cycle peaks. So, they are higher
because of where we are in the cycle, but they are also high compared to past
cyclical peaks.
We look at the implications of this for stock prices
from two different perspectives. From a
valuation perspective, this leaves us with skepticism about assurances from
some quarters that the price to current earnings ratio (P/E ratio) for the
market is within normal ranges when the earnings part of that ratio is being
inflated by unsustainably high margins. From an earnings growth perspective, we
know that earnings are determined by the interplay of revenues and margins. So, if there’s very little room for margins
to grow, then revenue growth must drive earnings growth. Given that revenue growth has been very tepid
recently (averaging less than 3%), the risks are high that earnings growth
disappoints. None of this means that
earnings can’t continue to grow or that stock prices can’t rise, but it does
tell us that market risks are elevated.