Climateer Investing: Why Jeremy Grantham is Right About Corporate Profit Margins

Tuesday, November 11, 2014

Why Jeremy Grantham is Right About Corporate Profit Margins

In April 2011 we awarded the prestigious Climateer Line of the day to Mr. Grantham for:

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” – Jeremy Grantham

I'm sure he treasures the memory of the spring day that he won the CLoD.

From Advisor Perspectives:

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” – Jeremy Grantham, Barron’s

“You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.” – Warren E. Buffett

As U.S. corporate profit margins have made it to record highs, a debate has raged between those who place their hopes on a new paradigm of sustained high profits and those who believe in capitalism’s efficiency and the tendency of margins to revert to the mean. We show that an often-cited explanation for the new paradigm – that the U.S. economy is more service-focused – lacks empirical support.

Notable amongst those pointing to high profit margins and their susceptibility to mean reversion include John Hussman, James Montier, Albert Edwards, Jeff Gundlach and Jeremy Grantham.

Most of the analysis concerning U.S. corporate profit margins has focused on national account data compiled by Bureau of Economic Analysis. Figure 1 shows the ratio of corporate profits (CP) to gross national product (GNP). Clearly, corporate profits margins are way over norm. The series depicts a very strong mean reversion tendency, confirming the effectiveness of the capitalistic system.

The term “corporate profits after tax” refers to profits of all corporations resident in the U.S. whether the profit is earned domestically or in a foreign country. GNP is the market value of goods and services produced by U.S. residents, regardless of where they are located.

Figure 1¹

This time is different
Corporate profit margins as shown in Figure 1 have been approximately two standard deviations above the mean for most of the last 10 years. Pointing to this behavior of profit margins, those advocating for the new paradigm claim that something has changed this time around. They suggest that productivity gains achieved and technological progresses made over the last couple of decades mean that corporate profit margins have arrived at a permanently higher plateau.

Another reason offered for higher profit margins is that service businesses like IBM, which have much higher profit margins, now account for a larger portion of the total corporate revenues and thus the high corporate profit margins.

In an interview with Matt Koppenheffer of Motley Fools, Columbia Professor Bruce Greenwald said, “I think Jeremy has been wrong about the reversion to the mean for about eight years now - and I think that there are structural reasons to believe that profits at or near this level may be more sustainable than he's giving them credit for.”

Greenwald then noted that increased contribution from businesses like IBM mean profit margins could be sustainable at the higher level. He said, “In contrast, if you look at IBM, IBM is also at historically high margins. If you look seven years ago, it's at 14% operating income to earnings. You look today, it's at 20.5%.” He concluded by saying, “To the extent that the market is moving away from the Apple direction, away from manufacture… into these very much more differentiated service markets, these much more fragmented service markets, it looks like the profits may be more sustainable than people are giving them credit for.”

A bottoms-up analysis of corporate profit margins
In our own examination of financial statements from several hundred companies annually, we have observed that profit margins for a large number of businesses have moved in the wonderland. Leaning towards the mean-reversion camp, we find this development troubling and are of the opinion that there is a non-trivial risk of decline in profit margins.

Let’s analyze the profitability of the S&P 500 Index on a bottoms-up basis. Much as the U.S. corporate profit margins in Figure 1, we will show that S&P 500 profit margins have reached new highs. Further, digging through the components of these profits, we show that some of the contentions of those hoping for a renaissance of corporate profits margins are outright incorrect.

Data Source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Corporate Profits After Tax (without IVA and CCAdj) [CP] and Gross National Product [GNP]; Bureau of Economic Analysis; accessed October 28, 2014.