Jeremy Grantham on Profit Margins and American Prosperity

Have profit margins risen to a permanently higher plateau? Are average Americans better off than they were a generation ago? I had the opportunity to discuss those questions, which are centrally important to investing and economic policy, with Jeremy Grantham a couple of weeks ago.

The discussion took place as part of a larger interview about climate-change investing. Grantham is the co-founder and chief investment strategist of Boston-based Grantham Mayo Van Otterloo (GMO).

It’s been widely reported that over the last 20 years the number of publicly traded companies has decreased by about 50%. The common explanations center on the fact that the number of de-listings, mergers, acquisitions and bankruptcies have outstripped the initial public offerings (IPOs).

But I wanted to know if there was a deeper explanation related to the fact that corporate profit margins are at historical highs. Over the last dozen years, with the exception of the financial crisis, profit margins have been between 9% and 11% of GDP. Prior to that, the last time they were above 9% was in 1951.

The U.S. economy has become more concentrated in the service and technology sectors, which are inherently more profitable than the manufacturing businesses that dominated 50 years ago. Those business, like Amazon, Apple and Google have built incredibly strong, near-monopolistic franchises that should translate to higher margins.

If the market has become dominated with highly profitable, monopolistic franchises, then maybe that is why there are fewer companies and profit markets are no longer “the most mean-reverting series in finance,” as Grantham once claimed.

GMO has looked at this issue extensively. As Grantham noted, “profit margins and return on sales will vary much depending on whether you are in the supermarket business or whether you are in some software company. There is no average to which it moves.”

But that doesn’t necessarily mean that returns for equities will be greater going forward. As Grantham explained, higher margins will attract more capital and reduce the returns relative to other asset classes. “If your capital is returning more in this area than the other area then capital will flow and balance it out,” he said.

Higher margins have been offered as an explanation, by Grantham and others, for why the cyclically adjusted price-earnings (CAPE) ratio is higher than its historical average. But CAPE ratios depend on other factors, such as real interest rates, so margins only tell part of the story.