The Next Problem: Too Much Profit? America’s profit-margin miracle has gone on for so long that rather than cheering it on, investors might want to ask what companies are actually doing to keep it going

The Next Problem: Too Much Profit

JUSTIN LAHART

March 27, 2014 4:05 p.m. ET

America’s profit-margin miracle has gone on for so long that rather than cheering it on, investors might want to ask what companies are actually doing to keep it going.

The Commerce Department on Thursday released data on corporate profits. Once again, these showed that income for U.S. businesses is growing at a faster rate than the economy. With after-tax profits up 4.8% in the fourth quarter from a year before and gross domestic product up 4.1% unadjusted for inflation, profits as a share of GDP—an economywide proxy for corporate margins—hit a new record of 11.1%. If the measure was back at the average of 5.4% that prevailed in the 1990s, profits would be half what they are now.

Analysts expect margins to keep expanding, estimating that profits for S&P 500 companies will grow by 7.4% this year even as sales expand by just 3.8%, according to S&P Capital IQ. That could be a dangerous forecast—not so much because companies might not be able to meet it but because of what they might be doing to try to do so.

Chief among the factors contributing to profit-margin expansion is the tight lid companies have put on costs. They have been slow to hire and slow to raise wages. Inflation has outpaced gains in private-sector employee compensation over the past five years, according to the Labor Department. Spending on new equipment has been muted, too. Aggregate capital expenditure for members of the broad S&P 1500 index has grown by just 0.8% annually over the past five years, according to S&P Capital IQ.

Low rates have allowed many companies to refinance debt, cutting interest costs. The effective yield on investment-grade corporate debt, according to the BofA Merrill Lynch Corporate Master index, is now 3.1%, versus 5.8% in December 2007.

Taxes have been low as well, in part as companies offset them with losses taken during the recession. Income statements from companies in the S&P 500 showed an effective tax rate, including state and local taxes, of 29% in 2012 versus 32% in 2007, according to ISI Group’s David Zion. He calculates that their cash tax rate—what they actually paid—was 25% in 2012, against 31% in 2007.

Keeping costs low by refraining from hiring or not replacing equipment can only be done for so long, though. And long-term interest rates look more likely to rise than fall over the next year. Losses to offset taxes, too, eventually get used up.

But the desire to show high profit margins will endure. Barring an unforeseen surge in economic growth, meeting Wall Street’s piqued expectations will tempt companies to continue underinvesting. Ultimately, though, that leads to deteriorating sales—making it even harder to preserve profits.

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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