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Profit Margins A Bottoms-up Analysis of S&P 500
“You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.” – Warren E. Buffett
Improving U.S. corporate profit margins has resulted in a debate between those who believe in new paradigm and those who believe in the tendency of profit margins to revert to the mean.
Scope For Analysis
According to Professor Bruce Greenwald increased contribution from services mean profit margins could be sustainable at the higher level.
However, we analyzed profitability of the S&P500 Index on a bottoms-up basis and found that the profit margins are in the wonderland.
Some of the contentions of those hoping for a renaissance of corporate profits margins are incorrect.
Corporate PAT/GNP ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Ratio of Corporate Profits (CP) to Gross National Product (GNP)
• Corporate profits margins are way above norm.
• Also , there is a very strong mean reversion tendency.
• According to market view profit margins have risen due to technological progresses and contribution of services businesses.
Data & Methodology
Our data sample consists of 1,079 companies that were members of the S&P 500 index between 1989 and 2013. *All data including fundamentals and price data are from Factset Global data feed.
We have excluded the Financials sector from our analysis given the significant differences between the income statements.
We have calculated total sales and total profits of the index and derived index’s profit margin using these totals.
Net Profit Margin ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Net Profit Margin: Non-Financial Stocks
As can be seen, the trajectory of net profit margins of S&P 500 non-financial stocks is very similar to U.S. corporate profit margins
Consumer Discretionary NPM ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Net Profit Margin: Consumer Discretionary Stocks
The trend in profit margins of the consumer discretionary sector is in
line with that of the broader index as well as that of the overall U.S.
corporate profit margins.
Consumer Staple NPM ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Net Profit Margin: Consumer Staples Stocks
While not as extreme as that of the broader
index, consumer staples sector margins are close to their previous highs
recorded in 2007.
Net Profit Margin: Healthcare Sector
Interestingly, the healthcare sector’s profit margins are
ruling at their lows.
Healthcare Stocks NPM ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Technology Stocks NPM ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Net Profit Margin: Technology Sector
▪ At about 16%, this sector has the highest profit margin of all the sectors.
▪ Much like the broader index, the technology sector’s profit margins is in uncharted territory as well.
Industrial NPM ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Net Profit Margin: Industrial Sector
Clearly, profit margins of industrials sector are in the
wonderland as well.
Net Profit Margin: Energy Sector
In this case, margins have retained their mean
reversion tendency and have reverted to their
mean.
Energy NPM ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Sector’s Profits as a % of S&P 500 Total Non-Financial Profits
Tech Sector’s Net Profits as % of Non-Financial Stocks’ Net Profits
Interestingly, the tech sector’s contribution to overall profits has flat-lined over the last few
years.
Our above analysis dispels misconceptions that higher profit
margins are driven only by services businesses and that such businesses have become a larger part of the U.S.
economy.
Gross Profit Margins ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
It is believed that technological progress and the productivity gains have contributed to profit margins.
So, a decline in cost of production per dollar of sales should improve gross
profit margins
However, Figure alongside shows that gross profit margins have stayed below
their mean.
Gross Profit Margins Non-Financial Stocks: Below Mean
Depreciation Expense as a % of Sales ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Depreciation Expense As A % Sales
Interestingly, depreciation expense as a percentage of sales declined while gross
profit margins were stagnant, i.e., minus this
benefit, gross profit margins would have declined.
Fixed Asset Turnover ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Fixed Asset Turnover: Down
Instead of following the trend, the fixed asset turnover ratios went
down.
Improving Operating Profit Margin?
There has been substantial
improvement in operating
profitability.
Operating Profit Margin ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
SGA & Other Operating Expenses as a % of Sales ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
How Have Operating Profits Improved?
SGA and other operating expenses as a percentage of
sales have persistently declined
over the last two decades.
Other operating expenses include marketing expenses, advertising expenses, R&D, software development costs, and product promotion expenses
Low Interest Rates & Increasing Profit MarginsCentral bank largesse has contributed to higher net profit margins as interest rates have declined
Calculations suggest that increase in borrowing costs to mean will reduce corporate net profits by 11%
While an increase in borrowing costs towards +1 SD will cut corporate net profits by 22%.
Average interest rate ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Effective tax rate ______ Mean …… +1SD ----- +2SD ……. -1SD ----- -2SD
Effective Income Tax Rate
Effective tax rates have trended lower and some of this is related
to foreign profits that are taxed at lower rates.
However, we think some of it is also a result of creativity of
accountants.
Total Sales Trailing Below Trend
While profit margins are setting new records, sales have been trailing
below trend.
Clearly, sales have failed to move above trend
over the past five years.
Total Sales …… Trend Sales
Our analysis rejects the hypothesis that improvement in profit margins is a result of structural shifts towards a service driven economy.
According to James Montier, the average lifespan of a company is down to about 15 years and the average tenure of CEOs is down to about 6 years now.
Hence, it is only logical for a CEO to look for higher stock prices, as his/her payoff depends on it.
Thus, cutting SGA expenses and postponing capital investments, look promising to a manager.
The problem is that in the long-term profit margins may have no choice but to remember their tendency to revert to mean.
SUMMARY
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