James Montier’s (author of the excellent Value Investing: Tools and Techniques for Intelligent Investment) monthly commentary has been released, courtesy of ZeroHedge: What Goes Up Must Come Down! [pdf]. This month he tackles the sustainability of record high corporate profit margins:
Currently, U.S. proﬁ t margins are at record highs according to the NIPA data (see Exhibit 1). More freakish still is that these record high proﬁt margins are coming during the weakest economic recovery in post-war history.
At GMO, we are ﬁrm believers in mean reversion, and as such record elevation in proﬁt margins causes us much consternation. Of course, we are constantly on the lookout for sound arguments as to why we might be wrong in our assumption of margin reversion. After all, believers in mean reversion are always short a structural break, and such a break clearly matters. For instance, Exhibit 2 shows that in simple trailing P/E terms the U.S. market isn’t actually expensive. However, the P/E is only one part of a valuation – it also depends upon the state of earnings. It is the margin component that is dragging our return forecast down. If we are incorrect on our assumption of mean reversion in proﬁ t margins, then our forecast radically alters. For instance, if instead of falling to 6% over the next 7 years margins stayed at today’s levels, our forecast would be closer to 4.5% p.a.
Clearly the ﬁ rst two elements of Exhibit 2 are all about cyclical adjustment: we are assuming that the market goes to a “normal” P/E based on “normal” E. Therefore, it is no surprise that we see the same point from a different perspective when we look at a comparison of the simple trailing P/E using the Graham and Dodd P/E (Exhibit 3). The latter tries to smooth out the business cycle’s impact upon earnings by using a 10-year moving average of earnings. Hence, differences between the two measures are a statement of how far earnings are from their “trend.” The simple trailing P/E is around 15x and the Graham and Dodd P/E is around 24x, again highlighting the divergence of proﬁts from their long-run normal levels.
Montier points to a Polish economist, Michał Kalecki, who created a framework for analyzing profit margins known as the Kalecki Profits Equation:
Kalecki’s derivation was perhaps the easiest to understand. He used the ﬂow of funds framework and national income accounting to ground his understanding of proﬁts.
Proﬁts = Investment – Household Savings – Government Savings – Foreign Savings + Dividends
Using this framework, Montier shows that the US government’s fiscal deficit and growth in corporate dividends have been the driver of corporate profits since the recession began. The consequence of this is that Wall Street’s forecasts of further growth in corporate profits (which are at a historical peak) are not grounded in reality. An analysis (which Montier provides briefly) shows that there is very little potential for any of the elements of the above equation to “break out” and provide further profit growth. Thus, Montier forecasts a mean reversion in corporate profits.
Author Disclosure: None