Why Jeremy Grantham is Right about Corporate Profit Margins November 11, 2014 by Baijnath Ramraika, CFA and Prashant Trivedi, CFA Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. 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, Barron s 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. Buffett As U.S. corporate profit margins have made it to record highs, a debate has raged between those who place their hopes on a new paradigm of sustained high profits and those who believe in capitalism s efficiency and the tendency of margins to revert to the mean. We show that an often-cited explanation for the new paradigm that the U.S. economy is more service-focused lacks empirical support. Notable amongst those pointing to high profit margins and their susceptibility to mean reversion include John Hussman, James Montier, Albert Edwards, Jeff Gundlach and Jeremy Grantham. Most of the analysis concerning U.S. corporate profit margins has focused on national account data compiled by Bureau of Economic Analysis. Figure 1 shows the ratio of corporate profits (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. 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. Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.
Figure 1 1 This time is different Corporate profit margins as shown in Figure 1 have been approximately two standard deviations above the mean for most of the last 10 years. Pointing to this behavior of profit margins, those advocating for the new paradigm claim that something has changed this time around. They suggest 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 reason 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, Columbia Professor Bruce Greenwald 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 noted that increased contribution from businesses like IBM mean profit margins could be sustainable at the higher level. 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 concluded 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. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.
A bottoms-up analysis of corporate profit margins In our own examination of financial statements from several hundred companies annually, we have observed that profit margins for a large number of businesses have moved in the wonderland. Leaning towards the mean-reversion camp, we find this development troubling and are of the opinion that there is a non-trivial risk of decline in profit margins. Let s analyze the profitability of the S&P 500 Index on a bottoms-up basis. Much as the U.S. corporate profit margins in Figure 1, we will show that S&P 500 profit margins have reached 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&P 500 index, there is some noise in our calculation introduced as a result of inclusions and exclusions of companies in that index. All data, including fundamentals and price data, are from Factset Global. We have excluded the financial sector from our analysis, given the significant differences between the income statements of financial businesses versus other businesses, i.e., our analysis uses the S&P 500 s non-financial components. This exclusion means that the yearly average number of companies in our analysis is 408, less than what would otherwise have been the case 2. 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 calculations were performed on an aggregate 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 derived the index s profit margin using these totals. S&P 500: Net profit margin Figure 2 shows the net profit margin of the S&P 500 non-financial stocks. As is seen, the trajectory of net profit margins of S&P500 is very similar to U.S. corporate profit margins shown in Figure 11. Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.
Now let s look at the net profit margins of the underlying sectors in the S&P 500. Figure 3 shows the net profit margin of consumer discretionary stocks within the S&P500 index. The trend in profit margins for this sector is very much in line with that of the broader index as well as that of the overall U.S. corporate profit margins. Figure 4 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. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.
Figure 5 shows the net profit margin of the healthcare sector. Interestingly, the healthcare sector s profit margins are running near their lows. Figure 6 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 margin is in uncharted territory as well. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.
Figure 7 shows the net profit margin of the industrials sector. Clearly, profit margins of industrials sector are in the wonderland as well. Figure 8 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. Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.
Figure 9 shows the technology sector s net profits as a percentage of the total net profits of S&P 500 s non-financial stocks. Interestingly, the tech sector s contribution to overall profits has flat-lined over the last few years. The discussion above dispels two misconceptions; that higher profit margins are driven by services businesses that typically carry higher margins and that the profits from such businesses have become an increasingly 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 has stayed pretty much the same over the past two decades (excluding the dot-com crash). Further, the data clearly shows that Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.
profit margins are high in a variety of non-service 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 true, we would see a significant improvement in gross profit margins 3 as cost of production per dollar of sales would decline. shows the gross profit margin of S&P 500 s non-financial stocks. What a contrast! Figure 10 Figure 11 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. Page 8, 2018 Advisor Perspectives, Inc. All rights reserved.
Another place where impact of technological improvement would show is in increased fixed-asset turnover, as older machines are replaced more rapidly with improved ones. shows the fixed asset turnover for all S&P 500 non-financial companies. Instead of going up, however, fixed-asset turnover ratios went down. Figure 12 Page 9, 2018 Advisor Perspectives, Inc. All rights reserved.
Choosing short-term gains (stock price increases) over long-term competitiveness While profitability has been stagnant at the gross profit margin level, there has been substantial improvement in operating profitability 4 as shown by Figure 13. As is seen in, sales, general and administrative (SGA) and other operating expenses as a percentage of sales have persistently declined over the last two decades. Included in SGA and other operating expenses are marketing, advertising, R&D, software development and product promotion expenses. This reveals the underlying cause of the profit margin boom and it has nothing to do with increased productivity or with a shift to a service-based economy. Figure 14 Page 10, 2018 Advisor Perspectives, Inc. All rights reserved.
Central banks and helicopter drops The central bank largesse (quantitative easing) is 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 an increase in borrowing costs to their mean level will reduce corporate net profits by 11% while an increase in borrowing costs to one standard deviation above the mean will cut corporate net profits by 22%. Figure 15 Page 11, 2018 Advisor Perspectives, Inc. All rights reserved.
Accountants and politicians No story about fundamentals and macroeconomics would be complete without the involvement of accountants and politicians. shows the effective tax rate for S&P 500 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 was related to foreign profits that are taxed at lower rates. However, some of it is also a result of the creativity of accountants and will likely attract increasing attention of politicians. Figure 16 Page 12, 2018 Advisor Perspectives, Inc. All rights reserved.
Sales 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. Figure 17 Page 13, 2018 Advisor Perspectives, Inc. All rights reserved.
Summary A bottoms-up analysis of S&P 500 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 much of the improvements in profit margins have come from the so-called low-hanging fruits: costs that are easy to cut where associated negative impacts do not show up in the short-term. As the world moved increasingly towards the idea of shareholder-value maximization, time horizons for management and the shareholders have shortened. As Montier shows, the average lifespan of a company in the S&P 500 in the 1970s was about 27 years and is down to about 15 years now. In tandem, the average tenure of CEOs is down from about 10 years in the 1970s to about 6 years now. Combine this with the incentive systems prevalent today (think stock options), and it is only logical that a CEO who is going to be around for as few as 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 a business 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 will have no choice but to remember their long forgotten tendency to revert to mean. Baijnath Ramraika, CFA, is a partner at Multi-Act Equiglobe (MAEG). Contact him at Baijnath.Ramraika@Multi-Act.com. Page 14, 2018 Advisor Perspectives, Inc. All rights reserved.
Prashant Trivedi, CFA, is a partner at MAEG and is the founding chairman of Multi-Act Trade and Investments Pvt. Ltd. Multi-Act is a financial services provider operating an investment advisory business and an independent equity research services business based in Mumbai, Maharashtra, India. 1. 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. 2. 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. 3. Gross profit is the difference between sales and cost of goods sold, where cost of goods sold includes depreciation expenses. Gross profit margin is calculated as gross profit divided by sales. 4. Operating profit is derived by reducing sales, general, and administrative (SGA) and other operating expenses from gross profit. Operating profitability refers to operating profit margins, which is measured as operating profit divided by sales. Page 15, 2018 Advisor Perspectives, Inc. All rights reserved.