By J. Keith Buchanan, CFA, Portfolio Manager – GLOBALT Investments
Supply chain disruptions. Escalating energy costs. Rising labor costs. Rising interest rates. If you were to listen to any economist outline their recent analysis or a corporate leadership team walk through their company’s recent performance or prospects for the future, one or more of the aforementioned developments will likely enter the conversation. In isolation, each of these developments would cause consternation within corporate America. However, when they arise in a simultaneous fashion, this unique occurrence can only mean one thing: The cost of doing business is going higher with a velocity that markets have not experienced for the better part of a generation.
Profit margin, or an entity’s revenue less expenses, is a general indication of the profitability of a corporation. How much of each dollar made does a company have to spend to earn the next dollar? It is the essence of the financial success of corporations, industries, and economies. In aggregate, profit margin encompasses many facets of the costs and competitive pressures faced by the included companies. The chart below shows that the operating profit margins of the S&P 500 Index have extended beyond recent records. Recessionary periods are usually associated with contracting margins as corporations’ revenue falls faster than they can lower expenses. However, the recent margin expansion beyond pre-pandemic highs has been dramatic and helps to justify the historic levels of equity prices and other risk assets. Corporations have never been as profitable as they are now. Investors are willing to pay more for a corporation (all else being equal) if and when they generate more revenue relative to expenses.
Source: Bloomberg Finance L.P.
Sudden and widespread cost inflation can pose a threat to these historically high corporate margins and profits, and, in turn, to investors’ appetite for exposure to affected companies. There’s a salve, however. There is one surefire way to weather the storm of uncontrollable input costs and other costly developments of procuring revenue. Raising the prices of goods and services faster than cost inflation has the effect of preserving the profitability of the corporation.
Can every company and industry exhibit this kind of pricing power all at once? Of course not. Undoubtedly, there will be winners and losers along the path to a more stable cost environment. However, we feel that the market, as the ultimate judge, will favor companies that demonstrate that they have enough pricing power to stay ahead of increasing costs as uncertainty persists around just how long this new cost environment will last.
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The opinions and some comments contained herein reflect the judgment of the author, as of the date noted.
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