- Corporate profit margins have been on an unsustainable growth trajectory and are now poised to unwind, according to Rob Almeida, the global investment strategist at MFS Investment Management.
- In a recent interview with Business Insider, he laid out why his colleagues have expressed this concern, and how he is investing for this eventuality in the portfolio he manages.
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Rob Almeida is in constant communication with various portfolio managers from his perch as the global investment strategist at MFS Investment Management, which oversees $US489.5 billion in assets.
One of the most common concerns they relay – and one he agrees with – is that corporate profit margins are unsustainable.
Almeida and his colleagues are leery of the disconnect between record-high profit margins on one hand and average revenue growth on the other. Gross domestic product growth has also lagged far behind the pace of profit-margin expansion – and it’s a sign to them that something is wrong.
“Absent some sort of normalization upward in the economy, this has to come down,” Almeida said of margins during a recent interview with Business Insider.
The firepower behind soaring margins has consisted of financial engineering tactics that companies use to improve their numbers, Almeida said. These include share buybacks, cost controls, leverage, and other things he calls “non-core-business levers.”
For example, companies have been able to simultaneously maximise margins and keep shareholders happy by keeping their costs in check.
“We generated above-average margins not by selling more and better dishwashers, but through cost optimisation,” Almeida said.
The heyday of such tactics is coming to an end, in his view.
That is because costs are rising, particularly the cost of labour as companies come under pressure to invest more in their employees.
Against this backdrop of rising costs, companies have the option of raising prices.
But that’s not an easy proposition due to technology. It has lowered the barrier of entry for many business models and made mass production easier. It has also improved price discovery, such that customers can always purchase at the lowest price and sellers can easily undercut their competitors.
Companies could also make up for higher costs by selling more products. However, this move equally depends on the demand pull from consumers – and there’s no guarantee of a resurgence on that end.
Preparing for a profit slowdown
While Almeida has clearly mapped out the road to lower profit margins, he is less certain about whether the reckoning will be an outright earnings recession. It could look more like a slog of slow earnings growth that jolts investors out of companies with the weakest value propositions and into those with the strongest.
“You’ve seen a lot of that incrementally this year, and I think that it picks up,” Almeida said.
In addition to being the global investment strategist, he is lead portfolio manager of the MFS Diversified Income Fund. The fund has returned 10% and bested 96% of its peers over the past year, according to Bloomberg data.
What’s worked includes shedding dividend-paying stocks and high-yield bonds, where he has an “almost maximum underweight,” and allocating capital instead to Real Estate Investment Trusts.
REITS, Almeida said, have not pulled the same kind of financial levers that companies in other sectors have to maximise their profit margins. He also likes the sector because housing is an income-producing asset that is not as easy to duplicate as other consumer products.