As an investment professional, I am often asked about my preferred reading list in terms of investment books and financial newsletters. The list of books is long, but the list of newsletters is short. My main issue with investment newsletters is that many of the authors seem to react poorly to cognitive dissonance—the discomfort our brains feel when presented with new evidence that conflicts with an existing belief. This behavioral concept was first introduced by the American social psychologist Leon Festinger in the 1950s.To deal with this discomfort, we as humans can either change our existing belief or avoid/reject the new evidence that is conflicting with our belief. Festinger, as well as later researchers, found that most people do the latter. Not surprising, people don’t like to be wrong.
Anecdotally, that is what I have found with most authors of investment newsletters—they tend to subscribe to their world view and either ignore or dismiss information that potentially conflicts with it. For example, without naming names, I have subscribed and unsubscribed to the technology analyst whose permanently bearish view on the sector led him to report every negative quarterly earnings report while omitting the positive ones. Then there is the economist I used to read who began to disregard his own research because it conflicted with his bearish view on the stock market. Clearly, taking financial advice from those who deal with cognitive dissonance in this manner is not advisable as investment recommendations should be based on objective analysis and not subjective opinions that never budge. Market conditions change, so your view of them should as well.
Fortunately, there is one highly-regarded investment newsletter that stands above the others in terms of objectivity—Grant’s Interest Rate Observer. Editor Jim Grant and his staff are not shy about expressing their opinions about the financial markets; you know where they stand without a doubt. However, as good analysts, their opinions change as new, conflicting information comes to light. In fact, they seem to go out of their way to present challenging views so that they can address them. As a case in point, the article that I read this morning—a review of a stock recommendation they made earlier this year—concluded with, “We were wrong.” If you find an investment newsletter that deals with cognitive dissonance in the manner in which Grant’s does, that is one I would likely endorse (along with Grant’s obviously).
In the spirit of Grant’s Interest Rate Observer, we would like to review something we wrote just over two years ago in this very newsletter.
Our Existing Belief
In July 2011, we penned the article, “Bye Bye Corporate American Pie,” which can be read here. In the article, we explored why corporate profit margins, which historically are mean-reverting, remained at elevated levels for an extended period of time. We concluded that there was the possibility that efficiencies achieved through technology, less powerful labor unions, and access to cheaper labor overseas had resulted in a permanently higher plateau for profit margins.
New Conflicting Evidence
Last month, I encountered an analysis of corporate profit margins from The Leuthold Group, a money manager and institutional research firm. In their report entitled, “Decomposing Margins,” they compared current profit margins as of second quarter 2013 with profit margins as of third quarter 1997, which represented the profitability “high achieved during the 1990s technology boom.” Net corporate profit margins are now 2.8% higher than they were then (10.1% vs. 7.3%).
Our argument two years ago was that increased efficiencies and lower labor costs were largely responsible for that 2.8% difference. However, Leuthold suggests two other variables as the main drivers of increased corporate profitability—lower interest payments and lower taxes. Between third quarter 1997 and second quarter 2013, net interest payments as a percentage of sales fell 2.1% (from 4.8% to 2.7%) and corporate taxes as a percentage of sales fell 0.4% (from 2.9% to 2.5%). The combined decline in interest payments and taxes added 2.5% to corporate profits margins over the last 16 years, which represents nearly 90% of the overall margin improvement.
Conclusion
We were (mostly) wrong. While improved efficiencies and lower labor costs certainly played a role in improved corporate profitability over the last 16 years, it was a minor one. Lower taxes and lower interest rates proved to be the main drivers.
Investment Implications
With inevitably higher tax and interest rates, corporate profit margins in the U.S. are likely to decline over time regardless of the amount of operational efficiency or labor cost savings that can be achieved. Given that U.S. stocks are already overvalued on an earnings basis, any possibility of lower earnings in the future only adds to that problem. While we do not view this as a near-term risk to U.S. equities as tax and interest rates are not going up overnight, it is informative from a long-term perspective in that it suggests a gradual move towards equity markets outside the U.S.—such as Europe, Japan, and the emerging world—where valuations and corporate profit margins are not as elevated. Or you can always just ignore the evidence.