Almost every corporate profit margin chart you’ll see since the financial crisis will share one characteristic: they go up.
Ever since the financial crisis, corporations have managed to deliver robust profit growth by offsetting the drag of weak sales growth with widening profit margins. These fatter profit margins come from cutting costs, which usually means getting more productivity out of a fewer number of workers.
With profit margins at historic highs, there are plenty of very smart folks warning that these margins will revert to a mean, which could also come with tumbling profits.
However, Morgan Stanley’s Adam Parker joins a handful of experts who believe profit margins, at least for those companies listed in the stock markets, are on a long-term upswing.
While most margin bulls focus on company specific structural changes like lower tax rates, falling interest costs, and less pressure on wage costs due to the waning of labour unions, Parker focuses 1) the resilience of the mega-cap behemoths and 2) the fact that margin mean reversion for small-cap companies mean rising margins. From Parker (emphasis ours):
…Why do we think margins can remain elevated? This will become clear if you look at net margins for US companies broken into four cohorts by market capitalisation (Exhibit 12). Mega cap companies (the largest 50 by size) have been able to pull their margins away from the smaller companies through globalization, productivity, scale, cost of capital, and taxes, among other reasons. We argue against frameworks that call for near-term mean reversion and base equity return algorithms off the concept of overearning. Why? The margins for the mega cap cohort in the last two downturns of 2001 and 2008 were well above the HIGHEST margins achieved during the 1974-1994 period. To us, this is a powerful indication that the mega cap cohort is unlikely to mean revert back to the 1970s to 1990s average level. Further, what probably isn’t universally known is that small cap margins are below their long-term average today. If our house view is correct — that this turns out to be one of the longest expansions ever — then we don’t see why small caps that still have low margins can’t also ascend over the next several years. In the end, our suspicion is that margins remain elevated for some time. As noted above, mega caps benefit from globalization, productivity scale, cost of capital, and lower taxes, among other phenomena, that have led to this 20-year trend of increased profitability vs. small companies.
Like others, Parker also acknowledges that companies have moved a lot of their operations to low-cost countries. Additionally, many of the biggest corporations are like Google, which carry no inventory and therefore their cost structures are very lean.
But Parker nevertheless acknowledges that margins can’t just go straight up forever.
“Ultimately, however, it is likely that margins will experience some mean reversion, and that is our base case on a ten-year view, but we do not think margins will revert all the way back to the long-term average,” he writes.
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