yep i read the silicon valley bubble in wsj. and i remember a friend from hs, who jjuss sold his company for 90m this year. all i could think of was he beat drake at 25.
This will give McD’s plenty of time to reinvent themselves. Not so much for Coke.
We are living in an era where a good number of people are underemployed. That’s what happens when there are less opportunities within your shop and elsewhere to jump ship. This generation and most likely the next one is screwed. There will be winners but in absolute numbers less so than the preceeding generations.
foreign profits and taxes have an effect but not a definitive one. the key to elevated profit margins is government spending, wages and interest rates.
which direction is government spending going? probably down.
which direction are wages, interest rates going? probably up.
will corporations be allowed to continue with their tax inversions beyond what has already been acheived? probably not for long as it is just another form of government spending.
all of these trends put profit margins at risk and current profit margins are probably at or near their peak. if we were to enter recession (Europe may be leading us there) and earnings are stagnant or down and thus market multiples drop by 20% and profit margins were to drop from by 20% from 10% to 8% due to rising rates and wages or zero/negative revenue growth, the market would be down 36% and it wouldn’t even look all that cheap yet. this is the danger with expecting margins to stay at these levels. a slight change in margins AND multiples leads to a major decline without making the market look all that attractive.
saying margins probably won’t revert back to 6% is extreme. they don’t need to fall that far for them to have an impact on market valuation. if margins went back to 6% and the market’s multiple goes back to say 14x from 18x today, the market would be down 53%, and we’d only be back to average margins and a slight discount to average multiple. hardly screaming buy territory using these indicators alone.
grossly above average profit margins are a risk, that is for certain. arguing when and if a reversion will come is pointless. just know you’re buying a market that probably trades at 20-23x trailing earnings with just a minor reversion of profit margins.
I agree with you here but keep in mind KO is really a distribution company, not just a company that sells Coke. If Coke is banned world wide the stock gets hammered and is a buy. KO would simply overpay to acquire whatever else people are then drinking and push it through the company’s monstrous distribution network. People will drink something. The barriers to entry on the distribution are very high. MCD is in worse shape with fixed ppe and a worse business model but is well hedged internationally and could always change their food mix to make it less toxic.
KO also has a history of buying other businesses that aren’t Cokey. IIRC they bought Vitamin Water a couple of years ago, they have Gatorade, taking a stake in GMCR (despite how odd/misguided). The company ain’t going anywhere.
As for MCD and other QSR stocks… It’s a minefield with probably a handful of good stocks. If you have company owned stores in the US, the whole raise the min wage phenomenon is a big risk, not to mention the structural shift away from fast food, which impacts both company owned and franchised models. I’d buy Chick Fil A if it were public. They have a top notch ship, IMO.
I disagree, while KO is obviously a great business, if for some reason they could not make Coke anymore, and started making say orange soda, we don’t really know what their profitability will be like. A big part of their business is that Coke has a very neutral taste, and people of all ages globally love their stuff, I do not see orange soda, or say Kombucha doing the same. They could continue making their syrup and shipping it to bottling firms, but they just wouldn’t have the scale they do now, plus it will also mess around with their input costs, whereas right now their only inputs are corn syrup (subsidized?) and caramel coloring.
Yep. Even the ones that arent company owned have risk now too. Activists are battling MCD, hoping that MCD will be liable for their franchisees actions as well. Their argument is that MCD has so much control on the operations of their franchisees that they could easily control how franchisees handle their labor side as well which makes sense and is fair but it would be a game changer.
Also I agree that there is a shift, but i dont think its structural. I still say its cyclical mainly because of 2008. Right now we are at the peak of discretionary free cash flow and people with incomes juss save. With unemployment (the fake and real one) pretty high Im pretty sure more people are cooking at home. Lastly unemployment is mostly affecting their larger market in the lower inc bracket.
btw forget chick fil a. all hail kfc
Matt,
I like the arguments and I thought the link was an interesting read. I came accross a counter argument to the Hussman piece that you may find interesting. Check out the debate in the comments section at the end as well, it’s interesting. The summary of the article is that margins are not 70% above the norm as Hussman argues, but are instead closer to 20%. Also there is a debate over the role that interest rates play in corporate margins.
