Hester: Why High Profit Margins Are Bad News For Stocks

Bullish market seers often point to today’s big profits when arguing that there are great things to come.  Because today’s big profits are due to today’s record-high profit margins, however, they should be arguing exactly the opposite. 

As William Hester of the Hussman Funds shows in this excellent analysis, high current profit margins usually mean bad news for both future earnings growth and future stock performance.  Why?  Because, as GMO’s Jeremy Grantham likes to say, profit margins are one "one of the most dependably mean-reverting series in finance."  When some companies are making fat profits, other companies rush to compete with them, and the new competition reduces the profits–and vice versa.  To believe that profit margins won’t revert to the mean, Grantham says, you have to believe that capitalism is broken.

Hester’s report shows that the 50-year profit margin range for the S&P 500 has generally been 5.5% to 7.5% of sales.  Only four times in 50 years have margins climbed above 7.5%, and the first three times, they quickly dropped down below the mean.  Now, the fourth time, profit margins have continued upwards, to a 50-year record of 8.5%.  Is it possible that outsourcing, globalization, and other structural forces have permanently changed corporate America’s profitability?  It’s possible.  It’s also very unlikely.  (Your competitors are benefiting from the same trends you are, so why should you all be able to maintain pricing power?)

Hester attributes today’s fat profit margins to three primary factors: slow wage growth, reduced corporate investment rates, and increased profitability in the financial sector.  He makes compelling arguments why none of these factors will bode well indefinitely.

Hester also includes a handy chart that shows how fast corporate profits will grow for the next five years under different profit margin assumptions.  Assuming standard sales growth of 6% per year (the long term average), if profit margins somehow remain at today’s levels, earnings will grow about 6% per year–a fine rate, but a significant deceleration from the past few years.  If margins revert to their 50-year mean, meanwhile, earnings will grow only 0.3% per year.

Hester also explains the other reason why fat profit margins are bad for stocks: Because investors always extrapolate today’s conditions into the hereafter.  Hester divides the 50 years of margin performance into quintiles and shows that, when profit margins are highest, investors are so happy and optimistic that they pay an average P/E of 25-times earnings, and when they are lowest, investors are so depressed and pessimistic that they only pay 13-times.  (Exactly the opposite of what they should do).   Not only do high profit margins presage slower earnings growth, in other words–they also presage severe multiple compression.

The bottom line: According to Hester, the 3-year anualized return for the S&P 500 after profit margins have hit the highest quintile has been -1% per year.  The 3-year annualized return when margins have dipped into the lowest quintile, meanwhile, has been 15%. 

But don’t worry.  It’s different this time.