Profit Margins & Stock Values

[joe blowe]

The Daily Reckoning Presents
The Danger of Peak Profits

Chris Mayer
One of the vulnerabilities in today's market is that profit margins are near peaks. Investors tend to like companies with fat profit margins, but high profit margins are like honey pots that attract competitors. They are rarely sustainable for long.

But what is more important for stock prices is not the profit margin itself, but the direction they move. Rising profit margins goose stock prices in wonderful ways, but declining profit margins are a tough anchor to overcome.

The problem today is that most of the big blue chips report record profit margins, as Horizon Management pointed out in a recent research note.

Here is a list of the profit margins of the top 10 technology stocks of the NASDAQ 100 by market cap. They represent more than 40% of the NASDAQ 100.

SEE IMAGE BELOW

"The average net profit margin is roughly 25%," Horizon observes, "which is without any historical precedent whatsoever."

This, then, is the Achilles' heel of the market as far as the fundamentals go. Profit margins are extremely high and unlikely to stay there, which ought to lead to earnings disappointments down the road. It was no surprise that Cisco Systems fell 16% in a day after the market fretted over weakening profit margins at the tech giant. The following chart puts today's profit margins in the context of the last decade. You can see that margins of the CBOE Technology Index are very close to record highs.

This phenomenon extends well beyond just the tech set. As Horizon points out, the same thing is in evidence in the S&P 500, which is a broad measure of the overall market. Let's look at the top 50 market caps in the index. This includes a mix of companies such as Chevron, GE and DuPont.

What do we find?

SEE IMAGE BELOW

Horizon notes:

"There are quite a few companies with very high absolute profit margins. For example, Apple, Coca-Cola, Oracle, Schlumberger, McDonald's, Occidental Petroleum and Freeport-McMoRan Copper & Gold all have the common feature of after-tax net profit margins well in excess of 20%... In general, a 20% profit margin for any company is a historical rarity."

This is important because many investors seem to be banking on the idea that such companies will enjoy fat margins in perpetuity.

In some ways, the surge in profit margins is what you would expect to see in the early phases of a recovery. Companies cut costs going in a downturn. Then, as sales rise, there is a big boost to the bottom line, as costs have yet to catch up.

Today, though, I doubt many of these firms have much more to cut. Instead, the focus is now growing sales and taking business from competitors or defending an existing business. The focus, too, is how to deal with rising raw material costs. All of these put enormous pressure on margins. We should expect to see them fall.

So perhaps the valuations of many of these stocks - often with price- to-earnings ratios between 12-16 - are more spot on than they appear if you assume falling profit margins, falling returns on equity and the like.

As an investor, I think it is better to focus less on what profit margins are today and more on where they will go in the future.

Titanium Metals (NYSE:TIE), Methanex (NASDAQ:MEOH) and Chart Industries (NASDAQ:GTLS), to name three stocks I recommended in my investment letter, Capital & Crisis, all had reported profit margins on the very low end of their historic ranges when I recommended them. But profit margins have since rebounded greatly, and each of these stocks has more than doubled. Even now, profit margins have room to grow and are nowhere near peaks.

Of course, each of these stocks rose for reasons other than just improving profit margins. The stock market overall has gone up quite a bit, lifting all boats to some extent. It is hard to isolate any single factor. Nonetheless, I think the point is that where profit margins are headed is more important than where they are. It's like hockey great Wayne Gretzky's advice: "Go where the puck is going to be, not where it is."

For the market overall, profit margins are likely headed south. Those that can maintain or increase their profit margins will be the exceptions. Finding them, though, could mean the difference between a winning investment and a losing one.

Regards,

Chris Mayer,
for The Daily Reckoning

[joe blowe]

Notice that a profit margin of 25% is considered excessive.
My own experience as an entrepreneur is that 12 % is good. Very good.
The WalMart & Target in the US have margins of 3 to 4 %. Big Oil varies between 8 and 12 %.
Like the article says, once the profit gets too high you will find that there sharks in the water and they will want a piece of it.

[Oreka Bailoak]

Nonetheless, I think the point is that where profit margins are headed is more important than where they are. It's like hockey great Wayne Gretzky's advice: "Go where the puck is going to be, not where it is."

But the catch is- nobody even the experts know where the market is going exactly.

