INVESTMENT INTELLIGENCER

Jason Trennert Responds: High Profit Margins ARE Sustainable

A few weeks ago, I took issue with Jason Trennert's argument in Barron's that today's P/Es were "low."  I felt that, like many other analysts, Jason had not taken into account the likelihood that today's record-high profit margins would eventually revert to the mean.  Here, Jason responds directly to that criticism:

I very much enjoy this website but I hope you don't mind, as one of its subjects, my posting a comment or two on your critique. Your point on margins is well-taken, but your readers should understand that that there is limited time and space to discuss all the nuances of one's views in such interviews, especially when speaking about something as broad as the stock market. I was unfortunately not asked about profit margins in my interview with Barron's but, as any one of our clients knows, we have written extensively about the subject.

There are many astute market observers that have rightfully pointed out that profit margins have been mean-reverting in the past. Although it's always dangerous to say it's different this time, it seems clear to us, after nearly three years of profit bears claiming that the end was nigh, that something has changed.

In our view the the double-barrelled secular changes of technology and globalization have made margins stickier, longer than the consensus would have ever thought possible. This is simply because companies have a better chance of arbitraging unit labor costs today than they have ever had in history. Labor costs comprise about two-thirds of total costs for the average company. With a seemingly limitless supply of labor in India and China, there has never been a better time to be an owner of a business or for companies to maintain margins. This has also been true, to a remarkable extent, in the service sector. Goldman Sachs' third largest branch office, as an example, is now in Bangalore. The greatest risk to profit margins, therefore, is not labor unrest, as it might have been in years past when labor markets were less fluid, but political efforts aimed at slowing the forces of globalization.

In the hope of prompting an additional thoughtful response from Jason (or another reader), my concern with the argument above is that it doesn't explain why companies won't begin to pass through these labor savings to customers, in the form of lower prices.  For a temporary period, the companies that are the first to exploit lower labor costs will benefit from higher margins and lower prices than their competitors, but over time, the competitors should follow suit--until outsourcing labor to Asia and India becomes not a competitive advantage but a competitive necessity.  Also, companies should begin to take market share by reducing prices, which will also put pressure on margins. 

So, bottom line, I agree that the massive reduction in labor costs from globalization should drive temporary margin gains (which I think we're seeing), but I don't understand why this should be expected to continue indefinitely.

Warren Buffett: Buy Low-Cost Index Funds

The Oracle delivered some secrets of intelligent investing in a press conference following the Berkshire Hathaway annual investor meeting:

• Buy low-cost index funds, which will outperform the majority of other investors (the vast majority).
• Avoid hedge funds.

Buffett also said he hoped that Berkshire would outperform the S&P by a couple of percentage points (which wouldn't be surprising, given the value effect).  He added that he would be "amazed" if Berkshire did any better than that.

Easterling: Earnings Do Not Grow 6% Every Year In Perpetuity

The seemingly prudent consensus these days is that corporate earnings growth will slow from the torrid double-digit pace of the last few years and settle in at a more normal rate of, say, 6% per annum (the long-term average).  Alas, this consensus is anything but prudent.

As fund-of-funds' manager, analyst, and SMU adjunct professor Ed Easterling writes, earnings just don't behave that way.  Yes, they average about 6% a year (6.6% in Ed's 80-year model).  But they achieve this average by shooting up for 3-5 years, collapsing for 1-2 years, shooting up for another 3-5 years, and so on.  In other words, for all of recorded history, earnings have followed a 3-steps-forward, 2-steps-back pattern, not safe, smooth trend-line growth.

So, what's the problem?  Well, as previously discussed, profit margins--"one of the most mean-reverting series in finance" (Jeremy Grantham)--just hit a 50-year high of 14% of GDP, as compared to the 9% average.  As Ed Easterling points out, profits have also now grown strongly for 5 years in a row.  According to Ed's data, there has been only one business cycle since 1950 in which profits grew for more than 5 years in a row (in the late 70s).  In the sixth year of that expansion, moreover, growth was miniscule, and in the following two years, it collapsed--taking the stock market to a 16 year low. 

As of this writing, meanwhile, "prudent" forecasters are expecting profits to continue to grow for not only 2007 but 2008--what would be the 7th year in a row.  Is this possible?  Anything's possible.  Is it likely?  A review of the business cycles of the past half-century suggests the answer is an emphatic "no."

If, instead of setting a record for consecutive years of impressive growth, earnings behave the way they normally do--collapse for a year or two--what is the stock market likely to do?  Happily deliver another two years of low-volatility, near-double digit growth?  We could do that math, but then we might be accused of always being the bearer of bad news. 

