He Who Solves This Puzzle Shall Be King

by: Cam Hui, CFA

OK, the title was a bit of hyperbole reminiscent of the story of the sword in the stone, but I have encountered an important investment puzzle which, when solved, would address the issue of whether stocks are cheap or expensive.

Why are margins so high?
At the heart of the question is this chart from BoAML (via FT Alphaville) showing that U.S. market cap to GDP to be highly elevated relative to its own history. Market cap to GDP can be thought of as a proxy for Price to Sales.

Click to enlarge

By extension, the P/E ratio is Price to Sales divided by net profit margins. So the question then becomes, why are profit margins so high?

On one hand, you have the likes of John Hussman who believes that profit margins are likely to mean revert. His analysis of non-financial market cap to GDP and subsequent 10-year returns indicates that the potential for equity capital appreciation is limited.

Non-financial market cap to GDP and subsequent 10-year returns

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On the other hand, analysts like Dan Suzuki of BoAML (via Business Insider ) wrote that the improvements in margins are the result of lower interest rates, lower tax rates, technology and energy costs. He believes that roughly two-thirds of the improvements in net margins, namely lower rates and taxes, are sustainable.

Click to enlarge

I have also seen Street analysis (that I can't find) which indicates that U.S. multi-national margins are much higher than companies focused on the domestic economy. This effect is likely due to the tax avoidance schemes of multi-nationals whereby they shelter much of their income in offshore subsidiaries.

The investment puzzle

These arguments about whether net margins are elevated amount to a top-down macro analysis (they are elevated and therefore should mean revert) vs. a bottom-up micro analysis (it`s a regime change because interest rates are low and companies have learned to lower their effective tax rates). A better way of phrasing the real top-down economic puzzle was raised by Ben Inker of GMO, namely that if margins are so high and returns so attractive, then why has corporate investment been so low?

Here is an excerpt of a Morningstar interview with Inker [emphasis added]:

Kinnel: In April, you wrote about how corporate profits have been very high for a long time, leading you to wonder why reversion to the mean hasn't hit yet. What's your current thinking on this?

Inker: The behavior of corporate profits in the U.S. for the last 10 or 15 years is weird. It doesn't follow a standard capitalist script. If you've got a situation where there is a very high return on capital, which there has been on average for the last 10 or 15 years, you would expect to get a lot of investments. If the return on investment is high, capitalists go out there and invest. [If] the return on investment is low, they don't.

Well, the return on investment has been high, and yet we have been investing really quite little. There was a burst associated with the Internet bubble, but since then investment has been somewhere between a little bit anemic and, today, downright depressing. That doesn't do anything for expectations of future growth, because productivity growth really does require investment and we're not getting much investment. So, it's hard to see how we're going to get productivity growth, but profits for companies are really less about productivity growth and more about the return on capital. And if you are not getting a lot of investment, then you don't get one of the avenues towards pushing profit margins back down. Normally, higher investment would happen and that would lead to higher competition and the erosion of profit margins. So, if we're looking for reversion in profit margins, which we are, it's sort of the longer-term more subtle issues about what does it mean to have high profits in the corporate sector that is not accompanied by high investment.

Antonio Fatas, Professor of European Studies and Professor of Economics at INSEAD, asked a similar question on his blog, why did investment decline?

When we compare the last four expansions in the U.S. economy we can see that while the real interest rate kept going down (especially in the 2001-2007 expansion), investment rates remained flat or even declined. I have included the current expansion in the chart although it's not comparable to the others as it has not finished yet.


In a separate post, Fatas pointed to a similar pattern of falling investments worldwide:


The Big Question

So here is the Big Question. If net margins are so high, what happened to the missing investment?

The analysis from Dan Suzuki of BoAML indicating that net margins are elevated screams "low cost of capital" to me. In past instances where we have see low costs of capital (Japan in the 1980's and China today), we have seen an investment bubble form. When companies enjoy low cost of capital, the proper response is to raise as much money as you can and buy something, anything, to raise your returns. So if the cost of capital is so low, why haven't we seen a surge in corporate investments in the developed markets?

Something is not adding up here. The analyst who solves this puzzle will resolve the margin puzzle and therefore the question of whether stock prices are cheap or expensive.

