Grantham Calls Corporate Profits Freakish
U.S. companies are the most profitable in more than 40 years, and some of the best-known stock pickers are divided over how long that will last.
Bob Doll, chief equity strategist at BlackRock Inc. (BLK), said low labor costs and cost-saving technology will allow companies to keep up their profitability. Jeremy Grantham, chief investment strategist of Boston-based Grantham, Mayo, Van Otterloo & Co., said margins will send stock markets tumbling when they eventually revert to their mean.
“The implication for the stock market is ugly, because it means earnings are unsustainably high,” Grantham’s colleague Ben Inker, GMO’s director of asset allocation, said in a telephone interview. GMO, an investment manager that oversees $93 billion, puts the fair value of the Standard & Poor’s 500 Index at between 950 and 1,000, compared with the 1,158.67 level at which it closed last week.
U.S. companies’ ability to squeeze more profit from each dollar of sales is pushing earnings higher, even as the economy has grown at a below-average clip since the recession ended in June 2009. Grantham, who called corporate profits “freakishly high” in an August commentary, sees wide margins as an aberration. Some of his competitors say changes in the economy and the way firms operate could keep them near peak levels for another year or two.
“We don’t think they have to fall,” Doll, whose New York- based firm is the world’s largest asset manager, said in a phone interview. BlackRock oversees $3.35 trillion.
Two forces that have lifted margins, a weak job market and investment in labor-saving technology, show no sign of reversing, Doll said. “We lean towards the optimistic side,” he wrote in a Nov. 21 note on the stock market’s prospects.
The margins of non-financial companies in the U.S., a widely used measure of profitability, reached 15 percent in the third quarter, according to data from Moody’s Analytics Inc. in West Chester, Pennsylvania. That was the highest level since 1969. When the recession ended in the second quarter of 2009, the comparable number was 8.7 percent.
Moody’s measures margins as total profits for non-financial companies divided by the contribution of those businesses to the gross domestic product. The number captures the results of a range of public and private companies and isn’t distorted by the big swings in earnings of financial firms, according Mark Zandi, the chief economist.
Those on both sides of the debate agree on two things: margins are unusually high and the driving force behind their rise is companies’ ability to keep a lid on expenses.
“Businesses have done a marvelous job of reducing costs,” Zandi said in a telephone interview.
The globalization of the workforce and a U.S. jobless rate of 9 percent last month have given management the upper hand in dealing with labor, Zandi said. Wages and salaries as a share of national income fell to 49.4 percent in the third quarter, the lowest since the government began collecting the numbers in 1948, Moody’s data show.
Companies, while slow to hire, have been upgrading technology.
Businesses invested in equipment and software at an annual pace of $1.15 trillion in the third quarter, up 26 percent since the fourth quarter of 2009, data from IHS Global Insight in Lexington, Massachusetts, show.
Profit margins have been bolstered by sales to faster- growing economies in Asian and Latin American emerging markets, which have helped companies offset weakness in the U.S. and Europe. American multinationals “are much less dependent on developed-market economies than they have been in the past,” William Stromberg, director of global equity research at Baltimore-based T. Rowe Price Group Inc. (TROW), wrote in a November newsletter.
Dennis Bryan is skeptical that the trends that have supported margins can continue. Bryan is co-portfolio manager of the $1.2 billion FPA Capital Fund (FPPTX), the top-performing diversified U.S. stock fund over the past 25 years, according to Chicago-based Morningstar Inc. (MORN) The fund gained 14 percent annually in the period ended Sept. 30, Morningstar data show.
Firms may be reaching their limit in wringing out costs, after two years of rising margins, Bryan said in a telephone interview from Los Angeles.
“Will companies be able to keep tightening their belts by cutting millions more Americans out of the workforce?” he said.
Profit margins have been trending higher since the mid-1980s, said Chris Christopher, an economist at IHS (IHS) Global Insight, who has written on the subject. Quarterly margins peaked at 11.9 percent in the 1980s, 13.6 percent in the 1990s and 14.5 percent in the most recent decade, Moody’s data show.
The S&P 500 returned an annual 20 percent over five years after margins peaked in the second quarter of 1984. It fell an annual 1.6 percent over five years after margins hit a high in the third quarter of 1997, and declined 1.2 percent a year after the third quarter of 2006, the peak for margins in the most recent decade.
Sales growth may slow as economies around the world lose steam, Bryan said. The International Monetary Fund trimmed its forecast in September for global economic growth through 2012 and said Europe and the U.S. risk re-entering recession if they fail to solve their financial problems.
When margins have peaked in the past, they have typically fallen over the following five years, Bryan told investors in his third-quarter newsletter.
“We expect a lot of profit disappointments coming our way,” he wrote.
Grantham also believes in mean reversion, the notion that most measures drop back to their historical norms over time.
‘The Great Threat’
“Lower margins are the great threat to market performance,” he wrote in the August newsletter. Grantham is known for his bearish investment outlook and for his successful record in identifying stock-market bubbles.
Margins have been propped up by a “great surge” in government spending that fueled consumption, Grantham said. As political pressures force the U.S. to cut its budget deficit, the economy will suffer and margins will drop, Grantham predicted without laying out a timetable.
GMO expects U.S. large-capitalization stocks to return 1.8 percent a year above inflation over the next seven years, according to its website.
With job growth likely to remain “sluggish” and interest rates low, rising costs are no threat to profits, said BlackRock’s Doll. If the U.S. economy continues to “muddle through” at the growth rates the country has achieved the past two years, sales should hold up as well, he said.
“We didn’t need a strong economy to get margins high,” Doll said. “Why do we need a strong one to keep them high?”
Here to Stay
Cloud computing, which provides access to software and computing tasks remotely over the Internet, rather than through a company’s own system, is just the latest tool corporations can use to keep costs in check, Sinai said.
“This is the way of the world now,” he said in a telephone interview. “CEOs are paid to maximize profits.”
Cisco Systems Inc. (CSCO) CEO John Chambers said in a Nov. 10 interview with Betty Liu on Bloomberg Television’s “In The Loop,” “We are all over our gross margins, the whole company is focused on that.”
Gross margin, Cisco’s fraction of revenue left after subtracting the cost of goods sold, fell to 61 percent in the third quarter from 63 percent a year earlier, even after the San Jose, California-based company eliminated jobs and scaled back operating expenses.
Analysts have reduced their estimates for 2012 sales growth among S&P 500 Index companies, after the biggest annual sales increase since at least 1993 this year.
Revenue for the firms in the index will climb 3.9 percent in 2012, based on the average estimate of more than 10,000 forecasts compiled by Bloomberg earlier this month. Sales will surge 11 percent in 2011, according to the analysts.
Grantham said of profit margins, “They do not seem to be connected to economic realty.”
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