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Equity Perspectives

Lower taxes, lower interest rates, and improved operating efficiencies suggest profit margins could remain above historical norms.

 

In Brief

  • Corporate profit margins are widely believed to be "mean-reverting," that is, fluctuating over the short term, but eventually returning to their long-term average.
  • But margins appear to trend in one direction or another, shrinking or expanding over a period of years.
  • Research by Bank of America indicates that margins have been expanding since 1991.
  • Two structural changes—lower corporate tax rates globally and lower interest rates—account for most of this change, according to Bank of America. Improved efficiencies arising from technology use have also contributed to higher profit margins.
  • The nature of these changes suggests they are not likely to reverse soon.

 

Stocks have staged an impressive recovery since they bottomed in March 2009, and even with the pullback in 2014, the S&P 500® Index remains more than 180% (on a total return basis) above that market bottom (as of January 31).1 Some investors have begun to worry, however, that corporate earnings are due for a downturn.

Corporate profit margins have been higher than normal for several years, and they could begin to revert to their long-term average. On the other hand, today's high margins may reflect structural and technological changes that could be long lasting. Addressing these and related questions is Lord Abbett Partner Deepak Khanna, Portfolio Manager of Large Cap Value and Value Equity.

Are Corporate Profits Mean-Reverting or Just Cyclical?
Historically, corporate profits as a percentage of gross domestic product,2 which can be interpreted as a rough estimate of an economy-wide profit margin, have averaged 6.3%, according to data from the Bureau of Economic Analysis. But the margin recently hit a high of 10.3%, and has been running more than two percentage points above the average since fourth quarter 2009. (See Chart 1.)
 

Chart 1. Corporate Profit Margins Are at All-Time Highs

Aftertax3 corporate profits as a percentage of gross domestic product, first quarter 1960–third quarter 2013


Source: Bureau of Economic Analysis.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment. 

 

This prompted some observers to predict that a reversal was imminent. As Société Général strategist Albert Edwards noted earlier in 2013, this "confirms our long-held view that margins have been forming a peak. Indeed, it is notable that, excluding financials, margins have failed to break out above their usual range. As night follows day, the market should be pricing in a decline in the margin cycle from here."4 And, indeed, margins dropped sharply in first quarter 2012, and stayed below 10% into first quarter 2013. Recently, however, they have rebounded.

But, in fact, while profits fluctuate with the strength of the economy, profit margins may not necessarily revert to an unchanging mean. As Bank of America Merrill Lynch equity strategist Dan Suzuki has written, "A look at the history of margins suggests that secular shifts in underlying margin trends can last for decades. The argument for the mean reversion of margins assumes that there is some natural equilibrium of margins and ignores the structural changes in the economy, policy, and mix that can have real and long-lasting impacts on profitability."5 Between 1967 and 1991, for example, the trend was downward, while the trend since then has been largely upward. (See Chart 2.)
 

Chart 2. Net Profit Margins Trended Downward for More Than 20 Years

Net profit margins7 on the S&P 500 and S&P Industrials Composite8 indexes, 1967–2012

Source: Bureau of Economic Analysis.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment. 

Two Structural Changes Suggest Wider Profit Margins May Be Here to Stay
Two changes that have contributed to today's high profit margins are reduced tax rates and lower interest rates. As a larger portion of the profits of larger companies has come from overseas where taxes are generally lower, companies in the S&P 500® Index6 have seen margins widen. And in the wake of the credit crisis, companies have refinanced debt at lower interest rates, resulting in lower interest expenses.

Bank of America estimates that among nonfinancial companies in the S&P 500, most of the improvement since 2004 has come from lower interest expenses and lower taxes,9 factors that are unlikely to change dramatically in the short term. Between 1995 and 2004, net profit margins averaged 6.8% among nonfinancial firms in the S&P 500. But since then, margins have risen, and in 2012 they averaged 9.2%. Of the 2.4% difference, two-thirds, or 1.6 percentage points, came from lower interest and tax expenses. (See Chart 3.)
 

Chart 3. Four Factors Have Contributed to Higher Net Profit Margins Since 2004

Net profit margins among nonfinancial companies in the S&P 500 Index, 1995–2004, and 2012

Source: BofA Merrill Lynch Equity and Quant Strategy.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment. 

