Consider this opening paragraph from a recent CNN news story:
"Corporate America is growing practically nonstop thanks to massive tax cuts and a booming economy"
Hyperbole like this usually sounds alarm bells in our ears. To date, no tree has grown to the sky, and bull runs have always run out. We're also cautious of "this time it's different" arguments, especially at this point in the cycle. Investors can be so eager to keep the good times going that they often deceive themselves into rationalising an analytical approach that justifies even higher prices.
We, however, prefer to stay grounded in rational valuation estimates based on fundamentals. And for some time, our analysis of the fundamentals has told us that U.S. stock prices in aggregate have run well ahead of their fundamentals. Yet, when the fundamentals change, we need to be prepared to change our minds.
Other asset managers recently have made just that point – that the fundamentals underlying U.S. profit margins have changed, specifically in four areas. In other words, there are four arguments for higher margins in the future:
1. Market Composition: Technology companies are claiming a larger slice of the market pie, and these companies are currently more profitable than others.
2. Rising Rates: Lower rates made the cost of debt cheaper for leveraged companies, boosting their profits. But will it continue?
3. Higher Concentration: The presence of more monopolistic firms means the market will more likely operate above its cost of capital.
4. Globalisation: Operating worldwide should raise revenue and lower labour costs, and companies with sustainable competitive advantages won't need to pass these benefits on to customers. We'll take these arguments in turn.
Tech to the Fore
There's something to this market compensation argument. Information technology became the largest sector in the U.S. more than two decades ago, but in that time has continued to take market share from every other sector but financials and energy.
The tech sector has seen strong growth, with six of the top 10 fastest growing industries within it. Tech stocks also tend to be more likely to carry a Morningstar Economic Moat Rating for having greater competitive advantages. Taken together, these factors lead us to believe that the market composition issue appears to be a structural shift that's already having meaningful impact on investors.
Rising Rates Should Put Pressure on Margins
Rates can have a profound impact on profits, especially for leveraged companies. Historically low interest rates since 2009 have lowered the cost of debt financing, but rates have begun to rise and appear poised to continue to climb. How might rising rates – the levels of which are still well below long-run averages – dent corporate profits?
We did some sensitivity testing to look at the relationship between rates and margins and estimate that, for every half-point of rate increase, margins might be expected to contract by 10 to 20 basis points. Given our expectations for higher rates, we expect margins might be lowered by nearly 1% for a high-leverage company and half that for a low-leverage firm.
Concentration and Margins: A Tenuous Connection
We found that the U.S. market as a whole has not grown appreciably more concentrated in recent years. A handful of industries look quite concentrated domestically, but in those cases major foreign competitors provide significant competition. Partly for that reason, the correlation between concentration and profitability within U.S. industries is weak.
We therefore concluded that the evidence did not support adjusting our U.S. fair margins based on market concentration alone. However, our research in this area left us with a tool to measure global concentration, which can be incorporated into our fundamental research on global sectors and global industries.
Globalisation May Prove to Drag on Margins
It’s a well-known story that multinational firms have been able to lower labour costs by moving jobs overseas, and this has helped boost margins. But compensation costs abroad have steadily risen.
We see no compelling reason to expect global wages to further drive margin improvements for U.S. companies. In fact, we believe profits would more likely moderate as labour costs continue to increase.
We Don't See a 'New Normal' for U.S. Margins
Apart from the rising importance and profitability of tech companies on the U.S. market, we see most of these arguments from their opposing viewpoint – that, if anything, these factors will likely contribute to the mean-reversion of profitability for U.S. companies rather than being arguments for higher margins.
Specifically, we believe rising rates and labour costs abroad could help bring today's lofty profits back to earth.
