Debating Corporate Profit Margins

Ordinarily, the following news would be cause to cheer: Corporate profit margins are increasing! But in a bizarre twist of sentiment, many headlines suggest this is bad—if profits are increasing at a faster rate than GDP, corporations must be cutting costs to the extreme, resulting in slow investment, wage and job growth. Effectively, the corporate leeches are sucking the lifeblood of the economy—consumer spending—this story goes. Absent jobs and wage growth, corporations won’t see demand increase, as their customers will be sapped of buying power. As usual, though, reality differs. Businesses are spending more and more to keep up with demand, and rising profits help sustain this—a plus for the economy and jobs. The combination of rising profits and the snarky interpretation of them is fuel for more bull market ahead.

Proponents of the too-high profit margin thesis presume slow hiring, business investment and wage growth—cost controls—are the primary reason profits are up. Their evidence? Corporate profits are growing at a faster rate than GDP! After-tax profits (+4.8%) slightly outpaced nominal GDP growth (+4.1%) in Q4 SAAR. Over the entire expansion so far—July 2009-December 2013—after-tax profits (+49.6%) and nominal GDP (+18.8%).^[1] But comparing corporate profits to GDP is comparing apples and cucumbers. Yes, a growing economy is a tailwind for rising profits, but there is nothing suggesting the two need to move in lockstep, to the same magnitude or even at the exact same time. Logically, we’d expect them to diverge. Corporate profits are a pure private sector metric—a straight up analysis of the after-tax success a business has in boosting sales, managing costs or both. GDP is not a pure private sector metric. For one, it includes public expenditures—in the present expansion a big drag. If we subtract public expenditures from total GDP, then GDP would have grown by +28.8% July 2009-December 2013!^[2]

Imports add another wrinkle. If you run a large retailer and sell European handbags and shoes, Australian slippers and sweaters, backpacks made-in-China, Canadian outdoor gear, South Korean appliances and more, every single good you sell detracts from GDP. Even though it adds to your top line revenue and potentially bottom-line profits! GDP’s calculation, which uses net exports (exports less imports) treats imports as a negative. Corporate profits do no such thing—a truer reflection of economic activity, in our view.

Now, if these profits didn’t translate to higher capital spending, the naysayers might have a point. But reality doesn’t square with their thesis. Total business investment, for one, hit its first real all-time-high since 2008 last quarter—businesses are spending plenty on equipment, software and R&D. They’re also hiring, if not at a blistering pace. Total non-farm payrolls remain -666,000 under their prior peak.^[3] But this number is up +8,044,000 since the February 2010 low.^[4] Moreover, if you strip out the 617,000 government jobs cut since then, you see private businesses have added a whopping 8,661,000 jobs.^[5] Wages, too, are ticking up each year—by +2.7% in 2013, +3.6% in 2012, +1.2% in 2011 and + 3.8% in 2010.^[6]Some say a future increase in wages means corporate profits can’t last. But, wage growth over the last few years hasn’t stopped healthy profit growth.

So if it isn’t all cost cutting, what’s generating increased profits? Revenues are rising. In dollar terms, sales in eight of ten S&P 500 sectors outpaced earnings growth in Q4. This is also not a new phenomenon—revenues have been growing for the last three quarters running. That’s not to say firms aren’t cutting costs at all—Energy and Financials appeared to have cut costs in Q4 2013. However, for the eight other sectors, it appears cost cutting was a lesser priority.

Finally, we’d note corporations that don’t manage costs well likely struggle to survive long term—profitable businesses tend to hire more than unprofitable ones. It says something today about sentiment that high profitability is a cause for concern and not celebration—that’s a pretty twisted fear, and it’s baked into current pricing, giving stocks plenty of room to rise as sentiment eventually catches up with reality.