During their latest episode of the VALUE: After Hours Podcast, Weniger, Taylor, and Carlisle discuss The Past Prosperity of Profit Margins. Here’s an excerpt from the episode:
Tobias: One of the kind of striking things over the last decade or so has been the persistence of profit margins. You can get a quote from Grantham, you can get a quote from Buffett and John Hussman as well to the effect that, the long run mean is about 6%. But we’ve been way above that mean. So, Jake’s got some veggies today. James Montier had a swing at it in his latest piece. Jeff, we do this veggie segment. Jake has researched something. He’s going to let us know. And then, Hussman has also left some comments about it, coming at it from a slightly different angle. Do you want to take it away, JT?
Jake: Yeah, absolutely. So, I picked this one today, because it’s very rare for someone in finance to admit when they’re wrong. I think we should celebrate that, that intellectual honesty. On the show, we’ve often wondered like, “What the hell is allowed US corporate profit margins to remain so elevated?” As you referenced, Toby, Buffett back in 1999 was saying, “You have to be wildly optimistic to believe that corporate profit margins as a percentage of GDP can for any sustained period hold much above 6%.” And so, corporate profit margins were around 8% when he wrote that, and then they proceeded to drop to about 5% over the next few years, which is that was 1999, call it 2003-ish. And then they ramped back up to 9% in 2007. Before then they crashed back down to about 2% in the GFC. And then they ramped quickly back up again and they’ve stayed elevated above 9% and peaking I think around 13%.
So, Montier, he wrote in 2012 in a white paper that, “US profit margins were unlikely to maintain nosebleed levels” where they were. I think we all looked at that same data set and agreed with what he was saying, reversion of the mean. But what ended up happening? Over the next 10 years, the decade average was 9.5%, which is obviously well above that long-term average, which at that point was, call it, 1950 to 2012, average 6.3%. So, he uses this national income accounting identity to back into what the profit margin is. Just real quickly, if you’re a nerd following this stuff at home, but it’s net investment, plus dividends, minus household savings, minus government savings, minus foreign savings.
So, when you looked at this, this accounting identity that the net investment was the primary driver of corporate profits. But then if you look at the chart, government basically started ramping up big time. There’s an interesting chart in here that shows like household savings as a percentage of GNP in the US. It muddles along from 1950 to let’s say, maybe the late 1970s at around between 5% and 10% always. And then, it starts to drift downward and actually bottoming out around 2005, 2006, 2007 period down at 2% or 3%, and then it comes back up a bit, and then in COVID it shot up to like 25%.
I don’t know if it was a combination of stemmy along with people trapped inside and they couldn’t go spend money. But then we’ve made up for it by– It’s dramatically dropped and now it’s the lowest ever. It’s down, like, just barely above zero. Where that’s actually, like, he decomposes that a little further looking at the personal savings rate as a percentage of income, and it breaks it up into the top 1% of wealth versus the next 9%, and then the bottom 90%. What you see there is that the top 1% have actually been saving for most of that time and actually increasing their savings. So, this inequality is what’s played out here. It’s been the bottom 90% that have not been saving and have just been barely trying to stay on the treadmill.
So, then the part that he points out is that the government deficits are what really made the difference in this time period for profit margins. Between 1950 and 2011, the federal deficit averaged just a little under 3% of GDP. And then in the last 10 years, it’s averaged more than double this at 6.6%. You would think like, “Oh, maybe that was just purely the pandemic spending,” but it’s not actually true. 2012 to 2019, the average was 5.5%. Obviously, it went even more parabolic in the last couple of years as we’ve been running these just absolutely insane deficits. It’s not that tax receipts have been roughly similar over that time period. It’s been just purely the expenditures. That’s what’s driving the deficit. And those expenditures are primarily made up of health, Medicare, income security, and Social Security. Those have just been ticking higher and higher.
Now, he does say that in an era of big government, if that’s here to stay, then profit margins as a percent of GMP could remain higher than they were in the past. So, maybe we’re in a completely new regime of just like bigger governments. And then of course, working at GMO, he’s going to then get into valuation, which right now it shows the CAPE at about 30 times. And so, based on that, he’s expecting about 3% real from here. But then, if you believe that the deficits are here to stay and that profitability is structurally higher because of that, then the market’s at 30 times. What he then asks you to imagine is, what if it was to go back to 20 times, which is still above the long-term average as valuations go. Well, that would represent a 5.8% per year headwind on returns, which is obviously pretty stiff headwind.
Then if you think about normalizing profit margins, that would indicate that today’s CAPE is really more around 45 to 50 times. So, of course, if you believe both of those things mean revert, then boy, you’ve really got a lot of headwinds in front of you. But this is actually a US specific phenomenon. He then goes on to talk about the rest of the world and CAPE’s average in Japan, I think he’s saying, is around it’s a little under 20, which to me still seems kind of high. Europe is like around 15, and then emerging markets are really more down around like 12. And then he breaks it out into growth versus value. The value side, deeper value called the bottom cheapest 20% in the US is relatively attractive as Toby’s pointed out every day or every show for the last-
Tobias: [laughs] Forever.
Jake: -four years. [laughs]
Tobias: Since the podcast launched.
Jake: Since inception. But one place that he points out that might be especially interesting is emerging market value right now is on a seven times CAPE, which is pretty cheap. That’s historically been a pretty good return, if you can find things at a seven times or lower CAPE.
Tobias: I remember an article, a paper that said that, “If you’re going to look at CAPEs, you shouldn’t compare them country to country. You need to compare them to their own mean.” That’s for anybody who’s thinking along those terms. Sorry, JT, I cut you off there.
Jake: That’s interesting. I wonder if Meb would agree with that.
Tobias: Yeah, that’s interesting. Yeah, that’s one of the cuts that he does for those funds. Hussman had one little bit to add and then I’ll throw it to you, Jeff. He looked at non-financial corporate profit margins, and he compared it to unit labor costs as a share of output prices, and then he compares these two charts. Basically, there are two huge outliers on this chart. You have to go to his most recent piece, which, I don’t have the name of it, but it’s on his website right now.
There’s a big outlier, it’s the early 2000s, mid-2000s. And he says, “Note that there are two enormous outliers in the data. One preceded the global financial crisis and was driven by consumers, not out of labor income, but out of equity cashed out of their mortgages amid a Fed induced housing bubble. The recent outlier was driven by trillions of dollars in pandemic deficits, which boosted corporate profits first directly through PPP subsidies, and later indirectly as households spent down their own surpluses.” So, I think that’s pretty interesting. That would describe a lot of the behavior that we’ve seen in those two bubbles.
Jeff: I got so many different directions I could go here.[laughter]
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