The trend in profitability is the friend of US stocks
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is founder and chief executive of Trivariate Research
Many investors are worried that the US equity market is expensive. The problem is that valuation worries alone are uninformative. After all, that was also the prevailing sentiment at the beginning of 2023, before the S&P 500 appreciated nearly another 40 per cent.
There is a reasonably high probability that the US stock market will remain expensive compared with history for several years, owing to cyclical and structural factors as well the potential impact of artificial intelligence on corporate margins. Investors might continue to think it pricey for a decade.
The key thing to watch is gross margins, the profitability of a company measured by what is left after deducting the cost of goods sold from revenues. There is a strong relationship between gross margins and what we see as an important valuation metric — the ratio of a company’s enterprise value (market capitalisation plus net debt) to forecast sales.
The higher the level of gross margins, the higher the enterprise-value-to-sales multiple investors pay for the business.
Therefore, our primary focus is on understanding what variables could introduce volatility into corporate margins. A potentially dangerous approach to thinking about the valuation of US equities is to assume the mean reversion of margins to historic trend levels. This logic lends itself to believing the market is overvalued for sustained periods. Gross margins for the median US company have had an upward slope for nearly two decades.
First, there are some important cyclical considerations. Pricing of products, of course, can have affect gross margins. If companies can raise pricing on their products without a commensurate loss of demand, this has a very positive impact on their margins on incremental income.
We have seen some signs of price cuts recently at some of the large US retailers, such as Target, Amazon’s grocery business and Walmart. But in aggregate pricing has been relatively sticky across many areas of consumer discretionary, healthcare, technology and industrials.
Employee cost pressures have been abating, with many companies suggesting labour productivity is offsetting wage inflation. Input costs such as materials and logistics are in many cases less onerous than a year ago. Hence, we are seeing sellside analysts forecast more cyclical margin expansion than usual.
Nearly three-quarters of the top 500 US equities will expand margins over the next 12 months, according to the consensus of analyst forecasts. And this appears to be the case regardless of the size of the company. While analysts are often poor forecasters, our research shows they are right nearly 75 per cent of the time regarding whether margins are up or down in absolute terms. Given that inflation expectations are not likely to see a sustained re-acceleration, there may be some short-term cyclical upside to margins.
Second, there are structural reasons why historical gross margins are not a good gauge for the current constitution of the US equity market. There are far more software and biotechnology companies today than 25 years ago. The percentage of the US equity market of companies with little or zero inventory costs has gone from 20 per cent in 1999 to more than 30 per cent today.
The ratios of capital spending to sales are down because there is less manufacturing among the largest US equities. As a result, the ratio of depreciation-to-cost of goods sold is 2.5 percentage points lower today than the long-term average. Lower capital spending alone explains nearly half of the reason gross margins are higher today than long-term averages. Add up these differences, and we estimate companies accounting for 36 per cent of today’s US equity market have greater than 60 per cent gross margins, the highest percentage ever.
Third, there is the reality and the future prospect of margin expansion from AI. We have noticed that many growth companies are being asked about AI on their earnings calls — meaning analysts think there may be some potential impact. These businesses are already showing more margin expansion than those growth companies where analysts aren’t asking about AI. We are aware of many businesses, in healthcare services, financials and technology, where meaningful revenue growth is possible over several years without much additional hiring. This could mean margins on new revenue are well above existing streams for businesses.
The bottom line for us is clear: the US equity market is going to trade at higher multiples for a long time because margins are going to be higher in the future than in the past.
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