A few weeks ago, I took issue with Jason Trennert's argument in Barron's that today's P/Es were "low." I felt that, like many other analysts, Jason had not taken into account the likelihood that today's record-high profit margins would eventually revert to the mean. Here, Jason responds directly to that criticism:
I very much enjoy this website but I hope you don't mind, as one of its subjects, my posting a comment or two on your critique. Your point on margins is well-taken, but your readers should understand that that there is limited time and space to discuss all the nuances of one's views in such interviews, especially when speaking about something as broad as the stock market. I was unfortunately not asked about profit margins in my interview with Barron's but, as any one of our clients knows, we have written extensively about the subject.
There are many astute market observers that have rightfully pointed out that profit margins have been mean-reverting in the past. Although it's always dangerous to say it's different this time, it seems clear to us, after nearly three years of profit bears claiming that the end was nigh, that something has changed.
In our view the the double-barrelled secular changes of technology and globalization have made margins stickier, longer than the consensus would have ever thought possible. This is simply because companies have a better chance of arbitraging unit labor costs today than they have ever had in history. Labor costs comprise about two-thirds of total costs for the average company. With a seemingly limitless supply of labor in India and China, there has never been a better time to be an owner of a business or for companies to maintain margins. This has also been true, to a remarkable extent, in the service sector. Goldman Sachs' third largest branch office, as an example, is now in Bangalore. The greatest risk to profit margins, therefore, is not labor unrest, as it might have been in years past when labor markets were less fluid, but political efforts aimed at slowing the forces of globalization.
In the hope of prompting an additional thoughtful response from Jason (or another reader), my concern with the argument above is that it doesn't explain why companies won't begin to pass through these labor savings to customers, in the form of lower prices. For a temporary period, the companies that are the first to exploit lower labor costs will benefit from higher margins and lower prices than their competitors, but over time, the competitors should follow suit--until outsourcing labor to Asia and India becomes not a competitive advantage but a competitive necessity. Also, companies should begin to take market share by reducing prices, which will also put pressure on margins.
So, bottom line, I agree that the massive reduction in labor costs from globalization should drive temporary margin gains (which I think we're seeing), but I don't understand why this should be expected to continue indefinitely.