One of the most heated debates among investors is the question of whether corporate profit margins can maintain their elevated level, or whether they will inevitably revert to mean.
Here’s a quick look at S&P 500-stock index profit margins, for example, going back more than 25 years. They remain high by historical standards.
A new note from Goldman Sachs Group Inc. analysts led by Sumana Manohar looks at the bull and bear arguments for the profit margins debate.
Manohar argued that profit margins have expanded, thanks to four key trends: strong commodities prices, emerging market cost arbitrage (companies making things more cheaply in emerging markets), demand growth from emerging markets, and improved corporate efficiency driven by the use of new technology. Continuing one of its major analytical themes of recent months, Goldman also noted that the market has rewarded companies that have undertaken mergers and share buybacks, as opposed to companies that have invested internally, further bolstering margins.
So will profit margins inevitably roll over?
Goldman went through both sides of the argument. On the bull side, the bank said that ongoing consolidation in industries, cost deflation, and tighter purse strings help keep a floor under margins. Ultimately though, it found that the above trends, coupled with weak demand and general industrial overcapacity, mean that margins are likely to come down.
But what if margins stay elevated? That too is possible, and its implications could be unsettling.
Goldman wrote: “We are always wary of guiding for mean reversion. But, if we are wrong and high margins manage to endure for the next few years (particularly when global demand growth is below trend), there are broader questions to be asked about the efficacy of capitalism.”
In other words, profit margins should naturally mean-revert and oscillate. The existence of fat margins should encourage new competitors and pricing cycles that cause those margins to erode; conversely, at the bottom of the cycle, low margins should lead to weaker players exiting the business and giving stronger companies more breathing space. If that cycle doesn’t continue, something strange is taking place.
Needless to say, it’s not every day you see a major investment bank say it might have to start asking broader questions about capitalism itself.