5 Structural Reasons for Higher Profit Margins

The debate about profit margins has been raging for years now.  Big bears argue that margins have to mean revert.  The bulls argue that margins either aren’t all that high or needn’t necessarily mean revert.   But an interesting note from Deutsche Bank argues that some portion of the higher margins is indeed structural.  Their arguments makes a good deal of sense (via Deutsche Bank):

  1. Constituent changes: 80bp of margin expansion has come from the ~5% annual constituent turnover.
  2. Lower effective tax rate: 80 bp of margin expansion has come from S&P effective tax rate dropping by 7 pct points as share of S&P profits from foreign operations doubled.
  3. Lower interest expense: 25 bp of margin expansion has come from lower interest rates and less leverage.
  4. Higher foreign operating margins: 85 bp of the margin expansion has come from this and mix shift.  The increase in aggregate foreign margins is from higher businesses expanding abroad and their foreign operations becoming more profitable.
  5. Mix shift: sectors with improving or higher margins have become larger share of the S&P 500.  Tech is now 20% of S&P earnings vs 12% in mid 1990s, while telecom and utilities share has dropped to 5% from 10% in mid 1990s.

I still think profit margins will necessarily contract when the next big profit recession occurs, but that’s kind of an obvious macro “insight”….

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. With really low interest rates companies get higher profit margins. You can imagine them buying a robot and having it make something they sell. If interest rates are near zero their profits will be higher. This also works in foreign countries. Also, refinancing their debt at near zero interest rate gooses their profits. Also, imagine they borrow at near zero and buy back half their stock. This would make them have about twice the profits per share.

    So to tell if “this time is different” we need to ask, “Will interest rates stay low forever?”. Making lots of new money and buying bonds will in the short term lower interest rates and this lowers the velocity of money. In the short term you don’t get inflation. But in the long term, making lots of new money always makes inflation. In the long term, inflation always makes for higher interest rates. This time will not be different.

    Look at the rates for the last year in this chart and ask yourself, does this look like rates will be staying near zero forever?

    http://www.fxstreet.com/rates-charts/bond-yield/

    • On the robot I meant to say they borrow the money to buy the robot. The lower the interest rate on the loan, the higher their profit margin.

    • That’s because negative real interest rates push up the savings rate by transferring income from the household sector (net savers) to the business sector (net borrowers). This is why profit margins are going up and taking asset prices along with them.

    • How can you possibly make the claim that higher interest rates result from high inflation? There is nothing “natural” about interest rates. Interest rates are a policy variable, and they are not market determined. The relative impact of interest rate changes is almost 100% dependent on the level of “debt” in the economy.

      With high levels of debt, changes in interest rates result in much higher nominal swings in fund flows.
      For example, lets assume a 1% private debt to GDP (not possible) with our current GDP to set the numbers and 100% T-bonds to GDP.

      $150B in private debt
      $15T in T-bonds

      For every 1% increase in the interest rate, Govt spending increases by $150B or 1% of GDP every year.
      So say we get a huge private sector boom causing inflation to increase, and the Fed raises rates to 10%, would $1.5T (10% of GDP) in new Govt spending be inflationary or deflationary?

      What if T-bonds outstanding were only $1.5T or 10% of a $15T GDP? Then a 10% increase in the FFR would result in only $150B or 1% of GDP in new Govt spending. How inflationary would that be?

      What if T-bonds outstanding were 200% of GDP or $30T? In this scenario, every 1% increase in the FFR would translate into 2% of GDP in new Govt spending. That sounds pretty inflationary to me.

      In what world do you live in where you think the Fed would unilaterally force the Govt deficit to increase seriously? Do you think Chairwoman Yellen would want to be responsible for increasing the FFR to 5% and thus increasing the deficit by $750 billion per year all by herself? What do you think the reaction of Congress would be?

      Interest rates are never going back up. Which is good, because interest rates increases are increasingly inflationary with higher debt levels.

