Integrated Equity Insights: Analyzing margin improvements and risks to sustained high profitability

The fourth quarter of 2024 demonstrated a marked divergence in global equity returns, strong factor returns, and, in our view, some counterintuitive results. We believe the factor returns largely reflect the market’s response to former President Donald Trump’s reelection and the Federal Reserve’s rate-cutting cycle in the U.S. We highlight three key themes:

• Global divergence in returns: The U.S. stock market rose slightly in the fourth quarter, buoyed primarily by large-cap growth stocks. In contrast, global markets were meaningfully negative (Figure 1). We believe the divergence between U.S. and non-U.S. markets reflects, at least in part, the presumptive U.S.‑focused policies of President‑elect Trump.
• Low-quality, high-risk, expensive stocks rally in the U.S.: Across all U.S. market segments, high-risk, low-quality, and expensive stocks outperformed significantly, with consistent growth over value leadership at both the index and factor levels. These dynamics persisted the entire quarter but appeared to accelerate following the U.S. elections in early November (Figure 2).
• Short-covering played a significant role in the U.S., particularly in growth indices: The low-quality, risk-on rally appears to have been partially driven by short-covering, which was particularly prevalent in the growth benchmarks (Figure 3).

“...this appeared to be a counterintuitive quarter in which investor behavior was not reflective of the fundamental setup....”

Stepping back, we believe some of this market behavior is counterintuitive. It appears that the market is anticipating a similar pro-growth agenda as during Trump’s first term, but we note the starting point today is very different: Tax rates have already been cut significantly; the federal budget deficit is larger and inflation is a primary concern, so fiscal stimulus will likely be muted; and interest rates are higher and could serve as a headwind if inflation reignites. We have concerns that the market may be inappropriately extrapolating the expected impact of Trump’s actions this time. Also, historically, risk rallies have typically occurred in positive market environments; the outperformance of low quality and high risk in muted market environments suggests so-called animal spirits at the stock level that are not reflected at the index level. And finally, we note that this pro-risk, pro-growth rally happened alongside a material increase in the 10-year U.S. Treasury note yield, which is a bit counterintuitive to us given the longer-duration nature of stocks that rallied. In short, this appeared to be a counterintuitive quarter in which investor behavior was not reflective of the fundamental setup, in our opinion.

Market insight—What we’re monitoring

Dovetailing with our previous newsletter, we further investigate the sustainability of a winner-take-all environment that has characterized markets over the last decade. The percentage of high-earning companies has reached levels not seen in over three decades, signaling a shift in market dynamics that favors scale, innovation, and efficiency. The digital era has widened the gap between leaders and laggards, creating a landscape in which profitability and operational excellence have been sustained. A symptom of the differentiation has been excess margins.

“...the artificial intelligence (AI) cycle may make the high-margin economy more capital intensive.”

In this section, we break down the key drivers of historic margin improvement and discuss potential risks to this structural change. The main takeaways:

• Improving margins can largely be explained by globalization, the shift to a services economy, lower interest costs, and lower tax rates, which are offset slightly by higher levels of research and development (R&D)—the “cost” of a service-oriented economy.
• These drivers also highlight the risks we see to sustained high margins: some of the margin tailwinds may be reversing, while the artificial intelligence (AI) cycle may make the high-margin economy more capital intensive.

We present the data and consider these trade-offs below.

Setting the stage—Where we are today

Since the 2008 global financial crisis, we have seen the S&P 500 multiple consistently march higher, with the year-end 2024 multiple at 21.8x forecast 12-month forward earnings, and with post‑pandemic multiples higher than at any time since the dot-com era of the late 1990s (Figure 4).

This premium multiple has been justified by persistently expanding profit margins. Analyzing quintiles of profit margins (Figure 5), we highlight two key trends. First, margins have generally been increasing for most cohorts in the last 20 years. Second, the margin advantage of the most profitable companies has been steadily growing.

Unpacking the drivers of margin expansion

The year-end 2024 net margin of 9.75% for the S&P 500 compares with an average of 5.85% from 1989–2015. This improvement can be decomposed into both fundamental and sector effects. Most of the increase can be attributed to globalization and the transition to a service-based economy, as reflected in a 450-basis-point decrease in the cost of goods sold (COGS) (top chart of Figure 6). Low interest rates and a lowered U.S. corporate tax rate have also been tailwinds to margins, contributing nearly 130 basis points combined. The biggest headwind to margins has been elevated levels of R&D spending, which has detracted 220 basis points. This trend has been fueled by technological advancement and increased government subsidies in defense and health care‑related companies.

Looking at the margin expansion a different way, we analyze the impact that index composition (changing sector weights) has had (bottom chart of Figure 6). Expansion in the three technology-heavy sectors—information technology, communication services, and consumer discretionary—collectively account for over 75% of the nearly 400-basis-point improvement we observe in aggregate margin.

