The Profit Margin Paradigm?

March 1st, 2006 - The Motley Fool

By Vitaliy Katsenelson, CFA

"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

Many investors (including the author) were caught off guard by the economy's surprising earnings growth over the last several years. Earnings of S&P 500 companies have grown more than 20% during the last two years, and they are expected to climb another 8% in 2006. This astonishing growth has exceeded the Gross Domestic Product (GDP), which topped out at 4.6% in 2004 and has grown at a slower rate since. Contrary to common perceptions, corporate earnings growth historically stays in line with GDP growth.

The source of this earnings growth was profit margin expansion (here we define profit margins as corporate profits / GDP), from 7.0% at the end of the third quarter 2001 to a whopping 10.3% in the latest quarter. As profit margins rise, corporations get to keep more of their sales, leading to improved profitability. To put things in perspective, the average profit margin for corporate America over last 25 years was approximately 8.3%, 200 basis points less than today.

The question comes to mind: Are the billions of dollars dedicated to productivity enhancements over last decade finally paying off? Did the new era of technology-induced corporate efficiency descend upon us? Are we in a "new"-economy, higher-profit margin paradigm? (OK, three questions). The answer is no, no, and definitely no.

Fallacy of composition Corporate America's enormous investment in technology did not go to waste. It made companies more efficient, helping them to produce more with less -- the definition of productivity. That's the good news. The bad news is that technology improvements were available to everyone. Oracle(Nasdaq: ORCL) will sell its software to any company that can spell "Oracle" on a multi-million dollar check. This is where the economic concept fallacy of composition (what is true for part may not be true for the whole) kicks into high gear. Though technological investment may help the first adapter to cut costs and get a leg up on the competition, competitors won't watch their economic pie being eaten by a more efficient company. Those who do sit still will be driven out of business. The others will adapt by writing a big fat check to Oracle, SAP(NYSE: SAP), or Microsoft(Nasdaq: MSFT), eventually catching up and competing the higher margins away. Thus, what was true for one company is not true for the industry.

As much as we would love to believe that productivity improvements brought to us by technological innovations will transform into corporate profitability, historically that has not been the case. Wal-Mart(NYSE: WMT) has changed the retail landscape by installing the most (at the time) revolutionary inventory management and distribution systems, passing the cost savings to the consumer, and driving less efficient competitors out of business.

However, Wal-Mart-like technology is available off the shelf to any retailer aspiring to coexist in today's competitive landscape. Even companies like Dollar General(NYSE: DG), with stores the size of several Wal-Mart bathrooms put together, wrote sizable checks to Manhattan Associates(Nasdaq: MANH) and installed perpetual inventory and automatic reordering systems. This investment will keep Dollar General in the game by helping it survive in the new competitive environment, but is unlikely to send its margins much higher from today's level.

Should all-time high corporate margins worry investors? Today's stock market valuation is higher than it may appear. As margins revert to the historical average (and they always do), corporate earnings growth will either decelerate -- disappointing Wall Street expectations of 8% earnings growth (according to First Call) for the S&P 500 over next five years -- or decline, driving earnings, the "E" in the P/E equation, down. The broad market index fund investor may be in a pickle when a cheap market suddenly becomes more expensive. If today's corporate profitability reverts to the mean profit margins observed over the last 25 years, corporate profits would decline almost 19%.

Putting macro-shmacro stuff aside, why does this all matter to investors holding individual stocks? Companies that don't have a sustainable competitive advantage (a metaphorical moat around their business) will not get to keep the benefits from the increased productivity. These benefits will get competed away, and their margins will decline. Do you own one of those companies? I strongly recommend you take a look at the companies whose margins are hitting an all-time high, and examine their competitive landscape and their business for sustainable competitive advantage.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. His firm own shares of Oracle and Microsoft. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

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