Ha! I see the FT's Izabella Kaminska was also perusing Mr. Grantham's letter. She has additional thoughts at "
GMO’s Grantham on what’s driving abnormal profit margins".
Great minds and all that.
Interestingly, we both zeroed in on the political power angle, which of course reminded me of something (what doesn't?), in this case a 2015 post, "
While the Cost of Stuff Declines, The Cost of Political Power Skyrockets":
In the comments section of an FT Alphaville piece
on Andreessen-Horowitz-backed bitcoin play, 21 Inc. Alphaville's
benevolent overlord pounded home a point Izabella raised in the
article:
From GMO:
This Time Seems Very, Very Different (Part 2 of Not with a Bang but a Whimper -A Thought Experiment)
Jeremy Grantham
Pages 9-16
Oh, the good old days!
When I started following the market in 1965 I could look back at what we might call the Ben Graham training period of 1935-1965. He noticed financial relationships and came to the conclusion that for patient investors the important ratios always went back to their old trends. He unsurprisingly preferred larger safety margins to smaller ones and, most importantly, more assets per dollar of stock price to fewer because he believed margins would tend to mean revert and make underperforming assets more valuable.You do not have to be an especially frugal Yorkshireman to think, “What’s not to like about that?”
So in my training period I adopted the same biases. And they worked! For the next 10 years, the out-of-favor cheap dogs beat the market as their low margins recovered. And the next 10 years, and the next!
Not exactly shooting fish in a barrel, but close. Similarly, a group of stocks or even
the whole market would shoot up from time to time, but eventually – inconveniently, sometimes a couple of painful years longer than expected – they would come down. Crushed margins would in general recover, and for value managers the world was, for the most part, convenient, and even easy for decades. And then it changed.
Exhibit 1 shows what happened to the average P/E ratio of the S&P 500 after 1996. For a long and painful 20 years – for someone betting on a steady, unchanging world order – the P/E ratio stayed high by 1935-1995 standards. It still oscillated the same as before, but was now around a much higher mean, 65% to 70% higher! This is not a trivial difference to investors, and 20 years is long enough to test the apocryphal but suitable Keynesian quote that the market can stay irrational longer than the investor can stay solvent.
1 In fact, between 1965 and 1995 cheap price to book stocks (best decile) continuously outperformed the market on a rolling 10-year basis with one exception – 1973 (French and Fama).
Along the way there were early signs that things had changed. First was the decline from the greatest bubble in US equity history, the 2000 tech bubble. Compared to the previous high of 21x earnings at the 1929 bubble high, this 2000 market shot up to 35x and when it finally broke, it fell only for a second to touch the old normal price trend. And then it quite quickly doubled. Compare that experience to the classic bubbles breaking in the US in 1929 and 1972 (Exhibit 2) or Japan in 1989.
All three crashed through the existing trend and stayed below for an investment generation, waiting for a new crop of more hopeful investors. The market stayed below trend from 1930 to 1956 and again from 1973 to 1987. And in Japan, the market stayed below trend for... you tell me. It is 28 years and counting! Indeed, a trend is by definition a level below which half the time is spent. Almost all the time spent below trend in the US was following the breaking of the two previous bubbles of 1929 and 1972. After the bursting of the tech bubble, the failure of the market in 2002 to go below trend even for a minute should have whispered that something was different. Although I noted the point at the time, I missed the full significance. Even in 2009, with the whole commercial world wobbling, the market went below trend for only six months. So, we have actually spent all of six months
cumulatively below trend in the last 25 years! The behavior of the S&P 500 in 2002 might have been whispering in my ear, but surely this is now a shout? The market has been acting as if it is oscillating normally enough but around a much higher average P/E.
How about profit margins, the other input into the market level? Exhibit 3 shows the return on sales
of the S&P 500 and Exhibit 4 shows the share of GDP held by corporate profits. Compared to the pre-
1997 era, the margins have risen by about 30%. This is a large and sustained change. And remember,
it is double counting: above-average profit margins times above-average multiples will give you
very
much above-average price to book ratios or price to replacement cost. Counterintuitively, if we need
to sell at replacement cost (most people’s view of fair value), then above-normal margins must be
multiplied by a below-average P/E ratio and vice versa.
To this point, we have looked at two of the three most important inputs in markets and they are very
different in the same direction, upwards. A third one – interest rates – is also very different. As is well-
known, short rates have never been at such low levels in history as they were last year. Come to think
of it, the population growth rate is also very, very different. As is the aging profile of our population.
