Author Topic: "normalized" profit margins  (Read 838 times)

perulv

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"normalized" profit margins
« on: June 25, 2020, 10:56:41 PM »
In this post the argument is that "if we normalize profit margins (...), we can see that stock prices today are more expensive than they were 20 years ago at the peak of the Dotcom mania." And that the profit margins could/should revert to mean.

These are not new thoughts, but I would like to have my thinking validated (or invalidated) by people here on the forum:

  • Is is not reasonable to argue that some (groups of) companies today can/will/should have a permanently higher profit margin that was normal earlier? Typically FAANG type companies. Or at least that such companies are more common now than earlier? Software eats the world, software scales.
  • An on average lower interest rate gives lower discount rate for DCF which means that a higher multiple now than earlier is "correct"?   

I am not arguing if todays valuations are too high or not, but just trying to see if this thinking makes sense. Would it be correct to say that ignoring these two factors makes us miss opportunities to invest in "wonderful companies at fair prices", because we fail to see that the price is indeed fair?


thowed

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Re: "normalized" profit margins
« Reply #1 on: June 26, 2020, 02:34:38 AM »
Thanks - I think these are interesting thoughts and ripe for debate right now.

As a non-expert who relies mostly on common-sense, I'd agree with your second point, but not your first.  The second point from memory is kind of what Buffett said a few years ago that equities weren't expensive if rates stayed low.

The first point... I see the argument for it, but I suspect that society usually finds a way to curb obviously monopolistic profits (which is basically what they are), either through break-ups, nationalisation, taxation etc.

It will be slightly different in different regions e.g. the US has been fairly comfortable with monopolies for the past 20 years, something I find ironic given that it is in so many other ways more capitalism-friendly than other regions.  Europe leans more towards break-ups/fines and being on the side of the consumer.  China - is more of an unknown but we've seen them step in on Tencent & game companies when they don't like what they're doing.

It's a hard one to call, as the 'Age of Software' is so new.  I appreciate that once you've got a system embedded in your business, it'll be a pain to change it, but maybe IT will evolve, if only for reasons of capitalism, so that rival products are roughly compatible with each other (to make it easier to switch).

Finally, the last bit about potentially missing opportunies - agreed, though I think one must also think of the Howard Marks idea of sentiment as well - how optimistic/pessimistic are people about these stocks.  It feels like expectations are quite high at present.

Look forward to other views.

Cigarbutt

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Re: "normalized" profit margins
« Reply #2 on: June 26, 2020, 06:10:54 AM »
^"And that the profit margins could/should revert to mean."
Looking at GAAP earnings, it does feel like corporate profit margins have remained high.

But the link is not about mean reversion of profit margins as the author shows that NIPA corporate profits are at the same level as 2010 and margins have reverted to the mean.
i think the article suggests that investors, as a group, have decided to pay a higher multiple on the same amount of profit. We may have reached another permanent plateau but this is about a different question.
A secondary point that the author is making (IMO) is that corporate profits were lower than average around the dot-com era and, normalizing that part, it could be argued that stocks were relatively less 'expensive" then.

There was this thread about profit margins before:
https://www.cornerofberkshireandfairfax.ca/forum/general-discussion/a-permanently-high-plateau-for-profit-margins/

SharperDingaan

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Re: "normalized" profit margins
« Reply #3 on: June 26, 2020, 06:27:54 AM »
'Normalized' means current conditions more or less the same as recent history; under Covid-19, this just isn't true anymore.
Q2 economic activity looks nothing like that of Q1. Most would expect the next 12 months under Covid-19, to look nothing like the last 12 months.

Sure, a lower discount rate will raise valuation. But the timing of the future cash flow is so uncertain that it more than offsets it. Smaller cash flows later than expected, really screw up your day.

Permanent higher margin is a stretch.
Most would expect that the Texas funeral business is likely to boom over the next 12 months, maybe the boom triggers consolidation into more efficient (higher margin) funeral homes, but once everyone is dead? High margin on zero business, is still a net zero.   

SD




« Last Edit: June 26, 2020, 06:31:05 AM by SharperDingaan »

TwoCitiesCapital

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Re: "normalized" profit margins
« Reply #4 on: June 26, 2020, 11:49:20 AM »
^"And that the profit margins could/should revert to mean."
Looking at GAAP earnings, it does feel like corporate profit margins have remained high.

