If capitalism works, and for the most part, it does, then the resources boom has to either peter out or bust. There can be no other way.
For the past 15 years, corporate profits as a percentage of GDP have increased from 4 per cent to 16 per cent. Economic theory, and commonsense (the two are not always the same), suggest that profit margins can't remain at these historically high levels.
And yet almost all professional investors are using financial models that incorporate this flawed premise. You may well be buying stocks on their recommendation as a result.
Sometimes, facts are so difficult to accept they get ignored altogether. That's how new ratios were invented to value internet stocks and the “stronger for longer” argument developed in the resource sector. Each has a self-justifying dynamic.
Changing circumstances can also appear to be permanent. An aberrant situation can remain unusual for so long that we cease to think of it as unusual at all. It becomes the “new normal”.
Commodity prices, and the rise in the level of corporate profits they have delivered, are one such example.
When assessing a stock, analysts tend to look at top line revenue growth. Then attention shifts to the bottom line: to what extent is that revenue growth impacting profits and dividends? Profit margins tend to get glossed over but on this issue at least, they are critical.
Dividing pre-tax corporate profits by GDP offers an indication of how important profits are as a proportion of the total economy. The higher the percentage, the higher corporate margins are likely to be.
Profits x 4
According to the Australian Bureau of Statistics (ABS), corporate profit margins quadrupled from 4 per cent in 1994 to 16 per cent in 2010 - a huge increase.
The mining boom has played a major factor. As the Australian economy recovered in the aftermath of the 2000 Olympic Games, higher commodity prices helped increase the overall level of corporate profits, despite the global financial crisis and retailers and manufacturers struggling with a high Aussie dollar.
But it's dangerous to expect the current level of profitability to continue, and to value companies based on unsustainable profit margins.
Ah, you say, but what if the “stronger for longer” argument is true?
That's to argue that resources are no longer highly cyclical commodities: that demand for them will always outstrip supply, and that prices for them can therefore no longer fall. And that's to deny a fundamental tenet of capitalism.
It's difficult to distinguish permanent margin increases from temporary ones. Woolworths, for example, spent a decade finessing its supply chain to become one of Australia's most efficient companies. Over the past five years grocery margins increased 50 per cent, allowing the company to share the benefit with consumers in the form of lower shelf prices.
Some of that increase was permanent. But how much was due to a weakened, and now reinvigorated, competitor in the form of Coles? And how much was due to a debt-fuelled consumption binge? It's impossible to say.
For mining and mining services companies, which have seen margins increase because of higher commodity prices, the case is even harder to make. But there's a very good chance we're going to find out.
Supply surge
There are tens of billions of dollars earmarked for resources projects in Australia, from massive LNG plants to new coal and iron ore mines. Major commodity supplies are about to increase on a grand scale.
That's exactly as it should be. Mining giants like BHP Billiton, Brazilian company Vale and Rio Tinto are making vast sums.
In a system with a capitalist strain, you'd expect there to be an increase in supply, especially in commodities that are relatively plentiful like coal and iron ore. High margins should attract new competitors.
Only if the increase in supply that these new entrants deliver is matched by increases in demand (which is, in effect, what every resources booster is banking on) will commodity prices remain at the same level. If demand doesn't increase at the same rate as supply, prices should fall.
There are two key points to understand.
First, be really careful about the level of profits used in making an assessment of company value. Currently, rosy scenarios and high expectations are the new normal. Underlying these forecasts is a widespread belief that resources are no longer the cyclical commodities that, up until now, they have always been. That increases the chances that you'll overpay for them.
Second, understand that corporate profit margins are what statisticians call “mean-reverting”. Over time, margins can deviate a long way from the average but they tend to return to them.
As professional investor Jeremy Grantham warns, “The 70's had margins well below average and the 80's were average, but since 1995, we have lived in an above-average profit margin world.”
Most current resource stock valuations don't account for the mean-reverting nature of corporate profit margins.
Long way down
With Australia's terms of trade off the charts thanks to the prices foreigners are prepared to pay for our natural resources, margins have a long way to fall if demand weakens, or supply increases at a rate greater than that of demand. And the supply of many major commodities is about to increase very sharply.
For the past 15 years, corporate profit margins have risen way above their long-term average. It's been so long, in fact, that many of us can no longer envisage a world where these margins might revert to their long-term averages.
And yet it's contradictory to believe in capitalism and the continual perpetuation of historically high profit margins. It is the function of the former to ensure the latter is only true temporarily, never permanently.
It is a dangerous fact that most broker and fund manager models aren't based on this simple truth.
This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investor. BusinessDay readers can enjoy a free trial offer. For more Intelligent Investor articles click here.
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