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By Pat Dorsey, CFA | 08-12-2010 03:45 PM

Must Profit Margins Return to the Mean?

There are a few reason margins could stay higher today than the historical average, says Morningstar's Pat Dorsey.

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar.

One of the big picture issues that you'll often see talked about is that profit margins in United States are at a cyclical peak. They are at an all-time high, and because they are very likely to regress to a long-run mean, well, that's going to be a big headwind for earnings growth as margins come down and companies have a more difficult time generating earnings growth because revenue growth will probably slow down as well.

And now this is a pretty strong theme often brought about by the folks who think the market is overvalued right now, and they put out a chart of profit margins in the United States going back 50 years or so, and then draw a line at the mean, and say, well, gosh, we're way above that mean, so we must need to come back down, because of course, isn't that capitalism. When you're making lots of money you attract competition, and so then your margins have to fall back down. And it all sounds really good.

However, I think, there are some flaws in the argument, and I wanted to kind of bring them out for you. Simply because this is a pretty strong and well-publicized thesis that's out there that doesn't get, I think, refuted very often. So I wanted to just kind of maybe bring up the other side of the coin.

One big other side of the coin to this idea that margins are very, very high right now and have to come back down to a long-run mean is that, well, the U.S. economy is what we call a non-stationary dataset in statistical terms, i.e., it changes over time. The U.S. economy looks different today than it did 50 years ago. We make different stuff, we do different things, and because of that, it's entirely possible that maybe margins can trend up over time.

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