But the link is not about mean reversion of profit margins as the author shows that NIPA corporate profits are at the same level as 2010 and margins have reverted to the mean.
i think the article suggests that investors, as a group, have decided to pay a higher multiple on the same amount of profit. We may have reached another permanent plateau but this is about a different question.
A secondary point that the author is making (IMO) is that corporate profits were lower than average around the dot-com era and, normalizing that part, it could be argued that stocks were relatively less 'expensive" then.

There was this thread about profit margins before:
https://www.cornerofberkshireandfairfax.ca/forum/general-discussion/a-permanently-high-plateau-for-profit-margins/

NIPA is for ALL companies in the country, correct? Useful information for sure, but less when discussing the valuations and profitability of public companies specifically. I believe S&P 500 margins were still massively elevated pre-COVID. Somewhat off their peaks, but nowhere close to 2010 levels.

This is due to
1) tax reform (which is reversible and becoming more likely) and
2) the tolerance for anti-competitive practices and consolidations in mega-corps (which is also reversible and becoming more likely IMO).

If the only thing supporting higher valuations was investor sentiment and a willingness to pay more, I'd argue that's the easiest of all factors to reverse.

U.S. stocks were expensive pre-COVID. This crisis is just going to make that glaringly obvious and once again everyone will agree in hindsight.


In this post the argument is that "if we normalize profit margins (...), we can see that stock prices today are more expensive than they were 20 years ago at the peak of the Dotcom mania." And that the profit margins could/should revert to mean.

These are not new thoughts, but I would like to have my thinking validated (or invalidated) by people here on the forum:

  • Is is not reasonable to argue that some (groups of) companies today can/will/should have a permanently higher profit margin that was normal earlier? Typically FAANG type companies. Or at least that such companies are more common now than earlier? Software eats the world, software scales.
  • An on average lower interest rate gives lower discount rate for DCF which means that a higher multiple now than earlier is "correct"?   

I am not arguing if todays valuations are too high or not, but just trying to see if this thinking makes sense. Would it be correct to say that ignoring these two factors makes us miss opportunities to invest in "wonderful companies at fair prices", because we fail to see that the price is indeed fair?

I think FAANG type stocks have been the beneficiaries of a lot of the trends I just mentioned above. Lower taxes, globalization, investor sentiment, anti-competitive consolidations, "free" capital, etc. All of this in addition to superior business models.

While the superior business models will help them survive in the long run, a reversion of any, or multiple, of these factors will dramatically impact their realized returns on a forward basis and I don't own then for that reason.
« Last Edit: June 26, 2020, 11:51:50 AM by TwoCitiesCapital »

perulv

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Re: "normalized" profit margins
« Reply #5 on: June 28, 2020, 10:37:15 PM »
Regarding #1, higher profit margin. I have little to none formal business/economics education, so perhaps some of you can help me here: I have a hunch that there might be some rule on the proverbial first page of every book on the subject, that says that if a business/industry have such a high margin, competition will make this go away? Which I think is the point several of you mention. That if there is such a "permanent" high profit margin in e.g. FAANG type companies, healthy competition etc should remove/ normalize this?


TwoCitiesCapital

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Re: "normalized" profit margins
« Reply #6 on: June 29, 2020, 09:44:42 AM »
Regarding #1, higher profit margin. I have little to none formal business/economics education, so perhaps some of you can help me here: I have a hunch that there might be some rule on the proverbial first page of every book on the subject, that says that if a business/industry have such a high margin, competition will make this go away? Which I think is the point several of you mention. That if there is such a "permanent" high profit margin in e.g. FAANG type companies, healthy competition etc should remove/ normalize this?
[/quote

Yes. One of the main tenets of economics is that competition drives out profit. More competition would erode the competitive advantage of FAANG type companies; however, that competition has been limited because the FAANG type companies were allowed to consolidate all potential competitors after becoming dominant in their respective fields. 

Think of Google - Google was the largest search-based advertiser which was what was grown organically. But then they used acquisitions to become the largest flash/banner advertiser (DoubleClick), the largest video advertiser (YouTube), and the largest mobile advertiser (AdMob). This was incredible for the shareholders and Google essentially locked down an advertising monopoly for all things internet with the exception of social media.

Facebook was allowed to do similar things with their acquisition of Instagram and WhatsApp despite already being a very dominant force in social media and messaging.

This is exactly the type of thing that regulators were trying to prevent when they busted up on Microsoft back in the late 90s and gave them trouble for using that position to better position other Microsoft properties like the Internet Explorer web browser. This time around, regulators have shown little concern, but if they ever do it will get much more difficult for Google to maintain margin in the face of competition.