Jeremy Grantham (GMO) 1Q17 Letter – How Long Will Higher Multiples and Higher Profit Margins be Sustained?


GMO Quarterly Letter (1Q17): This Time Seems Very, Very Different – Jeremy Grantham, May 2017

“We value investors have bored momentum investors for decades by trotting out the axiom that the four most dangerous words are, ‘This time is different.’ For 2017 I would like, however, to add to this warning: Conversely, it can be very dangerous indeed to assume that things are never different.”

Oh, the good old days!

  • When I started following the markets in 1965, followed Graham’s approach in buying stocks with larger safety margins and more assets per dollar of stock price
    • For the next 10 years, the out-of-favor cheap dogs beat the market as their low margins recovered (mean reversion of margins). And the next 10 years and the next
  • Since 1996, for a long and painful 20 years, P/E ratio stayed high by 1935-1995 standards – still oscillated the same as before but around a much higher mean (65 to 70% higher!)
  • Along the way were early signs that things had changed. Decline from the 2000 tech bubble happened after it shot up to 35x earnings, compared to 21x earnings at the 1929 bubble high – it fell for a second to touch old normal price trend and then it quickly doubled
  • Compare this experience to the classic bubbles breaking in the US in 1929 and 1972 or Japan in 1989 – all 3 crashed and stayed below for an investment generation, waiting for a new crop of more hopeful investors
    • Even in 2009, the market went below trend for only six months
  • Compared to the pre-1997 era, profit margins have risen by about 30% (large and sustained change)
    • Above-average profit margins times above-average multiples will give you very much above-average price to book ratios or price to replacement cost
    • Counterintuitively, to sell at replacement cost, above-normal margins must be multiplied by a below-average P/E ratio and vice versa
  • Interest rates is also very different: short rates have never been at such low levels in history as they were last year
  • Other factors like population growth, degree of income inequality, extent of globalization, indicators of monopoly in the US, extended period of below-trend GDP growth and productivity almost everywhere, climate change issues, oil prices in real terms, and modus operandi of the Fed are different
    • One might ask: Is there anything that matters in investing that is NOT different?

Corporate profitability is the key difference in higher pricing

  • With higher margins, obviously the market is going to sell at higher prices. So how permanent are these higher margins?
  • Used to call profit margins the most dependably mean-reverting series in finance and they were through 1997. So why did they stop mean reverting around the old trend? Or alternatively, why did they appear to jump to a much higher trend level of profits?
  • What will it take to get corporate margins down in the US? Not to a temporary low but to a level where they fluctuate around the earlier lower average?
    • Increased globalization has no doubt increased the value of brands, and the US has much more than its fair share of both the old established brands of the Coca-Cola and J&J variety and new ones like Apple, Amazon, and Facebook. Impeding global trade today would decrease the advantages that have accrued to US corporations
    • Steadily increasing corporate power over the last 40 years has been the defining feature of the US government and politics in general. As new regulations proliferated, they tended to protect the large, established companies and hinder new entrants. Regulations, however necessary to the well-being of ordinary people, are in aggregate anti-competitive. They form a protective moat for large, established firms which produces the irony that the current ripping out of regulations willy-nilly will of course reduce short-term corporate costs and increase profits in the near future, but for the longer run, stripping out regulations is working to fill in its protective moat
    • Corporate power hinges on the ease with which money can influence policy. Maybe it will weaken one day if it stimulates a broad pushback from the general public but it will not be quick enough to drag corporate margins back toward normal in the near future
    • Now, there is plenty of excess capacity and a reduced emphasis on growth relative to profitability. There has been a slight decline in capital spending as a % of GDP
    • General pattern described is compatible with increased monopoly power for US corporations: higher profit margins, reluctance to expand capacity, slight reduction in GDP growth and productivity, pressure on wages and labor negotiations, fewer new entrants into the corporate world, and declining number of large corporations
    • The single largest input to higher margins is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage. Pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower. At the old average rate and leverage, profit margins on the S&P 500 would drop back 80% of the way to their previous much lower pre-1997 average, leaving them a mere 6% higher
  • In a world of reasonable competitiveness, higher margins from lower rates should have been competed away. But they were not and other factors like increased monopoly, political, and brand power created new stickiness in profits that allowed these new higher margin levels to be sustained for so long
  • Best bet for higher rate equilibrium is a change in the dominant central bank policy of using low rates to stimulate asset prices and stimulate growth. It is a deeply entrenched establishment view. President Trump is admittedly a wild card in this game and he said a few anti-Fed things in the election phase. He also gets to appoint 5 new members in the next 18 months but in the end, will a real estate developer with plenty of assets and an apparent interest in being very rich really promote a materially higher-yield policy at the Fed? Possible but quite improbable
  • In short, lower rates than those in effect pre-1997 are likely to be with us for years; while we wait for higher risk-free rates, investors should brace themselves for continued higher multiples. What does this mean for value investing?
    • It does not mean that cheaper is not better but price to book was never a measure of cheapness. Low price to book ratios reflect the market’s vote as to which companies have the least useful assets
  • The greatest deviations from fair value occur at more macro levels – countries and asset classes – where career risk is higher than picking one insurance company over another and therefore the inefficiencies and opportunities for outperforming are greater

Outlook for corporate margins – and hence (probably) the market in 2017

  • 3 factors moving in favor of US profit margins this year
    • Oil and resource prices appeared to have bottomed out last year and seem likely to have favorable comparisons for a few quarters
    • Trump is likely to settle for a moderate reduction in corporate tax rates this year after bouncing off the infinitely complex task of a full redo of the tax code
      • In a theoretical world, corporate taxes are a pass-through to consumers but in the current, stickier, more monopolistic, more profit-fixated world, a corporate tax reduction will raise corporate profits for quite a while
    • Removing regulations here and there will, as mentioned, lower corporate costs in the short term
  • Net-net, unless there are some substantial unexpected negatives, US corporate margins will be up this year, making for the likelihood, of an up year in the market at least until late in the year
  • This does seem to make the odds of a major decline in the near future quite low
Image Source: Compustat, GMO



Leave a Reply

Your email address will not be published.