And the degree of income inequality. So too the extent of globalization and indicators of monopoly
in the US. Also the extended period of below-trend GDP growth and productivity almost everywhere but particularly in the developed world. And serious climate change issues that may be understated in
countries like the US, the UK, and Australia, where the fossil fuel industries are powerful and engage
in effective obfuscation, but pre-1997 the topic was not broadly appreciated at all. The price of oil in
1997 was more or less on its 80-year trend in real terms of around $18 a barrel in today’s currency. The
trend price today, based on the cost of finding new oil, is about $65 a barrel with today’s price only
slightly lower despite an unexpected surge in supply from US tight oil, or fracking. Three and a half
times the old price is not an insignificant change when you realize that almost all serious economic
declines have been associated with price surges in oil. And, finally, my old bugbear – the modus
operandi of the Federal Reserve and its allies is very different in its 22-year persistent effort to work
the highs and lows of the rate cycle lower and lower. One might ask here: Is there anything that really
matters in investing that is
not
different? (Actually, I have one, but will save it for another discussion:
human behavior.)
We value investors have bored momentum investors for decades by trotting out the axiom that the
four most dangerous words are, “This time is different.”
2
For 2017 I would like, however, to add to this
warning: Conversely, it can be very dangerous indeed to assume that things are
never
different.
Corporate profitability is the key difference in higher pricing
Of all these many differences, the most important for understanding the stock market is, in my opinion,
the much higher level of corporate profits. With higher margins, of course the market is going to sell
at higher prices.
3
So how permanent are these higher margins? I used to call profit margins the most
dependably mean-reverting series in finance. And they were through 1997. So why did they stop mean
reverting around the old trend? Or alternatively, why did they appear to jump to a much higher trend
level of profits? It is unreasonable to expect to return to the old price trends – however measured – as
long as profits stay at these higher levels.
So, what will it take to get corporate margins down in the US? Not to a temporary low, but to a level
where they fluctuate, more or less permanently, around the earlier, lower average? Here are some of
the influences on margins (in thinking about them, consider not only the possibilities for change back
to the old conditions, but also the likely speed of such change):
■
Increased globalization has no doubt increased the value of brands, and the US has
much more than its fair share of both the old established brands of the Coca-Cola and
J&J variety and the new ones like Apple, Amazon, and Facebook. Even much more
modest domestic brands – wakeboard distributors would be a suitable example – have
allowed for returns on required capital to handsomely improve by moving the capital-
intensive production to China and retaining only the brand management in the US.
Impeding global trade today would decrease the advantages that have accrued to US
corporations, but we can readily agree that any setback would be slow and reluctant,
capitalism being what it is, compared to the steady gains of the last 20 years (particularly
noticeable after China joined the WTO).
■
Steadily increasing corporate power over the last 40 years has been, I think it’s fair
to say, the defining feature of the US government and politics in general. This has
probably been a slight but growing negative for GDP growth and job creation, but has
been good for corporate profit margins. And not evenly so, but skewed toward the larger and more politically savvy corporations. So that as new regulations proliferated, they tended to protect the large, established companies and hinder new entrants.
Exhibit 5 shows the steady drop of net new entrants into the US business world – they have plummeted since 1970! Increased regulations cost all corporations money, but the very large can better afford to deal with them. Thus regulations, however necessary to the well-being of ordinary people, are in aggregate anti-competitive. They form a protective moat for large, established firms. This produces the irony that the current ripping out of regulations willy-nilly will of course reduce short-term corporate costs and increase profits in the near future (other things being equal), but for the longer run, the corporate establishment’s enthusiasm for less regulation is misguided:
Stripping out regulations is working to fill in its protective moat.
■Corporate power, however, really hinges on other things, especially the ease with which
money can influence policy. In this, management was blessed by the Supreme Court,
whose majority in the Citizens United decision put the seal of approval on corporate
privilege and power over ordinary people. Maybe corporate power will weaken one
day if it stimulates a broad pushback from the general public as Schumpeter predicted.
But will it be quick enough to drag corporate margins back toward normal in the next
10 or 15 years? I suggest you don’t hold your breath.
■
It is hard to know if the lack of action from the Justice Department is related to the
increased political power of corporations, but its increased inertia is clearly evident.
There seems to be no reason to expect this to change in a hurry.
■
Previously, margins in what appeared to be very healthy economies were competed
down to a remarkably stable return – economists used to be amazed by this stability
– driven by waves of capital spending just as industry peak profits appeared. But now
in a very different world to that described in Part 1,
4
there is plenty of excess capacity...
...
MUCH MORE, including GMO's Ben Inker on what keeps him up at night.
HT:
Value Investing World