      • How can I claim interest rates have to go up if inflation does? Simple. Imagine the average prices were going up at 10% and you could borrow money at 4%. Then on average people could borrow and buy random stuff and make a 6% profit. In this situation it is rational to borrow and hoard. But the more people there are that do this the more new money the central bank will have to make and the more prices will go up. But the higher the inflation the more profitable it will be to borrow at 4% and buy random stuff. In the end either the interest rates go up or the currency is destroyed but usually some of both.

        • Way to ignore everything I said and instead focus on your little bubble where hyperinflation is always just around the corner contrary to all evidence. Good job man

  2. Consolidation in many key industries, such as banking, airlines, hospitals, and online retail, has reduced competition, thereby structurally raising profit margins.

  3. Interesting stuff! I wonder if higher profit margins are a feature of the private sector in general, or just the private sector as represented by the S&P 500. In other words, is elevated profitability being widely shared, or isolated amongst the largest firms (or at least those large enough to be publicly listed). My inclination is that elevated profitability is concentrated across a small collection of very large firms, but without the data in front of me I can’t say for certain.

    Couldn’t one argue that the factors mentioned by Deutsche Bank are still subject to mean reversion themselves as a feature of passing in to later stages of the business cycle and likely to put downward pressure on profits as a result? Low tax rates support profits but increase deficits which at some point politicians and the public believe (wrongly usually) are a major problem that needs to be reversed, so tax rates are increased. I predict rates will remain subdued through the future and provide support to profit against historical averages, but we can still see a pullback versus the last couple of years when rates were almost half what they are today.

    Anyway, I’ve been in the reversion camp too early and for too long it seems, so I’ve come to doubt my own inclinations on the unsustainability of high corporate profits, so these comments are really for discussion purposes rather than my hard and fast beliefs.

  4. Deutsche Bank is one of the major offenders when it comes to painting a super rosy picture to convince investors to buy products.

    All the ‘structural’ reasons cited here focus on financial engineering, not on any substantive change in the way companies produce their goods. Higher sustainable margins come only when a company holds an effective monopoly on something which is in demand. Any other ‘structural’ change will not last, including squeezing wages and benefits to the poverty level. The ‘miracle’ of the 90′s has amounted to little more than constantly squeezing workforce benefits, helped by a complacent Fed that has helped mask this squeezing with unlimited leverage of the individuals.

    At some point people will wake up to this reality.

    • Andrea, your ideological blinders are on full display.

      “Mix shift: sectors with improving or higher margins have become larger share of the S&P 500.”

      Andrea: “Higher sustainable margins come only when a company holds an effective monopoly on something which is in demand.”

      Have you ever heard of the iPhone or iPad? The 1st, 3rd and 4th largest companies in the S&P500 are (as of Sep 13) Apple, Microsoft, and Google.

      Most people would take Andrea’s argument about margins and the facts (and the high compensation of workers in these companies) and see this as an argument opposite of her conclusion.

      • John, do you think that there is still validity to the claim that a meaningful portion of the gains in profit margins is a result of financial engineering?

        That is not a rhetorical question, I’m curious in your thoughts and insights here. I ask because, while you point out a clear and important flaw in Andrea’s argument, the general point about the existence and impact of financial engineering is not mutually exclusive to the pretty clear truths that you point out about companies like Google and Apple. I think it is totally possible that there are both large gains due to financial engineering at the same time there are large gains being made as a direct result of quality core research and development that pushes the ball forward (economically, socially, etc.).

        • Financial engineering is a term thrown about without much underlying basis. Is refinancing debt at lower interest rates “financial engineering”, or just basic good business sense? Do people make the same derogatory comments when families refinance their houses at lower rates? Every person I know with a mortgage refinanced at least once in the past 4 years. Is this financial engineering, or just common sense?

          What I would consider real financial engineering (e.g. using sophisticated Markov Chain Monte Carlo techniques) has helped to make top companies more stable financially, especially those with lot’s of international and/or commodity factors in their business. Some of this stability (e.g. hedging currency fluctuations) makes these companies more competitive and hence profitable. Is that a bad thing?

