Investors consistently overpay for stocks in periods when profit margins are high

William Hester, CFA
November 2006
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New-Era valuation assumptions are making a comeback. They may not be as extreme as they were six years ago, like counting "hits" and "eyeballs" as profits, but the assumptions built into stock prices here are nearly as important as they were in 2000. If the value of an investment is based on sustainable earnings and not just current ones, investors ought to be paying a lot more attention to profit margins.

There are a few ways to estimate economy-wide profit margins - the percent of sales that companies keep as profit. One is to look at government data. Corporate profits as a percent of GDP hit 13 percent in the second quarter, a 50-year high. The graph below shows a profit margin series for large U.S. companies since 1955. It was built by creating monthly portfolios of the 500 largest companies ranked by revenue, summing their sales and net income, and then using the totals to calculate a series of net margins.

The profit margins of large U.S. companies have ranged between roughly 5.5 percent and 7.5 percent through most of the period shown. During the mid 50's and early 60's companies enjoyed healthy profitability spurred by strong economic growth. From their peak in 1965, margins generally declined through 1983. During the 1990's they climbed back to their previous highs of 7.5 percent (although a chunk of those earnings would evaporate over the next few years after they were found to be fraudulent). Following the earnings plunge of 2001-2002, the recent economic rebound has put net income at about 8.5 percent of revenues, a 50-year record.

The direction profit margins take from current levels will have a powerful effect on future earnings growth. It will also determine whether or not the stock market's recent highs will be seen as reasonable, in hindsight. Analysts who assume that profit margins will remain high and expand further, as analysts using the Fed Model suggest, view current market levels as cheap. Analysts who are increasingly uncomfortable with those assumptions, including Jeremy Grantham and John Hussman, view the market as unusually overvalued. (see The End of Excellent Earnings and Profit Margins, Labor Costs, and Earnings Growth).

Record margins are already introducing disparities between valuation metrics usually in agreement. The graph below shows two price ratios. One is Dr. Hussman's price-to-peak earnings ratio (red, right axis). The second is the price to sales ratio of the largest 500 stocks (blue, left axis). Historically, the changes in multiples that investors paid for a dollar of sales have tracked closely the changes in multiples that investors paid for a dollar of peak earnings. The correlation is intuitive. Sales usually hold up much better than trailing earnings during recessions. And peak earnings make the assumption that index-level profits will regain their previous highs. So the two have moved mostly in tandem.

The chart shows data since 1975. But look at the divergence over the past 4 years. This is the result of an unusual widening in profit margins. Reading the P/S ratio along the right scale, you can estimate that if profit margins were at their usual norms, the current P/E ratio for the S&P 500 would be about 23 times earnings.

Explaining Higher Margins

There are at least three factors playing a role in record profit margins. The first is the trend in the growth of wages. This recovery has been marked by an unimpressive rate of job creation, and that has given workers less flexibility in their bargaining power. In the five years since the end of the 2001 recession Non-Farm Payrolls have grown at 0.7 percent a year. This is the lowest annual growth rate following the 9 recessions since 1950. Corporate profits have benefited directly from this environment.

Profit margins and wage earners' share usually move inversely to one another. While corporate profits as a share of GDP rose strongly since 2000, employee compensation as a share of GDP fell 3 percentage points, to 56 percent. Workers may be getting more say though. Compensation's share of GDP has risen in the last three quarters, and now threatens to reverse that recent 5-year downtrend, spurred by a tight labor market and an unemployment rate of just 4.4%.

Business investment is also playing a role in the level of margins. Though capital investment isn't deducted from earnings as a lump-sum expense, the plunge in capital investment since 2000 is part of a deep cost-cutting effort that may not be sustainable. This type of news was treated favorably during this quarter's earnings announcements. Wal-Mart told investors that it planned to slow spending on equipment and store openings. Amazon followed up with a similar message. The shares of both companies were up on the news.

While it's likely that CEOs enjoy the short-term rise in their stock prices after announcing such news, their decisions to allocate fewer profits toward reinvestment are more likely rooted in their uncertain outlook for the economy. The Conference Board announced last month that CEO confidence in September fell to 44, its lowest level since the 2001 recession.

Shunning typical rates of reinvestment is more pervasive than just these two retailers. The graph below shows total investment spending as a percent of corporate profits. You have to go back to the early 1960's to find investment at such a small share of profits. Publicly traded companies show a similar trend. For the Large 500 data series, capital expenditures as a percent of revenue has fallen from 7.5 percent in 2000 to 5.6 percent today.

Lower reinvestment rates aren't a good strategy for boosting long-term earnings growth. Companies earn profits off a base of assets. Over time those assets depreciate or become obsolete. When they aren't replaced, both productivity and earnings growth suffer.

