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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