My F&M

Profit Margins: A Hidden Risk in the Stock Market

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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.