Focus on three-pronged return strategy
Corporate profit margins are at or near historic peak levels across most major markets and there is growing concern that they will fall and drag down earnings growth. Given their long-term tendency to revert to their historical average, could this be a potential risk for equities in the medium term? After all, rising margins have been a major source of alpha over the past decade.
It is widely acknowledged that margins contract when the economy slows and our outlook remains one of slow and prolonged economic recovery against a backdrop of sovereign debt concerns and fiscal austerity in Europe and elsewhere in the developed world and worries that growth in China is slowing.
Profit margins are at their highest point now since the late 1960s and, in our view, their rate of growth is unsustainable. We believe that the rise in margins has been helped by a number of factors over the past 30 years or so which have driven returns higher: a technology revolution which accelerated productivity; the opening of new markets for consumption and a period of structurally declining interest rates. Most pertinent of all is the overarching theme of globalisation of the supply chain, which has allowed firms to reduce their cost of production.
Companies in the West have clearly derived benefits from moving supply chains to developing markets. The improvements seen in their margins over the past decade in particular can be explained in part by declines in both input costs and wages, measured relative to revenues. According to Empirical Research Partners, the cost savings for companies switching from a supplier in the West to one in the developing world has been about 50 per cent.
Many manufacturing jobs in recent years have simply disappeared from the West, given the broad shift to service economies, and the process has been largely outsourced to companies based in emerging markets. China’s manufacturing wages, for example, are just 13 per cent (when converted to dollar terms) of those in the US, up from 4 per cent a decade ago. Yet at some point, we believe it is reasonable to expect that rapid real wage inflation in emerging markets over the next few years will continue to erode this advantage.
The rising cost of wages in emerging market countries in the near-term is just one reason why there is likely to be more pressure on margins going forward. In addition, there are signs of fatigue in some of the other drivers of the current high levels of capital efficiency; there is now little to take out on the cost side. In the US, for example, the level of corporate taxation fell between 2000 and 2005, stabilising at about 32 per cent since then, and companies are unlikely to significantly increase leverage in this age of austerity.
Arguments still exist though as to why profit margins can continue to rise. Greater cross-border trade and capital flows in recent years have pushed developed market profits to above-average levels and if developed market companies maintain a steady share of profits in fast-growing emerging markets, then emerging market sourced income could push profits even higher. Historically, margins have not peaked until well after a recession, lagging recessions by three to five years on average after the past three recessions, according to Deutsche Bank.
Yet given their long-term tendency to revert to their historical average, we believe that margins are long overdue a correction. On this basis, our investment thinking is geared towards the risks of margin compression when looking at companies around the world. We have just witnessed a long and sustained trend of rising margins and falling capital requirements in developed markets explained by the shift of manufacturing to the developing world. We would argue that this was a specific period in time with a unique set of circumstances in place and that it has the potential to distort our view of history. We believe that the current high margins are unsustainable and for us it is a case of when, not if, they revert to the historical average.
Against a challenging investment landscape, we remain focused on our three-pronged long-term total return strategy of capital appreciation and the sustainability and growth of dividends (as opposed to headline yield figures). With this in mind, we use three key qualitative measures of companies: a high return on capital, generation of strong and sustainable cash flows and management teams who we trust to deploy that capital appropriately. We believe these types of companies are more likely to be able to return cash to investors in the form of growing dividends.
Clearly, dividends are a form of income but, more than that, research supports the notion that the combination of dividend yield and dividend growth can produce above market average returns over the long term. For many, equity income investing is not just about receiving the income but reinvesting the income received and allowing the power of compounding to drive their total return.
Of course, a dividend yield can appear high (albeit temporarily) when a company becomes distressed. It is for this reason that dividends must be considered in the context of a business’ ability to sustain and pay that dividend into the future. Crucial to this is the sustainability of profit margins which frames the likely outlook for growing and sustainable dividends. Our research examines the drivers behind corporate profit margins as a means to differentiate between sustainable and unsustainable dividends.
In other words, we are looking for ‘quality income’ as opposed to yield maximisation.
As bottom-up stockpickers, we do not employ a macro-economic overlay to our stock research. However, our macro views provide context. At this time of austerity, we believe there is scope for profit growth to be restricted. With profit margins currently at the higher end of their historical range, it is our view there is only one way for them to go.
Our investment process prizes the disciplined pursuit of high quality income at attractive valuations. We believe these businesses are in the best position to outperform not just in the context of austerity and margin pressure but throughout the economic cycle.
Paul Boyne is the manager of the Invesco Perpetual Global Equity Income fund
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