Will Profit Margins Continue to Move Higher?

Will corporate profit margins continue to set new highs, will they remain above long-term averages, will they revert to the long-term norm, or will they fall even lower? For some time, experts covering the markets and the economy have been debating this issue; it has yet to be resolved. Of course, no one can be certain of the answer. One can only make their best guess based on the available information.

According to data from Thomson Reuters I/B/E/S, in 3Q13, operating margins for companies in the S&P 500 averaged an all-time high of 9.9%, compared to a long-term average of around 6%. According to the current consensus forecast (also compiled by Thomson Reuters I/B/E/S), operating margins are currently expected to average 10.3% in 2014 and 11.0% in 2015. While margins can remain above the long-term average for several years, eventually, they are likely to revert. In fact, they will likely fall below the norm for a period of time, in order to maintain the long-term average.

It is possible that some of the factors contributing to higher margins today could be structural, and, therefore, help support the idea that margins will remain above their historical average. However, it seems less likely that margins will continue to march higher from current levels. We also note that analyst forecasts tend to be overly optimistic. For example, in 2013, expectations were that overall corporate profits would increase by 10% in 2013; in actuality, this figure will likely be about 5%. (We will not know the final number until all companies have reported their fourth quarter 2013 results.)

When evaluating companies for possible inclusion in client portfolios, we closely examine corporate profit margins and their long-term trends. Those companies earning the highest margins generally have some type of competitive advantage that can allow them to outperform over the long term. We typically favor companies earning higher margins. Such companies will likely outperform peers in both good times and bad. In fact, in a challenging environment, financially strong companies often have the financial wherewithal to expand their business, allowing them to be positioned for even better performance when conditions improve.