“Our data illustrate a systemic shift in the economy that has favored knowledge-based industries and led to historically high margin levels. This concentration of profitability should make us cautious....”

Our data illustrate a systemic shift in the economy that has favored knowledge-based industries and led to historically high margin levels. This concentration of profitability should make us cautious, as any disruption to these dynamics could have outsized impacts on market performance. In the next section, we consider risks to sustained high profitability levels using the framework developed above.

Identifying potential risks

The current market is dominated by high-margin, capital-light firms that leverage technology and network effects. However, this evolution is not without its vulnerabilities. Below we lay out key risks that could challenge the sustainability of margins and, relatedly, the high market multiples:

1. Unprecedented capital expenditures (capex):

• As companies invest heavily in infrastructure, AI, automation, and R&D, the associated capital expenditures are reaching unprecedented levels (Figure 7). While these investments aim to solidify competitive positions, the resulting depreciation and amortization (D&A) impact will eventually flow through to earnings and should become a headwind to profitability.
• As our colleague Portfolio Manager David Giroux underscores, the consequences of poor capital allocation will become increasingly evident in a high-stakes capex environment. “Academic research highlights just how difficult and counterintuitive good capital allocation can be…the tendency to dial up these activities when times are good can make it harder to generate favorable returns.…Technological innovation is accelerating [and] stakes for capital allocation are high. Some companies will flourish because of these decisions, and some will falter.”^[1] Historically, capital deployments of this magnitude failed to deliver the anticipated returns, and we do not believe this cycle will be an exception.

2. Reversing tailwinds in globalization:

• Geopolitical tensions, trade restrictions, and reshoring trends could reverse globalization benefits, increasing production costs and reducing margins.

3. The end of the zero interest rate era:

• We are no longer in a zero interest rate regime, which provided a critical margin tailwind for companies that borrow and also boosted the valuations of long-duration firms. Rising interest rates increase borrowing costs, strain highly levered companies, and should compress valuations of longer-duration firms, which are expected to produce higher earnings in the future. Such firms are viewed as more growth-oriented and sensitive to interest rate movements as higher discount rates can significantly impact the present value of their future earnings.

4. Corporate taxes have less room to fall:

• Following the Tax Cuts and Jobs Act (TCJA) of 2017, which lowered corporate tax rates in the U.S. to 21%, the runway for further reductions has been substantially shortened.

5. Base rates:

• The outside view suggests that industries with high profitability have a hard time sustaining those margins over time (e.g., because they often attract new entrants or face innovation‑driven disruption). (Figure 8)

As mentioned last quarter, the risk to the outside view is that it may really be different this time. The impact of technology, platform businesses, and now the race for AI are reshaping the landscape. The advantages of scale may prove more sustainable than in the past and possibly even amplify long-term profitability trends. In this evolving environment, prudent risk management and careful monitoring of quantitative factors are essential to navigating the increasingly less mean-reverting dynamics of the market.

Summary

The U.S. stock market is expensive relative to its history, but the fundamentals of some of the largest companies are also stronger than ever, and the shifting sector composition of the S&P 500 makes historical comparisons more difficult. In our view, the transition from asset-light business models to a more capital-intensive paradigm stands out as the most pivotal change. When the dust settles, this massive capex regime is likely to expose poor capital allocators, creating clear winners and losers in the market. This dynamic, combined with mounting pressures on the forces that once bolstered margins—globalization, low interest rates, and low tax rates—and the additional threat of regulatory changes, creates a backdrop that will challenge the sustainability of profitability.

 

Appendix

Factors are our internally constructed metrics defined as follows:

Valuation: Proprietary composite of valuation metrics based on earnings, sales, book value, and dividends. Specific value factor weighting may vary by region and sector.

Growth: Proprietary composite of growth metrics based on historical and forward‑looking earnings and sales growth. Factor selection and weighting vary by region and industry.

Momentum: Proprietary measure of medium‑term price momentum.

Quality: Proprietary measure of quality based on fundamental and stock price stability; balance sheet strength; and measures of profitability, capital usage, and earnings quality.

Profitability: Return on equity.

Risk: Proprietary composite capturing stock return stability over multiple time horizons (positive return means risky stocks outperform stable stocks).

Size: Market capitalization (positive return means larger stocks outperform smaller stocks).

Quintile Spread: Also referred to as long-short returns, a quintile spread is calculated by sorting securities based on a specific characteristic or factor criterion, dividing them into five groups (or quintiles), equal-weighting the securities within each quintile, and then subtracting the bottom-quintile returns (lowest 20%) from the top-quintile returns (highest 20%).

Factors and indices cannot be invested into directly and are shown for illustrative purposes only. They do not reflect performance of actual investments nor does it reflect the reduction of fees associated with an actual investment such as trading costs and management fees.