There is quite a debate going on in the world of economics in regards to profit margins. On one side of the debate we have those who believe that elevated profit margins are unsustainable and on the other side we have those who believe that not only are they sustainable, they can go higher. It’s important because most of our assumptions that make up our expected returns are in some form or fashion based on profit margins.
A basic law of economics…or logic for that matter is that in a functioning economy excess profits bring competition. If I create a company and it is able to make excess profits, it will attract competition, which will likely compress those excess profits. I’m not the only one who thinks this, those who are considered legend do as well:
Warren Buffett, 1999
[F]rom 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.
In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.
– Warren Buffett, Mr. Buffett on the Stock Market (November 1999)
Jeremy Grantham, 2006
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.
– Jeremy Grantham, Barron’s (c. 2006), via Katsenelson, The Little Book of Sideways Markets.
This brings us to the present day debate which I present from the blog Philosophical Economics (PE) and the blog run by Lance Roberts at STA Wealth Management. The PE blog is the one that irks me the most, but not for the reason you may think. While every fiber of my being wants to disagree with the ideas presented (essentially that profit margins are high and will remain so, potentially going higher and thus justifying high valuations) the post is well written and actually corresponds to what Jeremy Grantham is saying above – “If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” I’m not convinced PE blog is wrong because I’m not convinced something isn’t wrong with the system.
With that said, I still find it hard to believe that healthy competition in many markets doesn’t exist and that this should at some point in the a cycle act to lower profit margins.
The two blog posts I’m referring to are as follows:
50% Profit Growth And Historical Realities (STA Wealth Management)
Profit Margins: The Epicenter of the Valuation Debate (Philosophical Economics)
I’ll likely post both to this blog in their entirety later this week.
Scott Dauenhauer, CFP, MPAS, AIF