The debate about profit margins has been raging for years now. Big bears argue that margins have to mean revert. The bulls argue that margins either aren’t all that high or needn’t necessarily mean revert. But an interesting note from Deutsche Bank argues that some portion of the higher margins is indeed structural. Their arguments makes a good deal of sense (via Deutsche Bank):
- Constituent changes: 80bp of margin expansion has come from the ~5% annual constituent turnover.
- Lower effective tax rate: 80 bp of margin expansion has come from S&P effective tax rate dropping by 7 pct points as share of S&P profits from foreign operations doubled.
- Lower interest expense: 25 bp of margin expansion has come from lower interest rates and less leverage.
- Higher foreign operating margins: 85 bp of the margin expansion has come from this and mix shift. The increase in aggregate foreign margins is from higher businesses expanding abroad and their foreign operations becoming more profitable.
- Mix shift: sectors with improving or higher margins have become larger share of the S&P 500. Tech is now 20% of S&P earnings vs 12% in mid 1990s, while telecom and utilities share has dropped to 5% from 10% in mid 1990s.
I still think profit margins will necessarily contract when the next big profit recession occurs, but that’s kind of an obvious macro “insight”….