 

 

Mauboussin: Why the Market is Smarter Than You Are

Most people who write about the wisdom of crowds offer colorful anecdotes about crowd intelligence but don't explain why groups are smarter than individuals.  In a recent piece, Explaining the Wisdom of Crowds, Legg Mason strategist Michael Mauboussin solves this mystery.

Drawing on a book by Scott Page (The Difference) and some of his own experiments at Columbia Business School, Mauboussin first observes that, in order for crowd wisdom to prevail, several conditions must be met:

• The group must be cognitively diverse (the individuals in the group must have different approaches to analyzing and solving problems).
• There must be a way to aggregate each individual's opinion into a collective view (such as a stock market).
• There must be incentives: rewards for being right, punishment for being wrong.

In most cases, the stock market easily satisfies all three conditions.  (Mauboussin has argued in the past that part of what happens during bubbles is that there is reduced cognitive diversity, as most investors begin to think and invest alike). 

Mauboussin then describes three distinct types of situations in which groups are wiser than individuals. In the first, the "needle-in-the-haystack," a subset of the group knows the correct answer, but the majority does not (Mauboussin uses the example of the audience on Who Wants to Be a Millionaire).  Here, the crowd's "best guess" is superior because the subset of people who know the answer ensure that the correct answer is the most popular choice (everyone else's guess is random).

In the second and third cases, which are closer to the situation in the stock market, no one in the crowd knows the correct answer, so it must be estimated.  (In the stock market, no one knows what stocks are worth because the valuation process is subjective and because the key variable--future cash flows--is unknown).  In these cases, Mauboussin attributes the crowd's wisdom to Page's "diversity prediction theorem," which states the following:

Collective error (the difference between the correct answer and the group's average estimate) = average individual error minus prediction diversity (the dispersion of the individual estimates).

Mauboussin invokes his Columbia experiments--"guess the number of jelly beans in the jar" and "predict the Oscar winners"--to show how this theorem works.  He also summarizes the theory's implications, all of which apply to investing:

1. A diverse crowd will always predict better than the average individual.  Not sometimes.  Always. 
2. Collective predictive ability is driven by average individual accuracy and diversity.  In other words, a crowd composed of simpletons who think the same way will be less intelligent than one composed of independent-minded geniuses or experts.
3. The group is often smarter than not only the average individual, but the smartest individual.

The last point is critical for investors.  Because of our innate overconfidence, we quickly dismiss the fact that a diverse crowd is always smarter than the average individual.  (Most of us think we're above average).  What is far harder to dismiss is the fact that the crowd is often smarter than all individuals. 

In instances in which the crowd is not smarter than all individuals, moreover, the individuals who beat the crowd usually change with each successive prediction (which gives the investment media a parade of new gurus and "fallen stars" to write about).  Just because you are occasionally right when the market is wrong, in other words, doesn't mean you usually will be. 

Costs Matter: Vanguard Wins Again

Low-cost fund leader Vanguard had another strong year in 2006, with 78% of its funds beating their peer-group averages.  Over longer periods--three, five, and ten years--the percentage is even higher: more than 80%.

This performance, of course, has nothing to do with superior stock-picking and market timing--and everything to do with costs.  The industry-wide average mutual fund expense ratio was 1.27% of assets in 2006.  The average Vanguard fund expense ratio was 0.21%.  Since 1975, moreover, Vanguard's average expense ratio has dropped to one-quarter of its original level--while the industry-wide average has risen.

Given Vanguard's consistently strong performance, it is no wonder that it now manages more than $1 trillion of assets and is the second largest fund firm in the world.  What is a wonder is why more fund companies haven't copied Vanguard's "secret formula."

Actually, it's not a wonder.  Most other fund companies are for-profit corporations, many of them publicly held.  For-profit corporations, especially publicly-owned ones, have impatient shareholders to please.  And for impatient shareholders, even a three-to-five year time horizon is eternity.

Hussman: "Fair Value" on S&P 40% Below Today's Level

Not to keep beating the same drum, but John Hussman seconds Andrew Smithers's points about the U.S. stock market's overvaluation.  Hussman's bete-noire is the common use of "forward operating earnings" as a means of concluding that the market is cheap--a practice whose many flaws merely start with the fact that the historical average P/E multiple on "forward operating earnings" is about 11-times, not the 15-times that many investors use (Hussman cites Cliff Asness here).  Hussman is quick (and wise) to say that this condition doesn't mean that stocks will tank--just that future returns for the S&P 500 won't look anything like 10% a year.   

