No. of Recommendations: 38
You are confusing two things. It’s of course true that margins are range bound, that is obvious. But that doesn’t mean that profits can’t rise faster than sales over the long run. They can, they are just bound by their range.Mungofitch is aptly reminding that (1) the historical rate of real sales increase is lower than many realize, and will likely continue to be low, and (2) long term earnings cannot rise significantly faster than sales, and I add - especially if they already rose a lot and we have to start from here.
The crucial point is the last half of the above sentence -
when looking in the rear vision mirror we observe earnings rose at a rapid rate. But this was largely owing to a one-time near unprecedented expansion in margins (partly helped by improved taxation conditions).
The point is that margins cannot continually rise particularly *from the present near historically high level*
at the same rate that they rose in recent history which we may just mistakenly assume from casual observation.
One gets used to EPS rising a lot and start to think of it normal and perpetual.
The problem is that we now have historically high margins so it is more likely that a random time in the future (pick and time, 10 years away or 20 years away), margins will be lower than they are today. The world changes, and there is far more room below than room above.
Or if optimistic, at that point in time, the margins will still be around the same as today without any decline - in which case we have a much lower rate of earnings increase until that point in time (owing to the past margin expansion having stopped for 13 whole years).
In my earlier post about small caps (S&P600) I cited the sales incesse of both small caps and the broad market:
https://www.shrewdm.com/MB?pid=764838264.. for example revenue per share + dividends of the S&P600 rose 10% per year the last 20 years, versus merely 7% for the S&P500By the logic of limited available capital destinations (by this I mean that in aggregate, most people must be invested in the cap weighted S&P500 or on average rather correlated), most investors might expect further sales increases to match the past dividend + sales increase of the S&P500. So that means around the 7% as the last 20 years.
But half of that 7% was inflation, and the remaining 3.5% can be nearly halved again after taking out the dividend - so the actual real rise in intrinsic value at a per share level (for real capital gains) for most investors is down to about 2% per year if we have no expanding margins. If we have declining margins, we will of course have lower capital gains. Margins falling from their present 13% to even their still fairly high average 20 year level of 10%, is a 23% fall in the EPS - and that alone would more than wipe out the real 2% sales increase for 13 whole years.
In the future, if we are lucky to retain the present very high margins, then that 2% real rise in sales would permit the same 2% rise in the real EPS, and if valuations remain at their present very high level (I’m talking about only the broad market) then that 2% is also the real capital gains the average investor can hope for from stocks, other than dividend.
That is why investors become much wealthier if stocks trade perpetually very cheaply - as the dividend yield along the way remains much higher. Presently we have to acceot very low yields.
The above is what most investors are faced with whether they pay attention or not, as most investors - by the aggregate of shares held - will have returns similar to the S&P500 *only*.
By financial logic, only a small minority of investors are able to get the superior S&P600 returns. By holding the S&P600 (small caps) instead of the S&P500 (large caps) the future returns will be higher because of 3 *mutually exclusive* points:
1. Both the S&P600 (small cap) and S&P400 (mid cap) the rate of sales increase, the last 20 years, was 3% higher than the S&P500 (large cap), and the studies that go back much further show the similar trend (Gosh, it seems easy to stand amongst precious few with a 3% outperformance over a 40+ year full career).
2. We are starting today from a price to sales valuation that is far less elevated (in each case compared to their
own average level) for the S&P600 compared to the S&P500.
3. For the S&P600 we are starting from having moderately less elevated margins of 6% verus 5.5% 20-year average (so there is either more opportunity for further margin expansion or less far to fall in case of margin compression). For the S&P500 margins are 30% above their 20-year average, and 33% above for the S&P400 - so they are least elevated (at 9% above their norm) only for the S&P600.
Bt the way, is anyone else smelling some increased greed in the atmosphere? When there is greed in the psychology it spreads by osmosis. We catch commentary on TV and become unwittingly infected. Seeing quotes high, we start to talk about forward earnings instead of present earnings - and then, we block out the past bad times. We also watch others block out bad times, and we copy them, being kind social creatures. We atart to just assume that what is “good” (high margins, good tax conditions, high price to book value ratios, etc) is are permanent conditions - and what is bad won’t reoccur as in only out of date boring stuff that belongs to the past.
As I wrote the average equity investor is, by mathematical necessity, having returns correlated to the cap weighted S&P500. So most cannot avoid returns similar to this index. These returns have been lately elevated owing to both increasing expansions and increasing evaluations, rather than the underlying real sales rising at some magical level.
Berkshire Hathaway, like the S&P600, has accumulated underlying value at a higher rate than the S&P500, but the 20 year total returns of all 3 were similar. You want to be on a vehicle that it is actually moving faster than an average one, rather than a vehicle moving slower but the consensus opinion - for the moment - that it is flying along, even if it isn't. Yes, unlike an actual slow moving bus, with markets you can sell out to that consensus opinion, but remaining in the slow bus with everyone inside it believing it has moved really far doesn’t make it so.
- Manlobbi