I thought this statement from Hussman was shocking, I’d love to see the data behind it. “foreign profits of US companies as a share of GNP have been contracting since 2007”. I am under the impression that foreign profits are rising and if they continue to do so, then that is a major argument for margins to remain elevated or rise further. I’ve tried looking for a chart showing foreign profits/GNP, but I can’t find it.
i wouldn’t exactly call the analysis a counter argument as all it says is that we are roughly 45% above historic means instead of 70%, if you are to combine the two metrics together, which he contends as most appropriate. ~45% above historic means is still a major issue and a reversion of ~30% in margins would results in losses of 30% for the equity market. predicting a reversion to the mean isn’t even a big risk. even you believe we have entered some elevated profit margin environment, the bottom of the new profit margin range could easily be 33% lower than it is today, so you could be right and still see profit margins fall 33%, at least temporarily as interest rates, government spending and employment revert closer to their means.
and like i stated before, i wouldn’t be surprised to see market multiple contraction in an environment with declining margins so the effect could result in a 50%+ contraction without making the market look all that attractive.
as for Hussman’s statement on foreign profits, i think you can kind of make sense of it from the second chart in your link using the “US profits from abroad” line. foreign profits peaked in 2007 and currently sit at approximately the same level based on GDP so i can only assume that based on GNP, they are below the same level based on his statement.
it is clearly prudent to be more risk averse at the current time than bullish and to doubt current earnings mutiples as good indicators of valuation.
http://www.philosophicaleconomics.com/2014/08/capehigh/
Interesting article discussing profit margins in the context of the current market.
The author outlines how several different scenarios could play out but his/her belief is modestly bearish…
_ Possibility #2: Moderately Bearish Scenario _
The increase in profit margins is not going to fully hold. Some, but not all, of the profit margin gain will be given back. On this assumption, it becomes harder to defend the market’s current valuation.
Importantly, sustained reductions in the profit margin–as opposed to a temporary drops associated with recession–tend to occur alongside rising sales growth. In terms of the effect on EPS, rising sales growth will help to make up for some of the profit that will be lost. However, almost half of all sales growth ends up being inflation–the result of price increases rather than real output increases. With inflation comes lower returns in real terms (the only terms that matter), and also, crucially, a tighter Fed. If the Fed gets tighter, a TTM P/E of 19.3 will be much harder to sustain. The market will therefore have to fight two headwinds at the same time–slow EPS growth due to profit margin contraction and a return drag driven by multiple contraction. Returns on such a scenario will likely be weak, at least in real terms.
But they need not be disastrously weak. In a prior piece, I argued that returns might end up being 5% or 6% nominal, or 3% or 4% real. Of course, that piece assumed a starting price for the S&P 500 of 1775. Nine months later, the index is already at 2000. The estimated returns have downshifted to 3% or 4% nominal, and 1% or 2% real. Such returns offer almost no premium over the returns on offer in the much-safer fixed income world, and therefore, if any kind of profit margin contraction is coming, then the current market is probably pushing the boundaries of defensible valuation.
I also think there’s something to be said for his justification of present market levels:
Now, even if the current market–at a TTM P/E of 19.3 times reported earnings and 17.9 times operating earnings–is set to experience multiple contraction and lower-than-normal future returns, it doesn’t follow that the market’s current valuation is wrong. The market should be priced to offer historically low returns, given the historically low returns that cash and fixed income assets are set to offer over the next several decades. Indeed, if the market were not currently priced for historically low returns, then something would be wrong. Investors would not be acting rationally, given what they (should) know about the future trajectory of monetary policy.
“result in a 50%+ contraction without making the market look all that attractive” It’s hard to take you seriously with statements like this. Also, maybe you read through the article quickly, but his argument is not that they are 45% above average.
