Heard on the Street
U.S. Margins Defy Doom of Profits
Profit Margins Keep Widening, Confounding Forecasts. Here’s Why That’s Set to Continue
By Justin Lahart
Updated Nov. 17, 2014 1:45 p.m. ET
Alongside the inevitabilities of long-term interest rates picking up and inflation firming, one of the most obvious things that was going to happen over the course of this year was a narrowing of profit margins. So much for that.
Indeed, with third-quarter earnings advancing at around twice the pace of a sales gain of just 5.3%, profits as a share of revenue for companies in the S&P 500 look to now stand at 10.1%. That is the widest profit margin in the 22 years of data S&P Dow Jones Indices has on hand. A longer-dated measure—after-tax corporate profits as a share of gross domestic product—last year reached its highest level since 1929.
A big reason margins have continued to widen is wage gains—or more aptly, a lack of them.
Average hourly earnings continued to grow weakly in October, and were up just 2% from their year-earlier level, according to the Labor Department. That is even though companies have been hiring over the past year at a faster clip than economists expected, with the unemployment rate falling to 5.8% last month from 7.2% a year earlier.
Another reason margins are so high is that companies have been slow to spend. Commerce Department figures available through the first quarter show investing in new equipment relative to private industry output was low compared with prevailing levels before the recession. While there has probably been some pickup since then, companies remain reluctant to spend on longer-term projects without an immediate payoff.
The argument that margins must narrow goes something like this: Demand has reached the point where companies can’t meet it without hiring more workers, and the job market has reached a point where workers are in a stronger position to bargain for higher wages. So companies’ labor costs are heading up. And if they’re smart, they’ll spend more on labor-saving equipment that will help them boost productivity, and mitigate future labor cost increases.
Of course, this was also last year’s argument that profit margins were set to narrow. And 2012’s.
Today’s wide profit margins probably owe a lot to changes in the investing climate. Those other two mysteries—persistently low interest rates and inflation—have led to profound changes in what many investors look to stocks for.
With bonds offering little in the way of yields, for example, income-focused investors have turned increasingly to stocks. They are more apt to reward managers who generate and return cash to shareholders over managers who are looking to reinvest and grow. Moreover, low inflation lowers the risk for companies of not investing heavily in growth and seeing rising prices overwhelm the spending power for future revenue.
To that, add still-painful memories of the financial crisis and the growing clout of activist funds. So it’s easy to see why companies are reluctant to take chances that might damage margins and anger investors. That is the case even if those riskier moves have potentially big payoffs over the longer haul.
Eventually, things will change. Companies will no longer be able to keep labor costs at bay, interest rates and inflation will rise, and investors’ focus will swing back toward growth. But as the persistence of wide profit margins has shown, eventually can be a long time coming.
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