After triangulating with a variety of valuation methods, including the dividend discount model, Hussman puts the fair value of the S&P 500 at 850, 40% below today's level.  So anyone counting on U.S. stocks to appreciate at 10% a year for the next decade had better 1) scale back expectations, and/or 2) pray that it's different this time.

Smithers: P/Es and Fed Model Are "Nonsense"

Andrew Smithers, of London-based Smithers & Co., has published another free lecture, this one entitled "Behavioural Thoughts on Equity Valuation."  In it, Smithers takes aim at two of his betes-noire: the use of standard P/Es and bond-yield ratios to determine whether the market is cheap or expensive.  Such metrics are "nonsense," Smithers says, and have no predictive value.  He then produces the charts to prove it.

As previously discussed, the trouble with standard P/Es (based on Price/Current Earnings or Price/Forward Earnings) is that they don't take into account the business cycle: When profit margins are fat, as they are today, P/Es look artificially low, and when margins are thin, they look artificially high.  The trouble with bond-yield ratios, Smithers says, is threefold:

• They have no theoretical justification.
• They don't work.
• Their apparent predictive capability is the result of data mining.

The bogusness of these valuation metrics, of course, doesn't stop dozens of Wall Street strategists (and Fed governors and financial journalists) from using them--a fact that Smithers attributes to Wall Street's need to always conclude that stocks are cheap.

As in other reports, Smithers argues that the only two valuation metrics that are valid are cyclically adjusted P/Es (CAPE), which take into account the business cycle, and Tobin's Q, which is a measure of price to replacement cost.  These metrics, Smithers says, meet the five key tests of validity:

• The "fundamental" is measurable and relatively stable, and the price ratio to this fundamental is mean-reverting.
• The measure must make economic sense.
• The measure must tell you something (but not too much) about future returns.
• The measure must have been predictive in the past.
• If there is more than one measure, they must generally agree.

At the end of the lecture, Smithers uses CAPE and Q to show that the U.S. market is significantly overvalued, but notes that this tells us little about what it will do in the next year or two.  He observes that intelligent fund managers, whose jobs depend on not missing big bull moves, would be dumb to bet on an intermediate-term decline, even when it has a 70% chance of occurring.  Why?  "Because a 30% chance of ruining your business or career is too high."

In Search Of: A New Name For "Passive"

One of the many reasons "passive" investing gets dissed is that its name--"passive"--is both misleading and deflating.  Who wants to be "passive"?  The folks who do well in life are active, the ones who have gumption, the ones who get up off the couch and make things happen.  "Passive" investing, moreover, isn't passive--it's active.  Smart passive investors actively determine which types of stocks they want to invest in, actively screen the market to find such stocks, and actively manage their portfolios to make sure they contain only such stocks (and in the proper proportion). 

So smart passive investors, the ones who wouldn't mind earning some respect in addition to superior returns, are forever searching for a new term to describe what they do.  Alas, to date, none has been found.

"Indexing" doesn't work, because "indexing" suggests that the passive investor is simply trying to match the performance of the S&P 500, Russell 2000, or other index.  And now that such strategies are popular, the style suffers from herding, index-reconstitution, and other problems (even thought it still outperforms most active strategies).

"Rules-based investing" doesn't work because...well, because it's boring and vague.

"Factor-based investing" doesn't work because it's mystifying.

"Dimensional investing" doesn't work because...ditto.

"Quantitative" doesn't work because it has already been coopted by "quants."

The latest suggestion, "Equilibrium-based investing", put forth by DFA's Weston Wellington in a recent article, doesn't work because it doesn't mean anything that couldn't just as easily apply to the "active" world.  (Although it is arguably better than "passive").

So the search continues.  One thing is certain, however.  If passive investing continues to be called "passive," those who advocate the strategy will continue to operate at a major marketing disadvantage to their "active" competitors.  In fact, given the inherent connotations of the words "active" and "passive," it is almost certain that the nomenclature was devised by a traditional stockpicker.

Why So Many Advisors Are Incompetent

Dylan Ross submits:  Most financial advisors are not capable of providing good financial advice.  This is not because they are stupid or unethical; many are quite intelligent and almost all are well intentioned.  They can’t give good advice because they don’t know how.

