A Deep Look at Corporate Profit Margins

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 14, 2014 1:38:00 PM

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corporate profit marginsAlong with being aware of external problems, investors need to acknowledge one of the pending headwinds for the U.S. stock market: the potential for corporate profit margins to decline.

Today, I want to summarize a great analysis by Baijnath Ramraika and Prashant Trivedi, which suggests that margins can’t continue to climb.

What goes up must come down (and vice versa)

The authors lead off with the idea that profit margins—the amount of money companies keep after paying all expenses—are (and, in fact, have to be) mean reverting. In other words, when they get too high, they come down; when they get too low, they rise.

In short, high profits lead to more competition, which reduces profits, and low profits lead some firms to exit the market, which improves profits for those remaining. In a healthy capitalist system, this has to happen.

And yet, as this chart from the analysis shows, current margins have been well above average levels for more than 10 years. Has something changed?

profit_margins

Why margins may be headed down again

The authors present, and ultimately refute, two common arguments used to justify profit margins’ extended run:

  • Technology has made companies more productive, able to do more with less.
  • More companies are now service businesses rather than manufacturers.

The poster child here is IBM, which has both become more efficient and moved to a service-oriented business model.

A shift to service doesn’t explain it. Examining profit margins by economic sector, the authors find that many sectors have record margins, including consumer staples, consumer discretionary, technology, and even industrial stocks. Clearly, the rise in margins isn’t exclusive to service businesses.

What about increased productivity? If, in fact, companies were noticeably more productive, you would expect to see gross profit margins move higher, in tandem with net profit margins. The analysis shows that the opposite is happening. Supporting indicators, such as depreciation expenses and investment in new equipment, also move in the opposite direction from what the productivity argument would suggest.

In reality, the improvement in profit margins is tied to reductions in operating expenses; it’s almost entirely the result of cost-cutting of one sort or another, rather than a change in business mix or improved productivity.

This isn’t bad news. Lower expenses certainly can be sustainable. The problem is that companies may be cutting costs on things like research and development, which could very well hurt longer-term growth even as it juices short-term profits.

The other problem is that two of the major sources of reduced operating costs—lower interest rates on debt and lower effective tax expenses—are not sustainable. At some point, it’s likely that both will rise again, with a negative effect on corporate profit margins.

Reason to be wary

The paper offers some compelling reasons to expect margins to come back down again. I would argue that other factors are in play as well, starting with the low rate of wage growth during the period of rising margin.

As investors, we should be aware that projecting current trends straight forward is almost always a mistake. Analyses like these, that dig into the bases of common assumptions, are invaluable in testing our thinking and revealing potential problems ahead.

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Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

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