Profit Margins – Behind the Curtain

Profit margins are an important component of market valuation and are therefore a hot topic because the damn things won’t do what they are supposed to and mean revert.  As several writers have explained, the valuation arguments for U.S. stocks (bull and bear) hinge on the future of profit margins (my favorite pieces are by James Montier here and by “Jesse Livermore” here).  Bears say that margins are long overdue for a serious mean reversion, and that such a reversion would result in very low real rates of return over the next 5-10 years.

But everything I’ve read addresses margins at the market level, when we should be diving deeper to the sector level.  Comparing margins today to margins 50 years ago may be misleading, because the mix of businesses contributing to the market’s overall margin has changed considerably. There are very interesting trends within the 9 economic sectors (not including financials here), and their contribution to overall market margins have changed a lot over time. In particular, the contribution from the technology sector (with sustained high margins) to overall margins has grown steadily while contribution from the Materials sector (whose margins exhibit strong mean reversion) has fallen.  Here is the historical profit margin for all U.S. stocks (line in black) and the contribution to that overall margin from each economic sector. Notice the expansion of Info Tech and the shrinking of Materials.

It could be that businesses that are less labor intensive—like technology companies—produce sustainably higher profit margins. As their overall market share and earnings share (sales and earnings as a percent of total, previously discussed here) continue to rise, profit margins might stay higher than they have been in the past. 

Information Technology stocks contributed just 3% of the overall profit margin in 1963 (6.42% profit margin * 2.7% sales market share for the sector / total market profit margin), but tech stocks contribute nearly a quarter (23.3%) of today’s total profit margin.  

Apple is obviously a huge part of this trend.  Even with all its retail stores, Apple only has 84,000 employees.  That means Apple generates about $2M in sales per employee and nearly $500k of profit per employee.  Whole Foods has a similar amount of employees (78,000) but generates $164k in sales per employee and $7k in profit per employee.  Target—a very labor intensive business—has 360,000 employees, generates $200k in revenue/employee, and generates just $7k in profit/employee.  In addition to offering lower margin products, companies like Target have to deal with a much higher payroll tax burden than companies like Apple.

As Martin Ford says in his book The Lights in the Tunnel: Automation, Accelerating Technology and the Economy of the Future:

We can place any industry somewhere on the spectrum that runs from being extremely labor intensive to being highly capital intensive. In our current economy, some of the most labor intensive industries are in the retail, hospitality and small business sectors. Supermarkets, retail chain stores, restaurants and hotels all have to hire lots of workers. Capital intensive industries, on the other hand, hire relatively few workers and instead require investment in technology: in advanced machinery and equipment and in computerized systems. High tech industries such as semiconductor manufacturing, biotechnology and Internet-based companies are all capital intensive. Over time, as technology advances, most industries become more capital intensive and less labor intensive. Technology also creates entirely new industries, and these are nearly always capital intensive.

Might this evolution of business mean that profit margins will stay higher than the historical average? The James Montier paper referenced earlier gives the most compelling case that margins will mean revert, but perhaps margins will fall less than bears are expecting them to.  Except for the massive reversal during the internet/tech bubble, Technology margins have been much higher than the market and they’ve been gaining market and earnings share steadily.

Tech stocks’ market share moved from 2.6% in 1963 to 12.1% in 2014, and their earnings share moved from 2.7% to 23.1% over the same period.  The tech sector has grown to be a larger part of the economy, and a larger part of the market’s profit margins.  It is therefore also a larger part of the market’s valuation. High margins in the tech space may persist or they may not. Either way, arguments about the overall market’s margin–and its prospects for the future–should center around the businesses that contribute to that margin, not just about margin levels in the past.

Here are a few other interested trends. Consumer staples have not exhibited the same mean reversion in profit margin that we see for the market as a whole but consumer discretionary stocks are wildly cyclical (as expected).

Resource stocks—materials specifically—appear to have the most consistent margin mean reversion.

Note: for this post I used Compustat data throughout. I include all U.S. domiciled stocks with an inflation adjusted market cap greater that $200M, so it is a larger universe than the S&P 500 alone. Margins are just the sum of net income (at the sector or market level) divided by the sum of sales.