All that economics tells us is that the market is going upwards similar to its performance over the last 400 years. (7-8% percent average a year)

Greedy investing always results in taking on too much risk- resulting in unstable investing and often massive losses. (nobody needs to go for 25% returns LOL that is just ridiculous and totally unrealistic long term and highly risky both short and long term)

It's best to just go with the market average- in other words- diversify your stock portfolio.

Depending on your age you can take on a little more risk if you're young- say a stock market portfolio going for 12% returns (in small cap stocks) or if you're nearing retirement you should take on less risk (invest for say 4-6% gains) and invest more in bonds etc.

Everybody should invest their money (put your money to work making more money), I say if you're just starting out read the book "A Random Walk Down Wall Street" to understand the core basis of investing and go to a local investing office and get some help setting up your portfolio. Compound interest can be a beautiful thing.

IF you got 1,000,000 in your portfolio making 7% a year that's an income of 70,000 a year before cap gains tax.

[joe blowe]

But the catch is- nobody even the experts know where the market is going exactly.

All that economics tells us is that the market is going upwards similar to its performance over the last 400 years. (7-8% percent average a year)

Greedy investing always results in taking on too much risk- resulting in unstable investing and often massive losses. (nobody needs to go for 25% returns LOL that is just ridiculous and totally unrealistic long term and highly risky both short and long term)

It's best to just go with the market average- in other words- diversify your stock portfolio.

Depending on your age you can take on a little more risk if you're young- say a stock market portfolio going for 12% returns (in small cap stocks) or if you're nearing retirement you should take on less risk (invest for say 4-6% gains) and invest more in bonds etc.

Everybody should invest their money (put your money to work making more money), I say if you're just starting out read the book "A Random Walk Down Wall Street" to understand the core basis of investing and go to a local investing office and get some help setting up your portfolio. Compound interest can be a beautiful thing.

IF you got 1,000,000 in your portfolio making 7% a year that's an income of 70,000 a year before cap gains tax.

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Everything above is valid for the epoch before 2003 or 2005. The book was written with a 'normal' market situation which existed then. Although there was printing of money and there was undue control and manipulation of interest rates (since 1913), there was nothing like what we are experiencing now.

We have been led into a situation with close to 0 % interest rates and an overabundance of available capital freshly printed in astounding quantities. Everything you see is fake, the dollar, the stock market, the Euro, Yen, Remby, etc.

Also, keep in mind the corrupting power of the 4 Trillion dollars that have been printed (US alone) in the last 2 years...it is amazing. We have to be very careful with our money, a correction is on the way, I estimate it to be of the order of 50% on most world currencies except (quantitatively) maybe China & Japan.

All countries in the world have followed the US lead in printing money in order to be able to export their fares. In my estimation, a grand total of about 50 Trillion dollars equivalent have been printed worldwide in the past 8 years.

[Breedingvariety]

Also, keep in mind the corrupting power of the 4 Trillion dollars that have been printed (US alone) in the last 2 years...it is amazing. We have to be very careful with our money, a correction is on the way, I estimate it to be of the order of 50% on most world currencies except (quantitatively) maybe China & Japan.

2 trillion dollars USA budget deficits and humongous international trade and current account balance deficits. Dollar is going down.

I agree, of major currencies Chinese yuan and Japanese yen to be safer ones.

All countries in the world have followed the US lead in printing money in order to be able to export their fares. In my estimation, a grand total of about 50 Trillion dollars equivalent have been printed worldwide in the past 8 years.

Countries print money not because they want to increase exports, but because they want to support super rich, who have most debts or most investments. Inability to service debts would mean business going bankrupt and consequently investors losing.

Printing money keeps banks appearances of solvency. They will never stop doing that.

Current account and trade imbalances are allowed to persist because super rich are making money off of them. For example, it would be better for common people in China and Japan if their currencies were rising in relation to other currencies. But supper rich exporters in those countries don't want that. So their central banks keep supporting dollar and trashing home currencies. Also, a lot of financial speculation is dependent on differences in interest rates and fiscal policies among countries. Altering the system significantly would cause unwind of speculative investments and huge losses for some.

So all their policies are never in the interest of their countrymen, but always in the interest of ruling oligarchy.

[Rochefaton]

-------------------------------------------------------------

Everything above is valid for the epoch before 2003 or 2005. The book was written with a 'normal' market situation which existed then. Although there was printing of money and there was undue control and manipulation of interest rates (since 1913), there was nothing like what we are experiencing now.

