One argument we have increasingly observed put forward as a reason not to own equities is company margins in the US have reached peak levels but is that actually the case? After all, using one number to cover the whole US market is a fairly broad-brush approach so, if we dug a little deeper, might we find a different story? The following chart would certainly suggest so.
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Compiled by analysts at Morgan Stanley, it breaks the largest 1,500 US companies down by market capitalisation – into ‘mega’, large, medium and small-cap stocks. While it is impossible to deny that the mega-cap stocks are trading at peak net margins – they have been increasing in an almost straight line since the early 1990s – that is by no means the case at the other end of the capitalisation spectrum.
Smaller businesses are far more exposed to the ups and downs of economic cycles and so, when the credit crisis hit, the net margins of small and medium-sized companies fell far further than their large and mega-cap counterparts. Granted, they have since recovered to trade near the top of the current range but they could hardly be described as standing at a secular high.
There are also sector-based reasons for this disparity, with industrial firms that have outsourced parts of their operations to china or elsewhere seeing margins go through the roof. Once again, mega-caps such as general electric and tyco are in a far better position to outsource abroad than, say, mom & pop’s widgets. Strip out industrials from the picture, furthermore, and margins again look more reasonable.
In articles such as The nature of things and Dizzy heights, we have argued that, while the US market is historically expensive, pockets of value do exist for investors prepared to be more targeted in their approach. A similar emphasis on the importance of being selective underpins this warning not to dismiss the whole US market on the basis of one broad number reaching a high level.