Richard Bernstein agrees with the widespread observation that corporate profit margins are likely headed lower, given that they are at record highs right now and tend to revert to the mean. But that's not making him bearish.
"A myopic focus on profit margins may miss an important investment consideration," Mr. Bernstein, a former strategist at Merrill Lynch who now heads his own investment firm, Richard Bernstein Advisors, said in a note. "Whereas most investors remain fearful of margin compression, we prefer to search for an investment theme that could emerge if margins do indeed compress."
His theme: Some companies react to contracting margins by building market share, and he points to three investments that are well positioned in the longer term for this shift.
1. American industrial renaissance:
Small- and mid-cap U.S. industrial and manufacturing companies are already gaining market share thanks to several factors. Wages are rising at a slower pace than in emerging markets, including China, where wages are expected to increase by more than 10 per cent in 2014; emerging markets have less flexibility to compete against currency depreciation efforts because of their higher inflation rates; lower U.S. energy costs keep U.S. manufacturing costs down; and "on-shoring," or bringing back manufacturing to the U.S. from abroad, boosts quality control and removes expenses related to shipping parts.
"We think the odds are that Japanese manufacturing will gain market share because Japan has the flexibility to manage a lower exchange rate and Japanese production will become more competitive," Mr. Bernstein said. But he warns that this theme could take time.
3. Small U.S. banks:
While big banks downsize their balance sheets – or lend less – following the credit bubble and tighter regulations, smaller banks are far more nimble. "Whereas large-bank lending in the U.S. is contracting, smaller-bank lending is accelerating," he said. "Growth expectations for larger banks still seem overly optimistic, whereas those for smaller banks may be too conservative."