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US Corporate Margins: Abnormal or Not?


txlaw
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I read an article today on Jeremy Grantham's view of whether or not US stocks are expensive:

http://www.advisorperspectives.com/newsletters12/Jeremy_Grantham-US_Stocks_are_Expensive.php

 

Here's an interesting excerpt on Grantham's view on US margins:

 

Abnormally high corporate profits are the primary reason for Grantham’s contention that stocks are overvalued.  Reversion to the mean is the core expectation that undergirds his firm’s investment philosophy, and when profit margins revert to their historical averages, he argued, investors will suffer weak returns.

 

And then here is a rejoinder on the margin question by Mason Hawkins:

 

Mason Hawkins, the chairman and CEO of Memphis-based Southeastern Asset Management, spoke the previous day and articulated the opposing view: Margins and earnings are neither at peak or temporarily elevated levels.  He said margins are higher in the US (but not globally) because we have exported lower returning businesses to other countries, such as those that are manufacturing-based, and have kept the higher returning ones, in industries such as technology and pharmaceuticals.  Additionally, he said many US-based firms have significant overseas subsidiaries.  Often they own less than 50% of them and account for them on an equity basis, where income but not sales is consolidated.  That has artificially pushed up earnings, he said, but not temporarily.

 

So what do people think?  Are margins for US companies going to "revert to the mean"?  Why are margins so high? 

 

The follow up question is: Can revenue growth offset margin compression such that the E in P/E continues to go up or, at least, stays the same?

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Nothing new here, margins are abnormally high. The article seems to point that high government spending is the cause for margins expansion. It sure makes sense to me, governments are supporting the economy, but governments are not know to be the hardest negotiators.

 

BeerBaron

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I think one the reversion to the mean folks fail to realize (in addition to the LL point) is that historically there has always been some thing that has caused a labor shortage which has increased wages (and thus squeezed margins).  Before the 1920s, it included war, famine and disease.  Between the 1920s and the 1990s, it was communism and to a lesser extent war, famine and disease.  Since the 1990s, we have not had any of these factors in the developed and most of the developing world which has led to a labor surplus in most fields.  Most of the products and services we consume have large labor and IP components as portion of the price we pay.  Therefore until labor costs rise significantly there is no reason to expect margins to decline as they have in the past (as conditions have changed).

 

Packer

 

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I was present for each of the presentations mentioned.  One just has to love both Jeremy Grantham's letters and presentations and his keynote speech was great.  With respect to abnormal or not, can they both be right at the margins?  For example -- larger corporations can keep the higher margins at some length whereas mid to smaller cap companies maybe can not.  I am currently persuaded by both arguments and believe this is why larger caps have been performing so well of late.  Irrespective, the point above about increased wages will occur over time, or maybe sooner than later as wages are said to be increasing in southeast Asia (i.e. Apple).

 

Cheers

JEast

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Some recent comments from Steve Romick about margins:

 

 

Steve Romick: There is a lot of reversion to mean theories out there in looking at the operating margins. I would argue, when looking at U.S. operating margins, that the mean over the last 23 years is not as relevant. And it's not as relevant because there has been a structural change in the makeup of corporate America. We've moved our manufacturing offshore. Manufacturing historically has been a lower-margin business. So, we've taken our lower-margin business out and moved it to another country, and ... we've become more of a services-based economy, that are higher margin in many of these different businesses. Plus that which we do produce certainly has higher margins, you know a lot of these businesses, like Oracle or Google and others.

 

So, I think there is a structurally higher normal for operating margins today. That does not mean that operating margins can't go down. I think there's a very high probability that they will fall off of their peaks. I think that a lot of these companies, when there is more inflation, will not have the pricing power to offset their input costs, and those companies without the moats are going to be challenged as a result.

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Profit Margins are mean reverting but the mean itself changes due to structural changes in the economy and capital markets. As mentioned factors such as

 

1. The weights of different industries in the economy has changed dramatically over the last century and normalized profit margins have to be adjusted for these changes and these are probably very long term phenomenon.

 

2. Worker incomes are depressed due to rise of Indian and Chinese workers into the global markets and this is also a very long term phenomenon.

