This content is from: Portfolio
Profits and Losses On Seemingly Cheap Equity Valuations
Investors betting on seemingly cheap equity valuations will be rudely surprised when profit margins return to their norm.

Unfortunately, the cheapness argument falls flat on its face once you realize that pretax profit margins are hovering close to an all-time high of 13.3 percent. (The record was 13.9 percent in 2007.) Profit margins are almost 58 percent above their average of 8.4 percent since 1980. When they revert to their historical mean, the denominator in the P/E equation will decline. If stock prices didnt move in response, the S&P 500s P/E would rise to 24.9 times trailing earnings. So much for a cheap stock market.
But why cant profit margins remain high? Why do they have to revert to a mean?
Profit margins return to the mean not because they pay tribute to mean-reversion gods but because the free market works. As the economy expands, companies start earning above-average profits, which attract competition like bees to honey. Profit margins are probably the most mean-reverting series in finance, GMO co-founder and chairman Jeremy Grantham told Barrons a few years ago.
What about the billions of dollars that U.S. companies have poured into technology over the past decade? Wasnt that supposed to make their operations more efficient and raise profit margins?
Those billions of dollars did not go to waste; companies are more productive than ever. Efficiency gains were a source of competitive advantage and higher margins when access to cutting-edge technology was limited. For example, Wal-Mart Stores rise was achieved through a very efficient inventory management and distribution system that passed cost savings to consumers and drove less-efficient competitors out of business.
Today, however, that same or even better technology is available off the shelf to retailers like Dollar Tree and Family Dollar Stores, whose outlets are about the same size as a couple of Wal-Mart restrooms put together. Software makers Oracle and SAP will gladly sell state-of-the-art distribution and inventory management systems to any company able to spell its name correctly on a check. Increased productivity didnt and wont bring permanently higher margins to corporate America the consumer is the primary beneficiary of lower prices. If profit margins didnt revert to the mean, Wal-Marts net margins would be 25 percent today, not 3.5 percent.
Over the past 70 years, growth in corporate earnings and GDP havent differed significantly. There has been a permanent benefit from increased operating efficiency: It lets companies hold less inventory and adjust more quickly and precisely to changes in demand. This has led to less-volatile GDP.
But shouldnt average profit margins be higher now, as the U.S. economy has transitioned from an industrial (low-margin) economy to a service (higher-margin) economy?
The difference is not as big as you might think. In 1980 services represented 51.3 percent of GDP. After 30 years and a lot of changes, like outsourcing, services have increased to 65.3 percent of GDP. If we assume that the service sector has double the margins of the industrial sector (a fairly conservative assumption), increases in the service sector should have boosted overall corporate margins by about 40 to 80 basis points above their 30-year average to between 8.8 and 9.2 percent, but still far below todays 13.3 percent margin. Thus if we adjust corporate margins to reflect the transformation to a service economy, corporate profit margins are still 45 percent above their long-term mean.
What about globalization? Shouldnt it allow U.S. companies to increase margins?
A larger portion of U.S. companies profits is coming from overseas than ever before. Globalization, however, is a double-edged sword. U.S. companies will continue to expand overseas and capitalize on new opportunities, but as the world flattens they will also face new competition at home and abroad. Cisco Systems, for example, has been successful in Asia, but the Chinese telecommunications equipment maker Huawei has attacked its home turf.
Todays stock valuations are a lot higher than it appears if you normalize earnings to lower profit margins. And while its hard to tell when earnings will embark on a fateful journey to their historical mean, competitive forces will make that happen sooner than later. Companies that dont have a sustainable competitive advantage will face margin compression that much sooner.
Vitaliy Katsenelson (vk@imausa.com) is CIO at Investment Management Associates in Denver and author of The Little Book of Sideways Markets.