Charles Lewis Sizemore, CFA

About the Author Charles Lewis Sizemore, CFA

Charles Lewis Sizemore, CFA is the founder and principal of Sizemore Capital Management LLC, a registered investment advisor. Charles has been a repeat guest on CNBC, Bloomberg TV and Fox Business News, and has been quoted in Barron’s Magazine, The Wall Street Journal and The Washington Post. He is a contributor to Forbes Moneybuilder, and has been featured in numerous publications and well-reputed financial websites, including MarketWatch, SmarterAnalyst, TheStreet.com, InvestorPlace, GuruFocus, MSN Money, and Seeking Alpha. He is also the co-author, along with Douglas C. Robinson, of Boom or Bust: Understanding and Profiting from a Changing Consumer Economy (iUniverse, 2008). Charles holds a master’s degree in Finance and Accounting from the London School of Economics in the United Kingdom and a Bachelor of Business Administration in Finance with an International Emphasis from Texas Christian University in Fort Worth, Texas, where he graduated Magna Cum Laude and as a Phi Beta Kappa scholar. He also maintains the Chartered Financial Analyst (CFA) designation in good standing.

A Look At Corporate Profit Margins

 

As the first quarter earnings season draws to a close, the results have actually been quite a bit better than expected. The “beat rate,” or the percentage of companies beating the consensus earnings estimate going into the earnings announcement, is running at 67%. The average beat rate of the past five years has been 65%.

Of course, it’s a lot easier to beat when expectations are low enough, and this quarter analysts weren’t expecting a whole lot. Between bad winter weather, a strong dollar and an implosion of profits in the energy sector, analysts went into the season downright cranky.

For an idea of what we should expect going forward, let’s step back from the noise for a moment and look at earnings through a wider lens. Back in April, I recounted an article that Warren Buffett wrote in 1999 but that he just as easily could have written yesterday. At the time, Buffett suggested that in order for stocks to continue rising from their already elevated levels, corporate profits would need to expand to an ever-larger percentage of GDP.

Well…they didn’t, and we had one of the worst bear markets in history from 2000 to 2002.

Today, let’s look at after tax profit margins over time to get a little perspective. As you can see in the chart below, margins have fluctuated in a band of about 4% to 8% since the late 1940s. The white-shaded areas represent periods when the economy was in recession.

Profits

Interestingly, profits tend to peak several years before a recession. During the 1990s bubble, corporate profit margins peaked in the mid-1990s and had already been falling for years by the time the stock market bubble burst. Likewise, profit margins had already topped out and had started falling a couple years before the 2008 market meltdown.  And more recently, it looks like profit margins have stalled out and started falling again.

What are the takeaways here?

The first is that the corporate profit margins of the past several years are well outside of the bounds of “normal.” They’ve been made possible by the absolute collapse in capital spending since 2008. Capital spending may fuel the growth of tomorrow, but it’s a major drag on profitability in the short term. Falling bond yields have also lowered borrowing costs, which has boosted earnings further. And labor costs have been kept in check by high unemployment and automation.

All of these conditions may stay in place a little longer, but they won’t last forever. We’re due for a major profits correction, and we may already be in the early stages of one.