We have been led into a situation with close to 0 % interest rates and an overabundance of available capital freshly printed in astounding quantities. Everything you see is fake, the dollar, the stock market, the Euro, Yen, Remby, etc.

Also, keep in mind the corrupting power of the 4 Trillion dollars that have been printed (US alone) in the last 2 years...it is amazing. We have to be very careful with our money, a correction is on the way, I estimate it to be of the order of 50% on most world currencies except (quantitatively) maybe China & Japan.

All countries in the world have followed the US lead in printing money in order to be able to export their fares. In my estimation, a grand total of about 50 Trillion dollars equivalent have been printed worldwide in the past 8 years.

Joe, what do you think will happen when the Federal Reserve ends QE2 at the end of this month? Do you see the stock market plunging, interest rates rising, and/or the US housing market falling apart again? In my mind they are basically pulling the plug on the life support to the economy.

Also, do you believe this will be bullish for the US dollar? I've had most of my savings in precious metals, select commodities, and the Swiss Franc for the past 3 years, but I am uncertain what is going to happen in the short term.

Many of the economists I follow don't believe the Fed will stop debasing the dollar very long. I recently heard that Bill Gross is predicting that the Fed will begin another round of QE, except this time they will not set a specific amount of dollars they plan to spend like they did with QE1 and QE2. He predicts that this time they will just buy treasuries in order to maintain interest rates close to 0% until them deem it unnecessary.

In the long term, I think precious metals, agricultural commodities, and non-debased currencies such as the Swiss Franc are a safe bet, but trying to predict the short term keeps me up some nights.

[joe blowe]

Joe, what do you think will happen when the Federal Reserve ends QE2 at the end of this month? Do you see the stock market plunging, interest rates rising, and/or the US housing market falling apart again? In my mind they are basically pulling the plug on the life support to the economy.

Also, do you believe this will be bullish for the US dollar? I've had most of my savings in precious metals, select commodities, and the Swiss Franc for the past 3 years, but I am uncertain what is going to happen in the short term.

Many of the economists I follow don't believe the Fed will stop debasing the dollar very long. I recently heard that Bill Gross is predicting that the Fed will begin another round of QE, except this time they will not set a specific amount of dollars they plan to spend like they did with QE1 and QE2. He predicts that this time they will just buy treasuries in order to maintain interest rates close to 0% until them deem it unnecessary.

In the long term, I think precious metals, agricultural commodities, and non-debased currencies such as the Swiss Franc are a safe bet, but trying to predict the short term keeps me up some nights.

[joe blowe]

Joe, what do you think will happen when the Federal Reserve ends QE2 at the end of this month? Do you see the stock market plunging, interest rates rising, and/or the US housing market falling apart again? In my mind they are basically pulling the plug on the life support to the economy.

Also, do you believe this will be bullish for the US dollar? I've had most of my savings in precious metals, select commodities, and the Swiss Franc for the past 3 years, but I am uncertain what is going to happen in the short term.

Many of the economists I follow don't believe the Fed will stop debasing the dollar very long. I recently heard that Bill Gross is predicting that the Fed will begin another round of QE, except this time they will not set a specific amount of dollars they plan to spend like they did with QE1 and QE2. He predicts that this time they will just buy treasuries in order to maintain interest rates close to 0% until them deem it unnecessary.

In the long term, I think precious metals, agricultural commodities, and non-debased currencies such as the Swiss Franc are a safe bet, but trying to predict the short term keeps me up some nights.

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A number of countries 'hold' US$'s in their bank accounts. When the US purchases something from another country and pays in US$'s, then this other country buys something from some other country and the dollar keeps circulating until someone knocks on the door of the US and asks 'Mr. American, I have this US$ here, what can I buy from you with this ?' and the cycle is closed.

However, what has happened, (see export/import imbalance), is that some foreign country will a lot of times hold the US $ in their banks without returning it to America. China 'holds' about 4 trillion $'s in their banks, apart from the 1.3 trillion that the US owes them. China is already dumping them - there was an article in the last week or two about this...

Whoever 'holds' US$'s, (about 55 trillion worldwide) is afraid, very afraid, because of the latest contest going on in printing money. They know that somehow it will have to be 'digested' through inflation, which is in real terms already high. See:

http://politicalmetals.com/financial...teal-from-you/

also:

http://danielamerman.com/articles/2011/Cheating.htm

have fun and sleep well.