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Peak profit margins


rukawa
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Labour participation rate has gone down by 3% since 2007. 1.7% of this is due to the Baby Boomers retiring. The labour participation rate will continue to decline.

http://www.voxeu.org/article/decline-labour-force-participation-us

 

China's will soon be experiencing a labour shortage. The mass migration of rural workers to urban areas is basically done. In addition the result of the one child policy means less young people to replace older workers.

http://www.ft.com/intl/cms/s/0/211df974-ee47-11e4-98f9-00144feab7de.html#axzz3ZPncqbZI

 

My view is that the share of income going to labour is going to increase throughout the world and profit margins will shrink. We are at the point of peak profit margins.

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Labour participation rate has gone down by 3% since 2007. 1.7% of this is due to the Baby Boomers retiring. The labour participation rate will continue to decline.

http://www.voxeu.org/article/decline-labour-force-participation-us

 

China's will soon be experiencing a labour shortage. The mass migration of rural workers to urban areas is basically done. In addition the result of the one child policy means less young people to replace older workers.

http://www.ft.com/intl/cms/s/0/211df974-ee47-11e4-98f9-00144feab7de.html#axzz3ZPncqbZI

 

My view is that the share of income going to labour is going to increase throughout the world and profit margins will shrink. We are at the point of peak profit margins.

 

Can't argue with either of your points. Additionally, I don't think there's much fat on the bone left to cut interest expenses via refinancing.

 

On a separate note, when does the buyback express exhaust itself? Not a margin question, more related to EPS growth and balance sheet strength whenever the cycle turns.

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Whether this is the exact peak who knows, but I am firmly of the opinion that margins will mean revert and the labour argument is a good one.

 

As for the buyback express: it'll stop when share prices start falling ;)

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There are two factors in opposition to your thesis, namely, automation (which will reduce the need for labor and thus even if labor supply is reduced if productivity due to automation increases faster you need fewer workers) and the other emerging markets behind China that still have a lot of cheap labor (India, Vietnam and Africa).  Also based upon my understanding of China there are still many places where wages are very low and few (primarily in the coastal cities) where wages have been increasing.

 

Packer

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There are two factors in opposition to your thesis, namely, automation (which will reduce the need for labor and thus even if labor supply is reduced if productivity due to automation increases faster you need fewer workers) and the other emerging markets behind China that still have a lot of cheap labor (India, Vietnam and Africa).  Also based upon my understanding of China there are still many places where wages are very low and few (primarily in the coastal cities) where wages have been increasing.

 

Packer

 

Totally agree about other areas in Asia.  Not so sure about automation: a) it's been going on forever and b) it's presumably more expensive than the cheap labour or it would have been done before, so it still represents an increase in cost.

 

This is notwithstanding the normal improvements in technology that drive productivity in every decade.

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There are two factors in opposition to your thesis, namely, automation (which will reduce the need for labor and thus even if labor supply is reduced if productivity due to automation increases faster you need fewer workers) and the other emerging markets behind China that still have a lot of cheap labor (India, Vietnam and Africa).  Also based upon my understanding of China there are still many places where wages are very low and few (primarily in the coastal cities) where wages have been increasing.

 

Packer

 

I agree in principle, but in reality these factors are not so dynamic such that Chinese inflationary wage pressures can be easily averted over the near term by U.S. importers. Many of the companies I work with that have sourcing operations (either wholly-owned or via third parties) may have backup plans to find cheaper input costs, but those plans would not be easy to execute in the short term. Further, infrastructure in India, Vietnam, and Africa is nowhere near as robust as China.

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Not so sure about automation: a) it's been going on forever and b) it's presumably more expensive than the cheap labour or it would have been done before, so it still represents an increase in cost.

 

Both of these arguments are flawed. Like I answered in another thread, automation is not a smooth process. Think about self driving cars. There is no way to get rid of the human drivers with 50%-self-driving car. But once you have 100%-self-driving car, boom, all humans are gone. This is extreme example, but somewhat true in other places.

 

Edit: I guess I forgot to address your second argument. Actually this one is even more stepwise: automation is more expensive than cheap labor because it costs a lot to make robots. But if you automate making robots to make robots, the price of automation may plunge. Whether this will happen soon is unclear though.

