Do high margins justify high valuations?

The narrative that high profit margins justify the S&P 500 Index’s frothy valuation is only marginally correct. Our Asset Allocation Committee maintains a slight overweight to stocks, looking for better entry points to increase the position.

As I write this in mid-November, the S&P 500 is up 54% over the last two years. Its forward 12-month price/earnings (P/E) ratio is 22.¹ It’s hard to argue that stocks aren’t expensive.

Yet the bears have been quiet. The U.S. election outcome could favor pro-growth policies. The economy looks fine, the Fed is easing, and earnings growth is accelerating.

And, of course, artificial intelligence (AI) is awesome. I asked ChatGPT what it “artificially” thinks (see box below):

Some strategists argue that high profit margins justify the S&P’s high valuation. Here are some recent examples of this narrative:

High profit margins justify high valuations only if they are sustainable and generate high profit growth. Sustainable margins come from benefits of scale, barriers to entry, and reinvestments in profitable projects. In other words, they come from what Warren Buffet calls “economic moats.”

This has been true for growth stocks in the era following the global financial crisis (GFC), but not necessarily for value stocks.

Also, the pre-GFC data are less conclusive for growth stocks. Margins don’t grow to the sky, and we’ve had periods like the internet bubble when valuations divorced from fundamentals.

Hence, the recent 15-year expansion in growth stock margins has been unusual by historical standards. As our head of Integrated Equity, Peter Stournaras, recently wrote:

Digital business models are scalable. You can add a user to an online social platform at no cost. Plus, once a platform reaches critical mass, the network effect becomes a barrier to entry. More users attract more users, and the big get bigger.

And it’s not just about the network effect. Technology has been the key to building competitive advantages in software, phones, web searches, online shopping, and computer chips. And it’s been a significant factor in the U.S. stock market historically outperforming the rest of the world. Technology is steroids for margins.

The chart below compares the upward movement in margins for the technology sector after the global financial crisis with the rest of the S&P 500, for which margins have only slightly increased.

Using that lens, high margins justify high valuations. Below is a scatterplot of the P/E ratio and profit margins for growth stocks from Q1 2010 to Q3 2024. There’s a 75% correlation between margins and P/E ratios. High margins indicated strong future profit growth potential—and perhaps they still do if we think AI investments will be profitable.

The green dot shows the latest data point as of September 2024. It’s close to the regression line, which means that the current P/E for growth stocks—if we believe this relationship will persist—is neither cheap nor expensive. It’s high, but so are margins.

But there are caveats. First, high margins did not command high P/E ratios for value stocks over this same period. There was no relationship, as shown below.

Value stocks’ margins are linked to bank profits, commodities prices, and other cyclical factors that tend to revert to the mean.

There was no relationship for growth stocks before the global financial crisis either, as shown below. In particular, P/E ratios were divorced from fundamentals during the tech bubble. Internet companies commanded high valuations without generating revenues, let alone high margins.

Combining the data and examining the long-run relationship over more than 30 years, we find a 22% correlation and a relatively flat slope between P/E ratios and profit margins for the S&P 500, as shown below.

Our analysis justifies our moderate risk-on position. Valuations are high, but…

The bottom line is that high margins are a good thing, but they’re only part of the story about market fundamentals.

One last thing…

I’m regularly asked to discuss our views on live national television or to print journalists. It’s stressful. With one or two minutes per answer, nuance is out of the question. I often use facile talking points—like everyone else. So, I say this with empathy for anyone speaking in the media, including those I quoted at the beginning of this article: Beware of oversimplified narratives.

I’m grateful to William Liu for running this analysis and to Rob Panariello, Charles Shriver, Josh Yocum, and Dave Eiswert for their valuable contributions, as always.

Definitions:

Profit margin is used to identify a company’s health and its potential for growth. As a percentage, it is the amount of profit a company has generated compared with its revenue.

Relative valuation is the concept of comparing the valuations (such as price-to-earnings ratios) of different securities or asset classes.