INVESTORS FOCUS ON PROFIT MARGINS
Firms with high operating leverage, which allows revenue to boost earnings as costs stay low, have seen share prices rise 15pc
FOR years United States inflation has been the dog that did not bark, but rising prices and wages are now showing signs of squeezing profit margins across corporate America, leading investors to punish companies whose results are deteriorating.
Investors have long focused on rewarding companies that can multiply sales in a relatively slowgrowth US economy like Netflix Inc and Amazon.com Inc, but they are now paying more attention to figures further down the income statement like expenses and pre-tax margins.
So far this year companies with high operating leverage, which allows rising revenue to boost earnings while costs stay low, have seen their share prices rise 15 per cent, beating their peers by nearly six percentage points, Goldman Sachs data showed.
Investors have also been rewarding companies with high and stable gross profit margins, according to the data.
But a shift in investor focus may now be occurring as the impact of US corporate tax cuts encourages more spending and 10 years of ultra-low interest rates have stimulated economic growth and finally begun to push up prices and wages.
Large corporate tax cuts enacted last year boosted already hefty corporate profits, making most companies’ results look better by after-tax measures, but the benefit of the tax cuts also enabled companies to spend on talent and market share, sometimes raising expenses.
The other driver for investors’ increased focus on pre-tax margins may be inflation as industrial companies are forced to pay more for raw materials and companies dependent on consumer demand pay more in wages.
Tom Dorsey, co-founder of Dorsey, Wright & Associates LLC, said today’s market dynamics remind him of those in the mid1970s when he started in the investment business. US inflation skyrocketed during that decade, with oil prices spiking higher.
Take the case of Campbell Soup Co, which has seen its stock fall 30 per cent so far this year on concern that packaged goods companies are struggling to pass on higher costs to consumers through powerful distributors like Walmart Inc and following the departure in May of chief executive Denise Morrison.
In its most recent quarterly earnings, the canned-soup company reported “higher supply chain costs and cost inflation including higher transportation and logistics costs.”
Another example is provided by Stanley Black & Decker Inc whose stock is off 14 per cent year-to-date despite beating Wall Street earnings estimates.
The power-tool manufacturer’s chief financial officer, Donald Allan, said in April steel, batteries and base metals prices were going to take more of a bite out of earnings than they had warned, though they hope to offset those impacts by adjusting prices.
Airline stocks also sank this year with crude oil prices up about nine per cent this year, pushing up jet fuel costs. Airline stocks were down more than seven per cent this year.
By contrast, companies who have managed to widen profit margins such as Zoetis Inc, which makes medicines for animals, Calvin Klein apparel maker PVH Corp, and agricultural product maker Monsanto Co, have been rewarded with higher share prices this year.
US headline consumer price inflation was 2.5 per cent year-onyear last month and hourly earnings for private sector employees were up 2.7 per cent from a yearago, the US Labour Department reported recently.
In last month’s “Beige Book” on business conditions, the US Federal Reserve (Fed) reported moderate price rises in most regions and noted rising materials costs in some districts that are putting pressure on transportation, construction and manufacturing.
The Fed is expected to raise interest rates again at its policy meeting on Wednesday as inflation and unemployment have come closer to the central bank’s targets but it will likely keep an eye on corporate profit margins.