Must Profit Margins Return to the Mean?

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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Think about, say, all of the low value-added goods that we produced in the U.S. 30-40 years ago that aren't produced in the U.S. anymore. Apparel, are there any clothes made in the U.S. anymore; pretty much not, unless you're American Apparel, maybe. But most clothing is made offshore; that's a pretty low-margin business.

So most low-margin, high-labor content, low value-added goods, we don't make them here anymore. What's left in the U.S. is stuff like jet engines, Caterpillar tractors--that make pretty high profit margins.

So, again, it's entirely possible that the average margins in the U.S. economy today could be on a mean-normalized basis higher than they were 40 years ago, because we're different doing different stuff, we're making different things than we were 40 years ago.

And of course that leads into the second point, which is competition. People often talk about, well, gosh, we're in a more globalized world right now. Shouldn't that be pushing down profit margins in the U.S., things are going to be even worse going forward than they have in the past.

Well, think about again what globalization means. What's globalized over the past 10 or 20 years? It's that low-margin stuff I just talked about. It's the addition of a large global labor pool in China, in India  that's now competing effectively with the U.S., that wasn't competing with the U.S. 20 years ago. But again, those folks are mainly, at least at this point, competing in low value-added areas that are not contributing in a big way to the profit margins overall of the U.S. economy.

Now, you know, 20, 30 years from now that could change. China is working on making its own aircraft; emerging economies steadily march up the value chain; that's how the world works. But right now, we are competing for the high value-added stuff with the same developed economies we've been competing with for 10-20 years.

And the third reason why margins could just be structurally higher now than they were in the past is a fascinating one that was brought up to me in an e-mail conversation I had with a fund manager recently, and it's just kind of an accounting issue to be honest with you. And it has to do with what's called – sorry, accounting alert, geek here – income from equity affiliates, and this is basically, when a company has a minority stake in another company, it reports its piece of the income--if it owns 20% it brings in 20% of the income--but it doesn't report any revenue associated with that. It's essentially 100% margin income.

So, if you're seeing a lot – if there's a lot more of that in companies today than say 40 years ago, then I think just intuitively and anecdotally I think that's the case, especially given that a lot of foreign operations are carried out via joint ventures, minority interests in other companies. If a higher proportion of the total net income of the S&P 500 today is this 100% profit margin income from equity affiliates, income from joint ventures, well then, margins are going to be higher just mathematically, because there is no revenue associated with that income line.

So that's a really interesting point that we're actually going to be doing some more research on at Morningstar, and as we kind of develop the dataset better, I'll maybe do another video on that and bring it back to you. But it's an interesting reason why the mean for margins may not look like this, it might kind of look like this, and so perhaps we're not as high above the long-run mean as you think.

Again, these are all just pieces that are food for thought. The folks that are propounding this, "margins at a cyclical high" argument are not dummies by any stretch; they are very smart individuals. But I just don't see their argument being challenged very often, so I thought I'd just put out a few ideas there for you that might show why things may be different.

I'm Pat Dorsey, and thanks for listening.