According to Bank of America, the remaining 0.8 percentage points have come from two particular S&P 500 sectors: technology and energy. Profits in the technology sector have improved as the industry has matured and companies have moved increasingly from hardware to software and services, which offer higher profit margins. In the energy sector, operating margins have benefited from the long-term upward trend in oil prices since the late 1980s and 1990s, when oil averaged around $20 per barrel.10

David Bianco, chief U.S. equity strategist at Deutsche Bank, agrees that the improvement is due to structural, not cyclical, factors. He points to the difference in profit margins in the U.S. market and international markets. In 2012, pretax margins averaged a little more than 14% overseas versus a little more than 6% domestically, and that disparity has been in place for more than a decade.11 [Of course, there is no guarantee that this trend will continue.]

The gap in profitability also arises because more companies with high margins have expanded overseas, according to Bianco, and those foreign operations became more profitable in 2000 after years of investment. The disparity between companies with foreign sales and those with only domestic sales has been growing over the past decade. (See Chart 4.)
 

Chart 4. Companies with High Foreign Sales Have Had Higher Net Profit Margins

Net profit margins of S&P 500 Index companies, 1994–2012
Source: Deutsche Bank.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.
There is no guarantee that this trend in profits margins will continue in the future. 


Technology Has Boosted Gross Margins

While net margins have benefited from lower tax and interest rates, margins have also benefited from improvements at the operating level, according to Lord Abbett Partner Deepak Khanna. Among manufacturers, for example, gross margins have risen over the past five years because of gains in productivity due to technological enhancements. Like the structural changes mentioned above, these are also likely to be long lasting.

Technology, such as cloud computing, has helped to shrink overhead costs, such as those for selling and administrative functions. For example, it has facilitated more precise and effective customer calling, Khanna said, enabling salespersons to focus more on prospects that are most likely to make purchases. "In the past, if 10 salespeople were needed to cover a territory, today maybe only five are needed."

In addition, instead of hiring new workers, companies have opted to give existing workers more hours, which has helped keep down labor costs in administrative functions, such as legal, secretarial, accounting, and human resources.

These are the kinds of changes that investors pay particular attention to and will pay higher valuations for, according to Khanna, because they reflect improvements in operations, which are under a company's control. Lower tax rates and interest rates also benefit the bottom line, but companies have less control over those.

That said, margin expansion due to operating improvements has probably plateaued. Companies are operating at extremely lean levels, so additional profits from cost cutting are likely to be minimal, Khanna said. Sales are likely to expand if the economy improves significantly, but in that case, companies will probably have to hire new workers, which would raise costs as well, Khanna said.

Of course, even if reduced tax rates, lower interest rates, and improved operating efficiencies keep profit margins at a higher level for the long term, profits will still fluctuate with the business cycle. If the economy slows further, corporate profits could fall even if margins remain wide by historical standards. Still, if these changes to tax rates, interest rates, and operating efficiencies are long lasting, then the portion of each revenue dollar that goes to profits could remain high.

—Reported by Ron Vlieger
 

1 Bloomberg. As represented by the S&P 500® Total Return Index. The S&P 500 Total Return Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. Reinvested dividends are included in the index.
2 Gross domestic product refers to the total market value of all final goods and services produced in a country in a given year, and is equal to total consumer, investment, and government spending, plus the value of exports, minus the value of imports.
3 Aftertax corporate profits are profits that remain after income taxes have been subtracted. Pretax profits are profits prior to subtracting income taxes.
4 Sam Ro, "Everyone's Worst Fears for the Stock Market and Economy Have Been Confirmed," businessinsider.com, June 6, 2013.
5 Dan Suzuki, Savita Subramanian, Alex Makedon, and Jill Carey, "S&P 500 Outlook," BofA Merrill Lynch, May 17, 2013.
6 The S&P 500 Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
7 Net profit margin is calculated by dividing net income by revenues. It indicates how much of every dollar of sales a company keeps in earnings after subtracting all costs. It is usually expressed as a percentage. Net income differs from gross income. Gross income is income that remains after subtracting only costs that are directly related to producing a product or service. Gross margin is calculated by dividing gross income by revenues.
8 The S&P 500 Industrials Composite index is a subset of the S&P 500 Index that excludes stocks in the transportation, financials, and utilities sectors.
9 "Two Wall Street Analysts Independently Published Devastating Defenses of Record High Profit Margins," businessinsider.com, May 19, 2013.
10 Suzuki et al., op cit.
11 David Bianco and Priya Hariani, "S&P 500 Margins: Fact & Fiction," U.S. Equity Insights, Deutsche Bank, May 17, 2013.

 

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