          As many have pointed out (Rajan is good example) higher worker pay for people with higher talent has obtained across all disciplines since the 1970′s. Amazon may pay people in it’s distribution centers poorly, but I can assure you the people who designed and implemented it’s IT infrastructure all make very good money. I have a good friend (PhD Theoretical Physics, Cambridge) who works for Intel and routinely makes billion dollar decisions for Intel. He is both well rounded, and among the smartest people you will ever meet. As an Intel shareholder I have no problem with the fact his compensation is far more than 10x the median household income. Interestingly, almost all the people he hires (like himself) are non-native born (Russian PhD mathematicians are the largest component).

          I think a large component of what disturbs many people who use terms like “financial engineering” with a derogatory connotation is that we live in an era where the Pareto curve of compensation vs. intelligence is skewing further to the right. In the 1960′s understanding Metropolis sampling was confined to a small subset of Physicists and Physical Chemists, none of whom made much money. Today, a good understanding of this (along with huge developments like Hamiltonian based Markov Chain sampling, Baysian Networks, …) is worth a probable minimum of 4x median income, and for some 20x or more of median income. But perhaps only 0.1% of the population has the innate ability (even with the best education) to be in that group. Fear leads to discrimination, which is what terms like “financial engineering” are based upon.

          If you look at the top companies in the S&P 500, all are heavy users of exceptionally talented people, with rare talents, whom they pay accordingly in a competitive market, and many are large users of people (some with exceptional talent but not rare) of lower talent, whom they pay accordingly in a competitive market. The top companies are better at capturing the first group. It’s not some evil influence, it’s just natural progression. The social impacts are not good overall probably, but the solution is not to dumb down. Those who deride “financial engineering” (the use of mathematics beyond their comprehension) are arguing we should dumb down. Not a good idea.

          • John, thanks for the reply.

            I suppose you are accurate in saying that many folks use the term in a negative way, but I wasn’t necessarily doing so. Like any work, whether it’s part of the “real” economy or “financial engineering,” there are people doing good things and people doing bad things.

          • John,
            If you think that sophisticated financial engineering consists in using fancy Monte Carlo methods, and if you think that this type of financial engineering has helped make companies more stable, I’ll say that you do not obviously understand finance we’ll enough.
            Financial engineering has a more susbtantial meaning than using fancy math: it refers to the practice of using financial tools to massage a company’s true economic health, effectively a form of accounting, tax and regulatory arbitrage.

            And yes, I use financial engineering in derogatory terms because it has widely been abused and has been one of the causes of the financial crisis (contrary to your statement).

            You obviously have a mathematics background, not so much an economics one. You will probably disagree about my assumption, but it serves a point. You should be careful before making assumptions about other people’s gender and/or level of understanding of math, statistics or economics.

      • John,
        first of all, I am a ‘he’….

        Second, the companies that you quote like Apple prove my point about having a monopoly on some item in demand, so perhaps you have not understood my point. This is basic economics of competitive markets.

        Third, I do not think it is a matter of ideology to look at the data and, in agreement with other analysts as well, to conclude that margins have grown faster than revenues due to, among other things, cost cutting and financial engineering, including help from lower rates, etc …

        Fourth, the mix shift is an artifact of the S&P500 index construction, and is not indicative of a structural change in the economy. As such, it is subject to mean reversion once companies like Apple lose their margin advantage.

        Fifth, how many times do we have to read articles that try to claim that THIS TIME IS DIFFERENT?

        • Sorry about the gender displacement. Italians appear the only large culture that uses Andrea for male names.

          Margins have expanded. Cost cutting has been the primary driver. But what is “financial engineering”? Interest rates for high quality borrowers have been low since the financial crisis. What is strange about that? Businesses have responded exactly as one should expect.

          The idea of mean reversion is used completely without any valid statistical or logical basis in economics. It’s a myth. Mean reversion only applies to systems operating near equilibrium where all linearly independent basis functions have negative first derivatives away from equilibrium. The economy of a developed country is so far from equilibrium (subsistence level existence) that the concept of mean reversion is invalid.

          This time will always be different in economics because there is no stable equilibrium (except for subsistence, which changes constantly with population and real resource availability, and so is not a real equilibrium).