Many advisor trainees hired at Wall Street firms have no more expertise about investing or personal finance than the clients they will be expected to serve.  Many have less.  To ready these green advisors, most firms provide some type of in-house training program.  The training usually focuses on the the firm’s products and how to sell them.  For example, recruits are not taught about the negative impact fees have on returns, they are taught how to justify their fees.  The usual line goes something like this: “Lower fee products don’t come with advice.” Never mind that the “advice” usually amounts to “buy this more expensive product.”

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(New hires also study for the Series 7 Exam, which teaches them about different types of securities, how markets operate, and the regulations they must follow—but not how to give intelligent advice.)

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Brokerage firms make more money selling expensive, actively managed strategies, so their training programs rarely give new advisors an opportunity to objectively compare the merits of passive strategies (indexing).  Advisors are instead armed with talking points to overcome a prospective client’s inquiries about index funds.  Some of the more popular rebuttals include:

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• When you buy an index you are buying all of the market risk that comes with it (falsely implying there is less risk in active management).
• Yes, most mutual funds don’t beat the index, but I don’t use most mutual funds (implies that the advisor can select funds that will beat the index). 

• Indexing guarantees mediocrity (simply incorrect).

The sad part is that the advisor is not trying to pull one over on you; he or she probably believes this.  Advisors also believe that their firm’s rigorous manager screening process is the result of something other than sales agreements and revenue sharing. Advisors mistake sales tactics for universal truths from the start of their careers--and tend to hold tight to these learned biases.

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As they continue to build their practices, the advisors become more invested in those same ideas and their bias grows stronger. Unfortunately, the global effect of having so many pseudo-experts in agreement only perpetuates their misconceptions about fees, market-beating strategies, and other bad advice.

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On the bright side, there are some competent advisors.  The challenge is finding one.  Referrals and references can be misleading because people don’t usually know about their advisor’s shortcomings until it’s too late.  Asking probing questions about an advisors training and experience beyond the basic, “how long have you been at this?” may help uncover what he or she really knows.

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Dylan Ross is a CFP at Swan Financial Planning, LLC.  The opinions expressed in this post are his.

Hester: Why High Profit Margins Are Bad News For Stocks

Bullish market seers often point to today's big profits when arguing that there are great things to come.  Because today's big profits are due to today's record-high profit margins, however, they should be arguing exactly the opposite. 

As William Hester of the Hussman Funds shows in this excellent analysis, high current profit margins usually mean bad news for both future earnings growth and future stock performance.  Why?  Because, as GMO's Jeremy Grantham likes to say, profit margins are one "one of the most dependably mean-reverting series in finance."  When some companies are making fat profits, other companies rush to compete with them, and the new competition reduces the profits--and vice versa.  To believe that profit margins won't revert to the mean, Grantham says, you have to believe that capitalism is broken.

Hester's report shows that the 50-year profit margin range for the S&P 500 has generally been 5.5% to 7.5% of sales.  Only four times in 50 years have margins climbed above 7.5%, and the first three times, they quickly dropped down below the mean.  Now, the fourth time, profit margins have continued upwards, to a 50-year record of 8.5%.  Is it possible that outsourcing, globalization, and other structural forces have permanently changed corporate America's profitability?  It's possible.  It's also very unlikely.  (Your competitors are benefiting from the same trends you are, so why should you all be able to maintain pricing power?)

Hester attributes today's fat profit margins to three primary factors: slow wage growth, reduced corporate investment rates, and increased profitability in the financial sector.  He makes compelling arguments why none of these factors will bode well indefinitely.

Hester also includes a handy chart that shows how fast corporate profits will grow for the next five years under different profit margin assumptions.  Assuming standard sales growth of 6% per year (the long term average), if profit margins somehow remain at today's levels, earnings will grow about 6% per year--a fine rate, but a significant deceleration from the past few years.  If margins revert to their 50-year mean, meanwhile, earnings will grow only 0.3% per year.

Hester also explains the other reason why fat profit margins are bad for stocks: Because investors always extrapolate today's conditions into the hereafter.  Hester divides the 50 years of margin performance into quintiles and shows that, when profit margins are highest, investors are so happy and optimistic that they pay an average P/E of 25-times earnings, and when they are lowest, investors are so depressed and pessimistic that they only pay 13-times.  (Exactly the opposite of what they should do).   Not only do high profit margins presage slower earnings growth, in other words--they also presage severe multiple compression.

The bottom line: According to Hester, the 3-year anualized return for the S&P 500 after profit margins have hit the highest quintile has been -1% per year.  The 3-year annualized return when margins have dipped into the lowest quintile, meanwhile, has been 15%. 

But don't worry.  It's different this time.