Dipset, that is very interesting. While I won’t feel comfortable holding equities based only on the idea that they’re the only game in town, it’s certainly important to consider the alternatives. And speaking of alternatives, I think alternative investments may be the best game in town looking forward. Managed futures, L/S & M/N equity and unconstrained credit funds should be getting more attention from investors.
“The right approach could be somewhere in between.” - the article writer’s words.
if the market drops 50% as a result of margin compression and falling multiples, it won’t look much more attractive, no. it might look okay on a technical basis but who knows. it may be a good time to buy but you won’t have any indicators telling you so. if you think P/Es of 14-15x when profits are contracting is attractive, you probably have a high chance of losing more money investing at those levels. losing 15% from the top when investing 50% down from the top is a 30% loss. that isn’t what Buffett would call a fat pitch. show me a sign that margins are going to turn and a P/E of 12 and we can talk but falling margins and 14x, i’ll just get my darts ready.
the bottom line is that even the article you provided for support says that the market is likely overvalued by at least 17%-40%. if that is the bull case, how can that not be concerning?
clearly a crash isn’t necessary to for margins to normalize. we could just experience a sideways market for 5 years, with okay organic earnings growth but offsetting rising costs. but market valuations, as per P/E mutliples, would look the same, which is elevated and not particularly attractive.
I will buy the S&P everytime it drops 50% with no questions asked…unless a nuke is dropped on NYC or we are being invaded by aliens.
And seriously, read the article. Literally the next paragraph he gives his estimate of 15%.
assuming we can never see another 70-90% drop again is quite dangerous. there have been several in world stock market history. i’m not saying i can say i’ll sell at 100 and buy at 10 but this whole discussion is pointless if you’re just going to blindly buy at some arbitrary % of decline. why do you care about anything to do with valuation if your buys and sells are unrelated to valuation?
i used his “profit levels today may be closer to 20 percent elevated relative to historical norms” to calculate 17%. also, am i supposed to believe that foreign profits are not elevated considering the degree to which interest rates have fallen in recent years and the incredible degree of stimulus provided by the Chinese, European, Japanese and Brazilian governments? if he agrees that U.S. profits are elevated due to obvious factors, how can he disregard those same factors in foreign markets?
Sept. 25 (Bloomberg) – McDonald’s Corp. is trying to appeal to fans of chorizo sausage with a new burrito. There’s one catch: It’s made from chicken. About 2,000 McDonald’s restaurants in Texas, Hawaii and the Midwest started selling chorizo breakfast burritos last month, Terri Hickey, a spokeswoman for the Oak Brook, Illinois-based company, said in an e-mail. The wraps are made with dark-meat chicken, instead of the traditional pork, and include scrambled eggs, roma tomatoes, green chilies, onions and white cheddar cheese. The chicken is flavored with chorizo seasoning that includes paprika, chili and chipotle pepper
THE END IS NEAR!
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Because you’re vastly over-stating the downside risk to the point where it’s a waist of time to argue that you’re wrong. I’m not going to explain why I’d buy the S&P next year if it was below 1000 because it would never get there without something extreme happening that is completely unrelated to margins. If the market drops 90% I’m not worried about my investments, we’ll have much bigger issues than that to deal with.
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Thank you for raising a good point, I’d be curious to see where global profit margins are now. I don’t believe that profit margins move in unison, although they may have had a higher correlation during the lastest crisis. As correlation between asset classes continues to fall, I’d expect the same from individual economies. As the ECB may or may not provide further stimulis, along with Japan, margins may rise there. I believe European margins are no where close to a cyclical high. US margins may start to fall. If all margins are elevated, then yes that would be concerning, but I don’t believe that’s the case.
And again, his conclusion is that profit margins are 15% above the long term mean. This suggests they are too high, but that isn’t a large variance from the mean and certainly doesn’t suggest any immediate correction in margins is due.