Extremely interesting report on corporate profit margins
Comment of the Day

December 07 2011

Commentary by David Fuller

Extremely interesting report on corporate profit margins

My thanks to a subscriber for this important report by Andrew Smithers of Smithers & Co Ltd. Here is a brief sample:
…the outlook for profit margins will depend on what has driven them to such high relative levels today and whether this is a temporary phenomenon.

This is clearly a matter of great potential importance for the stock market. If the current level of profit margins is just a temporary phenomenon, then the outlook for profits is grim. We show in Table 1 that, if profit margins were now at their long-term average, then US profits today before tax would be approximately half their current level.

The prospect of such a sharp fall in profits, let alone the level that would be reached if margins fell to below average levels, is clearly one that not only threatens the prosperity of the financial securities' industry, but could be extremely damaging for the economy as a whole. It is therefore important to understand what has caused the odd behaviour of profit margins, both from the viewpoint of investing in shares and for the management of the economy.

There are obviously a large number of possible explanations which could account in whole or in part for the current high level of margins.

David Fuller's view This is a diligently researched but also easily comprehended report which I commend to subscribers.

Veterans among you will know that mean reversion is one of the more immutable laws of markets. Therefore we should be rigorous in our analysis before declaring: "This time it is different." It may actually be different but history shows that these incidences are occasional, indeed, distinctly rare exceptions to the norm.

Consequently, anyone looking at Chart 1 in the Smithers report: US Profit Margins 1929 - Q3 2011, should remain on the lookout for mean reversion. There is a simple, practical discipline to guide you in this respect since mean reversion by corporate profits, whether it takes place sooner or later, may occur on a staggered basis. The time to worry, I suggest, is when those currently outperforming Autonomies and Dividend Aristocrats fall beneath their rising 200-day moving averages which then roll over.

Meanwhile, and although I would normally defer to Andrew Smithers on the subject of corporate profits, here are some points, some of which I have made before, for possible consideration.

Managers of corporations which are prospering today went into survival mode in 4Q 2008, as I have said before. These companies have benefited from slashing overheads, including shedding non essential personnel, closing inefficient plant, and curbing excessive payouts to management. Managers have hoarded cash, while often instituting or increasing share buyback programmes.

These factors have certainly had a very positive influence on profit margins, although the benefits of slimming down companies are clearly finite as too much cost cutting will eat into growth potential. On this basis alone, corporate profits would certainly mean revert, and possibly more, in the current economic climate.

However, the Autonomies have also followed the money, steadily increasing their participation in growth economies. In doing so they have produced goods and services where they can do so most cheaply and sold where they get the best return. This often means sourcing locally as a means of gaining access to overseas markets and then selling locally. Consequently, the Autonomies are leveraged to the rapidly expanding middleclass in the world's many growth economies. These factors, which have had such a beneficial influence on corporate profit margins, were simply not possible for most of the last century. In other words, this really is different.

The Autonomies have increased awareness of their brands by virtue of becoming truly global companies. This has fostered consumer loyalty and also shareholder retention, particularly where dividends have been increased. It is true that share buybacks have flattered earnings per share but this need not be a concern provided it is financed by earnings cash flow, and provided those shares are not re-floated in which case they would obviously dilute earnings.

I also think that successful companies have invested in technology to a greater extent than the Smithers report allows for. I cannot prove this but why else would so many Nasdaq companies be outperforming? This is not entirely due to household consumer purchases. The smart phone and increasingly the iPad have become essential business tools. The unprecedented virtuous circle is that processing power and innovative software ensure that technology becomes much more useful and portable as it also becomes considerably cheaper. The commercial potential of these devices, not to mention steadily increasing automation in manufacturing and services, is limited only by our imagination.

In conclusion, when considering profit margins, globalisation and technological innovation really are different this time, rendering historic data extending back to the 1930s less relevant in today's world. This certainly does not mean that profit margins will go on expanding indefinitely or that we should ignore mean reversion. There are many other influences - stuff happens, there are business cycles and people make mistakes. Therefore, I would always be on the lookout for mean reversion in markets, not least regarding corporate profit margins. However, the time to worry and take defensive action is when the shares currently showing the best earnings growth begin to underperform, so keep an eye on the price charts.

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