A new report from Grantham Mayo van Otterloo (GMO) entertains a startling conclusion. The report is on the level of corporate profit margins in today’s economy and seeks an explanation to their height. Profit margins for corporations are at an all time high in a data set that extends back to the nineteen fifties. ValueWalk analyzed this issue recently, based on similar research from Oppenheimer.
The report, though complex in its analysis, is simple in its conclusion. The report suggests that the height of profit margins at this time will be balanced out in the future by much lower returns. That conclusion may seem overly simplistic but the economic model behind it is stringent. It is certainly a suggestion that should be taken seriously by investors as the S&P 500 (INDEXSP.:INX) heads for it’s 52 week high in its current rally.
Since the economic crisis profit margins for corporations have stretched above 10%, an amazing return and one never seen before. This has had many wondering as to the cause of the wide margins, given the sluggish performance of the economy. James Montier wrote the white paper available here concluding in the fall in corporate profit margins in the future. GMO generally adheres to the mean reversion theory which states that without any structural change in the long run performance will return to an average expected level. Taking this assumption in order for corporate profit margins to have increased to this extent there must either have been a fundamental change in the economy or simply factors applying temporary upward pressure that will be opposed in future.
Montier does not see a fundamental change and his analysis of the mechanisms of the upward pressure paint a chilling picture. Put in simplistic terms, the paper itself uses complicated models to illustrate the point, Montier found that the biggest driver of profit margins has generally been investment. Since the beginning of the economic crisis the investment from the private sector, households, has declined and that slack has been picked up by government investment. While the government spending is at the moment keeping those margins high they cannot stay that way forever. The government’s debt burden is becoming troublesome and the deficit will have to be reduced or eliminated in the near future. Once this happens government side investment will fall. Unless the lag is picked up by private investors, and its unlikely they’ll be able to step in as quickly as the government can step out, investment as a whole drops suddenly.
In Montier’s view this means the margins drop at some point after that.. Certainly food for though, particularly as companies like Apple Inc (NASDAQ:AAPL) post incredible margins.