 

Both these factors suggest the mean for profit margins should be higher than the past. What we cannot know is how much higher. My guess is profit margins would drop from the current high but to a much higher mean than before.

 

That said, I am shocked that profit margins have returned to such levels so soon after the 2008-2009 crisis.

 

Vinod

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Current Chinese wage inflation might be the start of a reversal in a) the mix change due to offshoring and b) the downward pressure on worker wages due to competition from Chinese and Indian workers.

 

This paper has some good stuff on a) analyst expectations for margins and b) the impact of the government deficit on margins:  https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBtbYEu0yy2D233Qql0krF9YIWDpyU9bC1DsIW9OxrQN38JW598obIegPVL5Vm43jTd74zJ0R1rY2lRRYvkFggPe%2bdZF4oUF%2bEun279ii1ThA%3d%3d

 

Personally my view is that even if the mean is slightly higher than it was, it is not different this time.

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My theory on why profit margins are so high is tied to my theory on why unemployment is so high.

 

Since about the mid 90's, businesses have been investing heavily in hardware, software, automation, and other technologies.  Businesses have always invested in improving productivity, but the mid-90s was unique in that it kicked off a lot of really interesting technology.  e.g. the web/Google, "Enterprise Software" (ERP, CRM, etc.), Email, global supply chain, etc.  These are technologies that can directly improve every kind of business.

 

These investments allow businesses to do more with less.  Between the mid-90s and '07, these corporations did more and more and more.  When the "great recession" hit, a bunch of people got fired in anticipation of the corporation doing less.  And what these businesses discovered is that they could do quite a bit more with quite a bit less.  GDP today is much higher than in 2007, but the number of people employed is much lower.

 

So I think what is happening is this..  Consumer demand is constrained because of persistently high unemployment.  Corporations are unwilling to move on hiring more people because 1) consumer demand is constrained and 2) if the demand dips again they will have to fire a bunch of people all over again.  Corporate profits are benefiting from this catch-22.  The first business to bring up its staff numbers is going to suffer the most, because they won't immediately benefit from the increased consumption stemming from their own hired staff, but they will immediately be punished with lower earnings.

 

Given this framework, my guess is that there will be some reversion to the mean as businesses bring on more staff to grow beyond today's constraints, but then that softening of the margins will be followed by improved profits as aggregate demand increases with greater employment.  Economically this makes sense to me..  these are economies of scale at work.  And the more these businesses scale, the greater the economies.  In other words..  I expect a permanent increase in corporate profitability, but would guess that we're at the short-term peak.

 

 

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I was disappointed with Grantham's response to the question about higher moat firms representing a larger portion of the US economy.  He basically said all firm values approach replacement value which is true for most firms but appeared to be an theoritical/academic resposnse to a practical issue.

 

Packer

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This talk about mean reversion is absurd. Why should they revert to the mean if underlying components have changed?

 

Look at healthcare as % of GDP. Will Grantham say that this is going to mean revert? Taken to an individual case, If my normal weight is 150 pounds and I gorge on fatty foods and gain 30 pounds, will I mean revert after a few years?

 

If Apple becomes a trillion dollar company, producing 100BB profit with margin of 50%, what will it do to the margin averages?

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This talk about mean reversion is absurd. Why should they revert to the mean if underlying components have changed?

 

 

The market doesn't let people get away with outsized returns on employed capital if it can help it. Eventually, you hit a wall with leverage and sales growth, and you have to dip into profit margins to make more money while still achieving acceptable marginal ROIC.

 

The weird thing about all these mean reversion articles is the static nature of the reversion. I guess sales hold and some expenses just increase? The increase in expenses affects nothing?

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To the extent that the argument for sustained high margin rests on the ability to outsource low margin activities, doesn't it implies that it's heavily underwritten by the current global geopolitical structure, i.e. a world dominated by the "Washington consensus" as to how the world's economic affairs should be arranged?  An argument for such sustained high margin would therefore assume that such structure would be mostly maintained, at least for the forseeable future. 

 

Is it even possible to handicap that?

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