          Based upon short term (100′s of years) experience with stock markets, the 1990′s tech rise is easy to evaluate in hindsight as a true bubble, yet even if you never owned stocks before, there was a long period in the 1990′s when even just the S&P 500 total 5 year return was between 10% and 25% per year.

          If you bought the market in 1965 (S&P500) your 26 year total return was 4.5x your original investment. If you bought in 1974 it was 220x. That’s not explained by mean reversion.

          I bought Apple late in the recent run up, at $20, and sold it too early, around $220. I’ve had a hard time staying with stocks I’ve made at least 10x in over a number of years. But for most part I buy things where I understand and respect the technology and the larger scale economics. I’ve made plenty of mistakes, but I’ve had an annual compound return of about 14% for my 30 years of investing (compound rate determined by cumulative 30 year performance). (I missed much of the high end tail of the 1990′s market by bailing out early on many plays, and staying with some not so good ones, like GE).

          I think the current market is priced a bit high, but my experience is that this makes careful analysis more valuable.

          • If you think that margins and earnings per share can keep growing much faster than revenues for very long, or if you think that the stock market can grow much faster than the economy, than I agree, mean reversion is a myth. However, this is not what historical data show. The only element of discussion is about the time scale over which reversion to the mean occurs, and this can vary depending on the cycles. Historically, S&P500 long term returns have mean reverted over something like 15-19 years.

            • No, that’s not correct. The first period of the (quite sinusoidal actually) S&P 500/GDP is ca. 45 years. The second period (if you subtract out the late 90′s bubble and the 2007-8 crash, looks to have a similar period). But two periods of an oscillating function have no statistical validity.

              Much of economics appears populated by people who could not pass undergraduate level Statistical Mechanics. But people are happy use concepts from physics they don’t understand to back up their economic ideologies.

      • The vast majority of the people working for Apple products make very low wages in 3rd world countries. This is part of restraint on domestic hiring as reduced production reflects reduced demand, actually a restraint on profits. Robots, taxes, etc. as already mentioned aid greater profits but continue actual high unemployment. Competition for fewer jobs allows lower wages offered and is another reason for greater profits.

  5. So tax, interest and labor arbitrage will keep corporate profits high despite muted revenues.

  6. there is only one reason for structurally elevated margins. It is if the capitalism is dead (Andrea described it asan effective monopoly). Otherwise more firms will chase the margins. It is not for me to know if competition is being restricted by policy or otherwise. Plus I don’t want to sound like a zero hedge troll :). it is said that people discussing it as if these are theoretical constructs. If plumbing businesses start earning huge returns I’ll start a plumbing business. If it is IT all the smart kids will quit med and law schools and will chase IT startups.

  7. Two of the major factors cited by Deutchebank are government policies: taxation and interest rates. As long as the government does not try to increase the effective corporate tax rates and keeps the interest rates low, profits will be booming. Somebody already mentioned that the low interest rates are a form of financial repressions which leads to higher savings and redistribution of income from households to business. This will lead eventually to a decrease in the share of consumption and increase of the investment share. I don’t know if this is just an unintentional consequence or part of some bigger plan for restructuring of the US economy.

  8. Competition is the great equalizer. The cyclical nature of profit margins owes a great deal to the natural flow of companies operating freely in a competitive environment. The example above of Apple is a great one… creative company with perceived new product technology and large distribution. Competition salvates over Apple’s margin opportunity and over time begins to compete against Apple by offering similar product at lower price. Bang… Margins contract… Wash.. Rinse.. Repeat.

    I am sympathetic to the confusion around this idea of a new normal, of magical companies with bullet proof balance sheets operating with the unwavering support of an omnipotent Fed. Inarguably, the current administration has juiced both the equity markets and corporate profits by manipulating some of the “free aspects” of our free markets (interest rates, acct. rule changes, direct market purchases, etc). These are not long term changes to the structural reality of markets. They are temporary political gimmicks.

  9. If wages rise, margins will compress over the short-term… but if this is a long-term economic expansion, I would expect those higher wages to result in greater aggregate demand, greater sales, and ultimately higher nominal profits. Give and take. Since ’08 these mega corps have mainly only been “taking.”