Peak Margins: A New Earnings Headwind
Portfolio Managers Brian Demain and Cody Wheaton share their insights on the headwinds driving margin compression, and what it could mean for stocks.
- After two years of expansion, profit margins may have peaked.
- Compressing margins could make it tougher for companies to generate earnings growth.
- Investors may benefit from discerning between the companies that could experience margin compression, and the relatively few competitively advantaged businesses that can sustain current margins.
As a new earnings season kicks off, U.S. companies face a fresh challenge to earnings growth: peak margins.
For the past two years, expanding profit margins have helped companies boost earnings – and ultimately share prices – even though economic growth was often subpar. But many factors that drove margin expansion are now reversing. Going forward, we believe companies’ ability to navigate new margin headwinds could prove a major differentiator in stock price performance.
A Farewell to Margin Expansion
Profit margins represent the percentage of revenue a company keeps after taxes and other expenses. Wider margins mean a company is turning a greater portion of its sales into earnings.
U.S. companies have expanded margins considerably in the last two years. But here’s the skinny on what made margins fatter: Most companies relied heavily on improving the cost side of the income statement to drive expansion. Fewer businesses drove expansion through substantial revenue growth or innovation.
In the last two years, corporations could pull plenty of levers to reduce their expenses. Low interest rates allowed companies to reduce borrowing costs. Slow wage growth kept labor costs in check. A stronger dollar made inputs from overseas less expensive. Most of all, corporate tax reform substantially lowered the tax burden on businesses.
Corporations can no longer rely on these same dynamics to widen margins. The U.S. jobless rate hovers near its lowest level in history and a robust labor market is starting to lead to increased wages. In our meetings with management teams, we increasingly hear that rising labor costs are a concern. Tariffs, meanwhile, threaten to make input costs more expensive.
The benefits of low interest rates and tax cuts have now run their course for most companies. While interest rates could remain low this year, many businesses have already refinanced debt at lower rates, or used a protracted period of low rates to pay down debt. Tax cuts, meanwhile, provided a one-time benefit to after-tax profitability. In 2019, year-over-year earnings comparisons will lap periods in which corporations already paid the lower rate.
Margins are Compressing as the Market Seeks Earnings Growth
Margin compression is coming as earnings growth could matter more to stock prices. The recent market rally has left valuations for many stocks on the high end of historical averages. With multiples higher, companies will likely need to demonstrate earnings growth to drive further share price appreciation.
In such an environment, investors may benefit from discerning between the bulk of companies that could experience margin compression, and the relatively few that can sustain current profit margins. Much will come down to understanding a company’s competitive advantages or the competitive intensity of its industry.
Companies that lack a discernible edge or that offer relatively undifferentiated products or services in a crowded market will have the toughest time maintaining margins. Such companies will lack the pricing power to offset the rising labor and input costs that are already working against them. More trouble could lie ahead. Next, competitors could use the windfall from last year’s tax savings to cut prices and try to grab market share. The business would have no choice but to follow suit. This could drag revenues down and crimp profits further.
Not every business will suffer this fate. A company with a superior business model, a must-have product or service, or that operates with little competition can offset margin headwinds with higher prices. Such companies can also dictate what they do with tax savings, instead of their competitors determining it for them. These businesses will be better positioned to produce earnings growth in a market environment that demands it.