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Thinking about Profit Margins

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Often there is a persuasive argument, apparently supported by data, that can be misleading for the long-term investor.  Sometimes this relates simply to facts, but it can also involve analysis.  Such is the case with what you see about profit margins.

The basic thesis is that profit margins are mean reverting.  If any company gets an excessive margin, competition will arise and bring the profits to a more normal level.    This is a persuasive argument, consistent with how we expect capitalistic economies to work.

Let us suppose that we agree that profit margins will return to long-term norms.  (Good here!)

What are the implications?

The Bearish Viewpoint

Those with a bearish perspective take current revenues and do what they refer to as “normalizing” to chop the earnings down to lower levels.  If you reduce S&P 500 earnings by 30% or so, you can easily conclude that most stocks (and the market as a whole) is richly valued.

I do not want to give this viewpoint short shrift, but it gets a lot of visibility, and the basic contention is simple.

The Bullish Viewpoint

First Trust’s Brian Wesbury raises a sharply contrasting argument:

Yes, the Fed is loose and is holding interest rates down artificially. But even if we assume more normal interest rates and stable profits (with implies declining margins), stocks are very cheap. Cheap enough in our view to take us to 14,500 on the Dow and 1475 on the S&P 500 by year end 2012.

Using a capitalized-profits approach, we divide corporate profits by the current 10-year Treasury yield of 2% and then compare the current level of this index from each quarter for the past 60 years. Hold on to your hats…this method estimates a fair-value for the Dow at 46,000. But, this extremely bullish result is largely due to artificially low interest rates. Current levels on inflation are above the 10-year Treasury yield and we believe that once the Fed normalizes its policy stance interest rates will climb to much higher levels.

If we use a more realistic discount rate of 5% for the 10-year Treasury, we get a fair value of 18,800 on the Dow and 1,975 for the S&P 500.

Another potential problem is that profits have been an unusually large share of GDP – currently almost 13%.   If profits revert to a historical norm of about 9.5% of GDP at the same time the 10-year Treasury yield is 5%, fair value would be 13,900 for the Dow and 1460 for the S&P 500. Just to be clear, that would be in a world where profits fall roughly 25% and interest rates more than double from their current levels. In other words, this doesn’t look like a dead cat bounce to us.

Our Conclusion

Let’s face it.  The argument about mean reversion in profits is several years old.  Profits keep rising and margins have held up pretty well, mostly because companies have been slow to bring back employees. The P/E multiple declines, partly because the world is full of skeptics about future profits.

The leading advocate of profit mean reversion is Vitaliy N. Katsenelson.  I did a favorable review of his excellent book, which has excellent advice on stock picking.  A  book about a sideways market is a coup on many fronts, and I enjoyed reading it.

Unfortunately, many investors are convinced from these arguments that profits are about to decline.  This conclusion is not supported by the data.

High profit margins came when companies held down costs and new hiring.  If the margins fall, it implies that new workers have been added.  That is the basis for additional costs.  This means that employment, GDP, and tax revenue are all moving higher.

Briefly put –  Those who look at mean reversion in profits alone, without any attention to changes in employment, are guilty of an inconsistent forecast.

I have a simple challenge for those forecasting a mean reversion in profits:  Do you really expect the overall S&P earnings forecast to move lower?

If not, why should we care about profit margins?

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Jeff Miller
Jeffrey Miller is president and CEO of NewArc Investments, a registered investment adviser, and Capital Markets Research. He also serves on the board of directors for Helix BioMedix and Think-A-Move. Miller has been director of research for KTZ Trading, and taught political science and public affairs for the University of Wisconsin and Lawrence University. Miller is the author of numerous articles and papers on taxation, policymaking and the equities market. He holds a bachelor’s degree from Bowling Green State University and master’s and doctorate degrees from the University of Michigan.
Jeff Miller
Jeff Miller

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Comments

  1. Anonymous says:

    I hate to think what those assumptions mean for the budget deficit.  Everyone I read BTW is recommending TBT longs – is it possible everyone is wrong and rates stay down for longer, and profits stay up at same time, or do stable profits imply higher rates (ie.., not end of world)?

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