Another month and another U.S. stock market all-time high. A day cannot seem to pass without a headline that warns of a financial bubble of some sort, each of which is proclaimed positioned to imminently pop.
Markets, most of them anyway, are at historical highs. And each is perched there on a seemingly credible basis. U.S. equities have benefited from a rebound in corporate profits and excess liquidity from central bank intervention. The bulls expect equity markets to grind higher over the next several years as the U.S. economy reaches escape velocity, a term used to describe growth without the help of the Fed. Bears, on the other hand, suggest equity markets are doomed, propped up by easy money and record high profit margins that are set to collapse.
The likely path of profit margins should be front and center in this discussion.
It is often said that margins are among the most mean-reverting of series. Today, corporate profits are at all-time highs and drive near-peak margins.
The 30-year average of after-tax corporate profits as a percentage of Gross National Product (GNP) is 6.5%. In the second quarter of 2013, the figure touched 9.9%, the second highest rate on record–a staggering difference. Most analyses mistakenly stop there, concluding that margins are unsustainably high and will shortly fall. We need to dig a little deeper, however, to do fair justice to the topic.
In equity analysis, it is best to look at a company’s operating margin–the rate it earns on sales before it pays interest and taxes. Focusing on earnings before interest and taxes, called EBIT, eliminates the effects of different tax rates and capital structures between companies. Likewise, if we add back the interest and taxes paid by U.S. corporations, we arrive at an economy-wide EBIT margin that eliminates the impact of different tax regimes and interest rates on corporate profitability. EBIT is more directly under the control of a corporation, while the interest rates and taxes to be paid are driven largely by external factors.
In the second quarter of 2013, the U.S. economy’s EBIT margin was 15.0%, slightly higher than the 30-year average of 14.3%. In 2006, that figure reached 16.3%. The highest EBIT margin on record is 16.8% and was achieved in the early 1980s as corporations battled high interest costs and high corporate tax rates.
Put simply, an EBIT margin of 15.0% isn’t significantly above either the 30 or 50-year average. From this we can gather that nearly all of the current difference between the 9.9% after-tax profit margin and the 30-year average of 6.5% is due to either tax rates or interest costs. The case for mean reversion in these is limited. Neither is driven by risk-taking corporations competing for profit, like EBIT margins are, and instead are derived by more complicated relationships largely outside the control of business.
Corporate tax rates have averaged just 21% of pre-tax corporate profits since 2008. As a percentage of GNP, corporate taxes have averaged 2.5% over both the last 10 and 30 year periods. In the most recent quarter corporate taxes as a percentage of GNP were 2.5%–spot on average.
Just today, Senate Finance Committee Chairman Max Baucus released a draft proposal for U.S. corporate tax reform. We will spare you the details of his proposal, which is in the early stages and lacks specifics, but both political parties appear to be in favor of actually lowering corporate income tax rates. On this basis, one cannot make a case that the tax rate on corporate profits is going to head substantially higher.
One could argue that tax rates may rise over the next few years as carry forwards are used up, but we suspect they don’t get materially above the 10-year average of 24% of pre-tax corporate profits–which, by the way, would only cause after-tax profits to fall by 4.6% compared to today’s level. That shaves the after-tax profit margin to 9.4%, not 6.5%. So very little of the record profit margin in effect today is due to either EBIT margins or tax rates. That leaves interest costs.
Interest costs are more difficult to forecast. They ultimately depend on the level of interest rates, which are determined by inflation and real return levels, as well as economic growth. The speed at which debt is raised and refinanced is also relevant. 80% of nonfinancial corporate debt is long-term, so the impact of rising interest rates will take time to drive interest costs as a percentage of GNP higher.
Interest costs were just 2.6% of GNP in Q2 2013, below the 10-year average of 3.6% and well below the 30-year average of 5.3%. If interest costs rose to its 30-year average in isolation, after-tax corporate profit margins would fall to 7.7%. Historically low interest rates–and the low financing cost that comes with them–are the driver of currently outsized profit margins.
The real issue, then, is what happens to interest rates. When someone claims that profit margins are set to collapse, they are really stating–even if they don’t realize it themselves–that interest rates are going to shoot up in the near-term. Economic growth remains tepid, inflation is below 1.0%, and the Fed has repeatedly stated it intends to keep its policy rate close to zero for at least two more years. Skyrocketing interest costs over the next few years is therefore not likely.
The likely outcome then is that interest cost as a percentage of GNP rise in a more measured fashion over the course of the next several years, pushing profit margins down. Total corporate profits, on the other hand, should at the least remain stable–barring another recession.
Offsetting some, most, or all of the impact of rising absolute interest costs will be higher EBIT (not necessarily higher EBIT margins) resulting from the same economic growth that drives up interest rates.
The claim then that corporations as a group have unprecedented and therefore unsustainably high profit margins requires more analysis. Today’s high after-tax profit margin is due primarily to low interest costs and not high EBIT margins (which are competed away in a capitalist system). Interest costs will likely rise as a percentage of GNP over the course of the next five years. That is to say, economy-wide profit margins should gradually fall as interest rates rise–not collapse as some predict.
We write all this to address a topic frequently debated and to lay out a case that the most negative scenario of collapsing margins outside a recession is a low probability event.
But we are left with a stock market that is richly valued and is, in fact, priced to deliver low-single-digit returns over the medium to long-term. That’s still a dismal situation. Though, the idea that corporate profits are going to plummet next year “just because” doesn’t hold water. Expecting another five years of double digit returns in an index fund doesn’t either.
Fortunately, we do not own the stock market. We own a collection of businesses with better prospects and better valuations than the broad market. Our portfolio is priced to deliver double-digit returns with lower volatility and less downside risk. Our valuation methods smartly adjust for the types of things we discussed in this letter–as well as the effects of the business cycle more generally–and position us well.
Black Cypress portfolios rose 5.4% in October.