Index-level profit margins are also being boosted by financial sector results. Financial companies - including investment banks, regional banks, real estate companies, and insurance companies - now contribute 28 percent of the S&P 500's total income. This earnings stream is being supported by record profit margins for the group. The financial sector profit margin is now 14 percent, easily outstripping the other 10 sectors.

In a little more than a decade, net margins for the financial sector have climbed from 8 percent to 14 percent. It's been a favorable environment. There's been a bubble in both the equity and real estate markets and a trend of increasing leverage on the balance sheets of individuals, companies, and the government. But the ability of companies in this sector to sustain such favorable profit margins is open to question. Not only is the environment for financials less favorable because of a bursting real estate bubble and a flat yield curve, but competition will probably continue to increase in the group.

Earnings Growth and Stock Returns

Profit margins are bit like P/E multiples in that when they move from low levels to high levels, they can provide a tailwind to returns. On the other hand, when margins move from high to low levels, earnings growth becomes more challenging.

You can see this in the graph below. It plots profit margins (blue) and subsequent 3-year earnings growth (red, shown on an inverted scale, so a declining red line represents faster earnings growth). Earnings growth normally slows following periods of elevated margins. In the few times margins have reached a level of 7.5 percent or above, subsequent 3-year earnings growth has been flat or steeply negative.

Decelerating earnings growth and contracting profit margins don't sound like a good combination for stock returns, and they're not. The table below puts profit margins since 1975 in quintiles. The first row of the table contains the 20 percent of the months with the lowest margins. The bottom row contains the 20 percent of months with the highest margins. For each level of profit margins, the table shows the median P/E of the 500 largest stocks, their median annual return over the subsequent 3-year period, and their median return over the subsequent 5-year period.

The Median P/E column is worth notice. Investors consistently overpay for stocks during periods of high margins. The median P/E during the 20 percent of the highest margin periods is 25. During the 40 percent of periods with the lowest margins, the median P/E has been less than 13. This isn't surprising. When earnings are weak, investors become frustrated and are unwilling to pay much even for a dollar of depressed earnings. The opposite is true after a long expansion in earnings.

It's not difficult to guess what happens when investors buy richly priced stocks with high profit margins. The last two columns in the table show the returns of the median stock in our Large 500 portfolios. When profit margins were lowest, the median stock returned 15.7 percent over the next five years. When profit margins were highest, the median stock returned just 3.5 percent over the next five years.

Profit Margin What-If Scenarios

Aging bull markets have a way of encouraging the abuse of what otherwise might be acceptable methods of analysis. The ratio of "price to forward earnings" is the current bull market's victim. If you assume that earnings will continue to grow at recent growth rates, you can make the market's P/E look quite attractive. But by taking into account the current levels of profit margins, a different set of expectations develops.

With our historical profit margin series in hand, we'll run a few scenarios to highlight potential outcomes for future earnings growth. The companies currently in the S&P 500 have earned about $970 per share in sales over the prior 12 months. The net income on these sales has been about $82 a share. These numbers differ from the index level data found in Barron's and elsewhere because S&P adjusts its cap-weighted indexes by 'float adjusting' the index level data, counting only the shares that are available to investors. (This doesn't affect the analysis below, because we focus on the growth rates in sales and earnings and not their levels).

We'll assume that the total sales of the companies in the index grow by 6% a year over the next five years. This has been the long-term growth rate of nominal GDP, (excluding a brief period of spiraling inflation in the 1970's). Assuming various profit margins five years from today, the table below shows the expected annual earnings growth that would result.

Earnings will grow at about 5.9 percent a year if we assume profit margins remain near their current record levels. Assuming a decline in margins toward the long-term average of 6.5 percent, earnings will grow at one-third of a percent a year. If profit margins dropped to 5.5 percent, the level they reached in 1975 and 1983, earnings would decline 3 percent a year. Remember, this assumes a continuation of healthy top-line sales growth. Those are the headwinds that result from high profit margins.

If you believe that there have been permanent structural changes to the U.S. economy as a result of globalization and outsourcing, you can run your assumptions through the table. For example, if long-term profit margins stabilize at a hypothetical norm of 7.5 percent, a full percent higher than the historical long-term average, then earnings would grow at 3.2 percent a year. That still represents a substantial deceleration in earnings growth.

Earnings growth is much easier to produce from low margins. For example, if sales grow at 6 percent and margins increase from 5.5 percent to 8.5 percent, earnings would grow 15.7 percent a year over the five-year period, more than double the long-term average. That's the tailwind from low margins, and helps to explain a portion of the strong gains in earnings we've seen over the last few quarters.

But profit margins aren't at 5.5 percent anymore. They're at a historical extreme near 8.5 percent. And earnings aren't at a trough, they're at record levels. Reinvestment to fuel future earnings growth is at 40-year lows. The financial sector's 14 percent profit margin contributes nearly a third of the S&P's earnings. While it's possible that profit growth will continue to surprise, investors should recognize that they are paying high P/E multiples on high profit margins, and should be prepared for some possible headwinds.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).