FOOL ON THE HILL: An Investment Opinion
Averaging Up

A recent Wall Street report shows that the average operating profit margin for S&P 500 companies is close to a 50-year high. Investors can thank business efficiency improvements and the greater imprint of technology companies for the rising margins, which have carried over into higher market values. But for margins to rise further, companies will need to balance the cost-cutting, yet price-eroding, power of the Internet.

By Brian Graney (TMF Panic)
September 26, 2000

As a general rule, investors hate being average. The point of any active investment strategy, no matter how flashy or sophisticated, is to do better than average, to end up as far to the right along the bell curve distribution of total returns as possible. Otherwise, what's the point?

If you don't happen to have a problem with average returns, then your investing life becomes much simpler. All you need to do is buy an index fund and watch those average returns roll in year after year. No Wall Street Journal subscription required. CNBC becomes a greater waste of time than it already is. You could probably even do without this very website, although there's no need to take the idea to an extreme.

If you're not a passive investor, then topping the average return of the market becomes the name of the game. For investors working with a long-term time horizon -- which is the only time horizon that really makes sense when it comes to investing in stocks -- one effective way to seek out above-average returns is to invest in above-average companies at reasonable prices. That strategy sounds logical enough, but it helps to first know what the "average" company looks like. (We'll leave the question of what makes for a reasonable price for another day and, with any luck, to another writer.)

What constitutes "average" for the companies in the S&P 500 Index has changed quite a bit over the past decade or so. As Lehman Brothers chief investment strategist Jeffrey Applegate pointed out in a recent report that is available at Multex.com, the average S&P 500 company has become much more profitable in recent years, suggesting the gap between today's fictitious everycompany and the real above-average outliers is more than likely contracting.

According to Applegate's numbers, the after-tax operating profit margin for all of the companies in the S&P 500 was nearly 7% at the end of the second quarter. Sure, that may sound like chicken scratch to investors accustomed to looking at some of today's high-flying, high-margin, intellectual property-based businesses, but this is the S&P 500 we're talking about. You know, the so-called blue chips. Today's margin level is the highest in almost 50 years. For comparison's sake, the overall profit margin for the S&P 500 hit its recent nadir of 3.7% in 1991, when the economic and business environment in the U.S. and elsewhere was decidedly much worse than it is today.

In his report, Applegate identifies a variety of factors for the rise in the index's profit margin over the past eight years. Inventories and interest costs as a percentage of revenues for the index as a whole both dropped more than a full percentage point between 1991 and 1998. On top of that, the aggregate cost of goods sold as percentage of revenues fell even faster, to 83.3% in 1998 from 87.1% in 1991.

Also behind the margin run-up has been the changes in the index's components over the years. Technology stocks now account for 32% of the index on a capitalization-weighted basis, up from just 7% in 1989. (The figure for 1991 was not referenced for some mysterious reason, but it's likely to have been in the same general neighborhood.) In particular, the additions to the index of Cisco Systems (Nasdaq: CSCO) in 1993 and Microsoft (Nasdaq: MSFT) in 1994 have played a large role in this shift.

Like the Fool's own NOW 50 Index, the S&P 500 is capitalization-weighted, which means the index as a whole tends to take on the flavor of the most dominant member firms. It's not like each of the 500 companies receives an equal 0.2% representation; for instance, Cisco and Microsoft combined account for nearly 6% of the index's current value. Given the large weighting of Cisco and Microsoft and the pair's super-normal margins, it's little wonder that the after-tax margin for the index's total technology component has increased to 11.2% today from 6.4% in 1989.

Higher margins helped trigger an increase in total operating earnings for the S&P 500 companies to $426 billion last year versus $129.5 billion in 1991, or a compounded annual growth rate (CAGR) of 16%. The earnings growth has led to significant wealth creation, as the market capitalization for the entire index has exploded to roughly $12 trillion today from just under $3 trillion over the same span, approximately a 19% CAGR. As a general observation, it's worth noting how closely the earnings growth rate -- fueled in part by higher margins -- has correlated with the market's overall growth rate over the past eight years. The difference can largely be explained by multiple expansion.

These facts and figures make for a nice history lesson, but in the end they tell us little about where the average S&P 500 company is headed from here. "The trend is your friend," or so the saying goes. However, in this case, the trend may work against the interest of long-term investors in the coming years, especially if it turns out that the recent margin expansion is butting up against some type of theoretical business ceiling. I have no idea whether this is the case or not, but expecting profit margins to expand in the next decade like they have in the past may be wishful thinking.

For starters, the downsizings and restructurings that swept through Corporate America in the 1980s and 1990s have already wrung out a great deal of operational costs. To illustrate, some 22 million people are currently employed by Fortune 500 companies (which are close enough to S&P 500 companies for our purposes), up only 38% from the 16 million Fortune 500 employees in 1979. That's a compounded annual employee growth rate of just 1.6% per year, far from an indication of corporate bloat. Further, the widespread implementation of enterprise resource planning software from the likes of SAP (NYSE: SAP), PeopleSoft (Nasdaq: PSFT), and others over the last decade has already yielded major efficiency benefits to big business as well, as has been documented in this space before.

However, there is a wild card that could dramatically affect the future margins of the average S&P 500 company. It's the Internet. With its ability to push middlemen-induced frictional business costs to zero, the aggregate benefit of the Internet to businesses could be huge. Just last week, General Electric (NYSE: GE) CEO Jack Welch told the Australian Financial Review that the company is aiming to use the Internet to cut selling, general, and administrative (SG&A) costs by a stunning $7 billion to $12 billion over the next 30 months. As other large businesses follow GE's example, the "Net net" could be savings in the hundreds of billions of dollars.

Those cost savings will surely come in handy, since the flip side of the Internet is its power to crush margins and corporate pricing power right along with frictional costs. With the Internet, the idea of perfect competition, where all participants have perfect and equal information about the markets for their goods and services, suddenly jumps from being just a fancy theory in a college economics textbook and becomes more and more a modern business reality. How companies cope with the much-ballyhooed benefits, as well as the attendant business drawbacks, of the Internet will play a key role in determining whether the average S&P 500 company becomes more or less profitable in the years to come.

Related Link:

  • Reversion to the Mean, Fool on the Hill, 1/07/99