Everyone knows corporate earnings will be miserable this quarter. What really matters for stock prices, though, are the prospects for next year and subsequent years as the world moves past the new coronavirus.
On that score, there is reason for hope.
James Mendelson, a research analyst at money manager GMO LLC in Boston, argued in a report this week that companies’ ability to generate unusual amounts of earnings remains largely intact. While corporate profit margins have swelled to extraordinary heights in recent years, they show no signs of permanently falling back to earth.
“The challenges of COVID-19 will undoubtedly pressure the profits of almost all companies, even those in the highest-quality businesses,” Mr. Mendelson writes. “But on the other side of this crisis, we believe we will see a strong recovery in profitability.”
Investors have to hope so. The net income margin of companies – that is, the amount of profit they manage to squeeze out of every dollar of sales – has surged over the past 30 years. Economists debate the reasons for this, but there is no disputing the dramatic impact of growing profit margins on corporate bottom lines and on stock prices.
In recent years, a dollar of sales by a typical U.S. company has produced roughly twice the profit it did back in the 1960s or 70s.
Last year, for instance, the net income margin for companies represented in the S&P 500 Index of large U.S. corporations hit 15.1 per cent. That is far more than the 8.5 per cent that has been typical since 1950.
If profit margins were to slide back to their historical norms, corporate earnings would fall by nearly half. So, presumably, would stock prices. Even if profit margins fell only part of the way back to the levels typical a generation ago, stocks would face a serious headwind.
So what makes Mr. Mendelson so sure the pandemic won’t precipitate such a long-lasting slide in profit margins? He argues that strong underlying forces have helped to drive margins skyward. These forces aren’t going away.
The most important force, he argues, is a shift in the mix of companies within the S&P 500. Companies with higher operating margins have replaced ones with lower margins and helped to expand profit margins for the benchmark as a whole.
There is little reason to think this trend will reverse, he says, because some industries, such as technology, have always generated stronger margins than other sectors. If high margin, high growth sectors such as technology continue to grow as a portion of the S&P 500, so should the typical profit margin of the benchmark.
Low tax rates should also help maintain high profit margins, Mr. Mendelson argues. He says corporate tax rates have been falling for decades across the developed world. There is no reason to think the trend has ended.
Many economists will tell you that high corporate tax rates penalize savings and investment and make a country less attractive to investors. Even Joe Biden, the presumptive Democratic candidate for president, is promising to undo only half of the Trump administration’s 2017 tax cuts. Given all this, “it seems more likely than not that statutory tax rates will fall while tax deductions continue to rise,” Mr. Mendelson writes.
Finally, there are interest rates. They have steadily fallen over the past 40 years, helping to reduce borrowing costs for companies and adding to profit margins. Mr. Mendelson doesn’t have a view about where rates will head next but sees no reason to think they will hobble earnings for the foreseeable future.
This suggests that high-quality companies should see a rapid bounceback in earnings once the crisis is past. “Longer-term concerns about corporate profit margins are overblown,” Mr. Mendelson says.
Could he be wrong? The biggest caveat is that the outlook for profits is likely to depend on which sector you are discussing. Restaurants, airlines and theme parks may face long-lasting challenges, especially if researchers fail to develop an effective vaccine against the virus.
Another caution is that Mr. Mendelson may be understating the effect of possible political and social changes. The decline in unionization since the 1980s probably helped drive profit levels upward. So did tolerance for growing income inequality and monopoly power. If the pandemic fundamentally shifted attitudes among voters, higher tax rates and stronger legislation may threaten today’s elevated profit margins.
But investors should take comfort from his core point. For many companies – and for broad benchmarks such as the S&P 500 or the S&P/TSX Composite – the long-term impact of the coronavirus may be relatively small. That is something to bear in mind as this quarter’s ugly results roll out.
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