The Danger of Peak Profits

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One of the vulnerabilities in today’s market is that profit margins are near peaks. Investors tend to like companies with fat profit margins, but high profit margins are like honey pots that attract competitors. They are rarely sustainable for long.

But what is more important for stock prices is not the profit margin itself, but the direction they move. Rising profit margins goose stock prices in wonderful ways, but declining profit margins are a tough anchor to overcome.

The problem today is that most of the big blue chips report record profit margins, as Horizon Management pointed out in a recent research note.

Here is a list of the profit margins of the top 10 technology stocks of the NASDAQ 100 by market cap. They represent more than 40% of the NASDAQ 100.

“The average net profit margin is roughly 25%,” Horizon observes, “which is without any historical precedent whatsoever.”

This, then, is the Achilles’ heel of the market as far as the fundamentals go. Profit margins are extremely high and unlikely to stay there, which ought to lead to earnings disappointments down the road. It was no surprise that Cisco Systems fell 16% in a day after the market fretted over weakening profit margins at the tech giant. The following chart puts today’s profit margins in the context of the last decade. You can see that margins of the CBOE Technology Index are very close to record highs.

This phenomenon extends well beyond just the tech set. As Horizon points out, the same thing is in evidence in the S&P 500, which is a broad measure of the overall market. Let’s look at the top 50 market caps in the index. This includes a mix of companies such as Chevron, GE and DuPont.

What do we find?

Horizon notes:

“There are quite a few companies with very high absolute profit margins. For example, Apple, Coca-Cola, Oracle, Schlumberger, McDonald’s, Occidental Petroleum and Freeport-McMoRan Copper & Gold all have the common feature of after-tax net profit margins well in excess of 20%… In general, a 20% profit margin for any company is a historical rarity.”

This is important because many investors seem to be banking on the idea that such companies will enjoy fat margins in perpetuity.

In some ways, the surge in profit margins is what you would expect to see in the early phases of a recovery. Companies cut costs going in a downturn. Then, as sales rise, there is a big boost to the bottom line, as costs have yet to catch up.

Today, though, I doubt many of these firms have much more to cut. Instead, the focus is now growing sales and taking business from competitors or defending an existing business. The focus, too, is how to deal with rising raw material costs. All of these put enormous pressure on margins. We should expect to see them fall.

So perhaps the valuations of many of these stocks – often with price- to-earnings ratios between 12-16 – are more spot on than they appear if you assume falling profit margins, falling returns on equity and the like.

As an investor, I think it is better to focus less on what profit margins are today and more on where they will go in the future.

Titanium Metals (NYSE:TIE), Methanex (NASDAQ:MEOH) and Chart Industries (NASDAQ:GTLS), to name three stocks I recommended in my investment letter, Capital & Crisis, all had reported profit margins on the very low end of their historic ranges when I recommended them. But profit margins have since rebounded greatly, and each of these stocks has more than doubled. Even now, profit margins have room to grow and are nowhere near peaks.

Of course, each of these stocks rose for reasons other than just improving profit margins. The stock market overall has gone up quite a bit, lifting all boats to some extent. It is hard to isolate any single factor. Nonetheless, I think the point is that where profit margins are headed is more important than where they are. It’s like hockey great Wayne Gretzky’s advice: “Go where the puck is going to be, not where it is.”

For the market overall, profit margins are likely headed south. Those that can maintain or increase their profit margins will be the exceptions. Finding them, though, could mean the difference between a winning investment and a losing one.

Regards,

Chris Mayer
For Daily Reckoning Australia

Chris Mayer
Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.
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