Republished courtesy of the National Post
by Tom Bradley
"It’s cyclical, stupid."
This rather blunt phrase is one of my most reliable rules of thumb when analyzing investment themes, since most headline-grabbing trends that are dubbed secular, disruptive or even paradigm shifts turn out to be cyclical in nature (that is, periods of prosperity are followed by contraction).
This theory has served me well over the years, but is being tested today when looking at corporate profits in the United States. Since the financial crisis, profit margins have risen to cyclically high levels and managed to stay there. This higher-for-longer trend runs in the face of economic theory, which suggests that high profits attract more competition and, as a result, should come back to normal levels.
It should also be noted that corporate profits are what drive stock prices and, ultimately, investment returns. The remarkable profit cycle we’re in is fuelling one of the longest bull markets in history.
There are a number of reasons why my cyclicality motto is being tested.
First, the economic cycle in the U.S. has been extended. Indeed, it’s on the verge of being the longest ever, although by no means the strongest. Healthy economic activity provides fertile ground for corporations. Everything works better and is more profitable when there’s a steady flow of customers coming through the door.
But revenue growth hasn’t been the main driver of profit margins. It’s the cost side that has driven that.
Labour, which is the biggest expense for most companies, has been cheap and abundant. Costs have remained in check despite economic growth and low unemployment. Workers have not fully participated in the profit cycle due to technological advances and the continuing trend toward offshoring.
James Montier, a strategist at GMO, a U.S. asset manager, summed it up in a December 2018 report: “Whenever labour productivity outstrips real wages (adjusted for inflation), the result is a falling share of the GDP pie going to labour.” He went on to point out that wage increases haven’t even kept pace in industries that have had large productivity gains, such as manufacturing.
Companies have also benefited from more free labour. In our do-it-on-your-phone society, they’ve been able to offload more tasks onto willing customers without any corresponding price reduction.
But labour hasn’t been the only low-cost input. Capital has also been cheap and plentiful. Companies can borrow as much as they want at low interest rates. This improves the economics of new projects and acquisitions, and makes share buybacks a reliable profit-enhancing strategy.
Also boosting profits are corporate tax rates that have stayed low (or declined) due to government policies and ever-increasing cross-border creativity. And, so far, companies have not been required to fully pay for their impact on the environment.
The one factor that’s not talked about enough is consolidation. After three decades of frenetic merger activity, all industries have fewer players and many have moved into the oligopoly category (a state of limited competition).
Think about sectors that now have two or three dominant players: railroads, telecom, oil services, banking, wealth management, life insurance and media. There are no weak competitors slashing prices to gain market share.
Beyond the emerging oligopolies are a number of monopolies created by new technologies: Google LLC in search, Facebook Inc. in social media and Amazon.com Inc. in online retail.
It’s telling that research on trends in corporate communications (annual reports, press releases and the like) reveals that the number of times the words “competitor” and “competition” are being used has plummeted. The business world is more civil than it used to be.
Some of the forces outlined above will (eventually) prove to be cyclical. Labour shortages are becoming more common. Tariff wars and protectionism are making offshore manufacturing riskier. There’s increasing demand for corporations to pay their fair share of taxes. And in the Western world, the push to make companies better stewards of the planet is gaining momentum.
Profits will be cyclical, too. Even if margins have found higher ground, they’re guaranteed to dip during economic slowdowns.
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