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There's two arguments, first being that profit margins are peaking and the forces that have driven them there can't propel them further higher; the second being the idea of mean reversion, so profit margins must fall back to where they've been.

 

I dont think i've done anywhere near enough research to be qualified to talk to either point, but my intuition points to the first argument being likely true and the second having little basis to support it.

 

Quite simply it seems to me that when you read about Corporate America 40 years ago versus today, the focus on efficiency is there today much more than it once was. There simply isn't the ability to hide and allow inefficiencies to persist anymore. The rise of private equity and more recently of shareholder activism has to play some role in that.

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People talking about peak profit margins are looking at a narrow set of SP500 stocks. Look further down below and you will see profit margins are around 5%-6% level in the midcap and small cap space. that's very normal

 

http://www.yardeni.com/Pub/peacockfeval.pdf See margins for SP400 and SP600

 

Now why is SP500 profit margin so high? Its simply because of the composition of that particular index. Companies such as MSFT, GOOG, AAPL etc are  big chunks of this index and they have stupidly high profit margins that they distort the picture of the entire index. More and more large caps have built strong moats and pricing power into their business model. they are more and more service oriented rather than manufacturing or commodity companies like it was traditionally. These traditional businesses haven't gone extinct, they have either migrated down to the midcap and small cap space or have gone to other emerging market countries with a lower cost base as one would expect with average businesses.

 

Another reason profit margins appear to have risen recently is because some big financials as a whole were contributing negative amounts post the crisis for a long time. things have improved in that space recently so the profit margin trend appears to trend higher. If you believe AIG, BAC,IBM etc will have better normalized profit margins going forward, then you are also betting that SP500 profit margins will increase.

 

This is why I feel the argument that profit margins have peaked and will mean revert is flawed. They will probably turn down at some point (mostly when recessions inevitably happen), but people looking at this narrow index will be surprised at the levels these margins are going to stabilize at.

 

Margins are not peaking. Multiples are "okay" based on the markets probabilistic judgement of future interest rates and growth scenarios. Moving to cash just to reinvest in downturn is a form of market timing. If you have cash because you cant find enough good businesses meeting your criteria, then that's a rational argument.

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Both of these arguments are flawed. Like I answered in another thread, automation is not a smooth process. Think about self driving cars. There is no way to get rid of the human drivers with 50%-self-driving car. But once you have 100%-self-driving car, boom, all humans are gone. This is extreme example, but somewhat true in other places.

 

Agreed.  My point was more a long term one.  It is stepwise and always has been.  Maybe we are on the cusp of a step (I believe we are in driverless cars).  Maybe we are not.

 

 

Edit: I guess I forgot to address your second argument. Actually this one is even more stepwise: automation is more expensive than cheap labor because it costs a lot to make robots. But if you automate making robots to make robots, the price of automation may plunge. Whether this will happen soon is unclear though.

 

I'm surprised the making of robots is not already automated.  I do worry that technology may final reach the point where it is a net negative for the majority of people in terms of their quality of life (earning power vs. price of what they buy).

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There's two arguments, first being that profit margins are peaking and the forces that have driven them there can't propel them further higher; the second being the idea of mean reversion, so profit margins must fall back to where they've been.

 

I dont think i've done anywhere near enough research to be qualified to talk to either point, but my intuition points to the first argument being likely true and the second having little basis to support it.

 

Quite simply it seems to me that when you read about Corporate America 40 years ago versus today, the focus on efficiency is there today much more than it once was. There simply isn't the ability to hide and allow inefficiencies to persist anymore. The rise of private equity and more recently of shareholder activism has to play some role in that.

 

That may be right but I suspect competition has more impact on efficiency and that has always been tough.  Competition, ultimately, will cause returns on equity to revert and probably via margin compression.

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I do worry that technology may final reach the point where it is a net negative for the majority of people in terms of their quality of life (earning power vs. price of what they buy).

 

Yes, I believe we are heading into a jobless future long term (20+ years or so). How this will be handled is currently unclear. I have some thoughts, but I'd rather not OT too much here. ;)

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