Wednesday, October 17, 2007

A random musing: profit margins

Much of the recent thoughts as to why we are heading towards a bear market - other than the usual phalanx of bears arguing the "edge of recession" - have centred on the extraordinarily high level of profit margins, arguing that this can't go on forever. As put succinctly:

"Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly."
- Renowned Investor Jeremy Grantham

In essence, the bears argue that while the "PE" looks fine, the "E" in "PE" is bogus, and not supported by sustainable metrics. However, most marketplace observers cannot offer a compelling reason why margins have continued to grow (although there is some rationale offered here that makes some sense) at the back end of a long bull market. While I have no doubt that the lengthy margin expansion will reverse at some point, I wonder if corporate conservatism is having some impact.

That is, typically during most other bull markets, fat profits led company managers to buy into so-called "complementary" (not really!) businesses through buyouts and mergers, with poorly focused conglomerates emerging. This, I suspect, led to much poor business practice, including a focus on revenues, instead of contribution to the bottom line - i.e. margins that are accretive to earnings.

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However, the business mantra today is single-minded focus, "the mission" of the business if you will. Not much room for sloppy, drunken, buying binges that are covered up by growing ill-thought-out revenues, even at the expense of declining earnings and/or margins. Today, excess cash is more often deployed through share buybacks and, to a lesser extent, cash dividends.

With that thought in mind, I wonder if the button-down managers of today are primarily responsible for continued profit margins at extraordinarily high levels? And if so, for how long will they be able to keep up the admirable restraint before they, as a managerial collective, feel compelled to sow the seeds of their managerial genuis?


The Confused Capitalist

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