A longtime client recently posed the following question (expanded here to flesh out his thinking):
- Think of aggregate US corporate profits as being a “share” of total US GDP plus some contribution from income created by non-US economic activity.
- As of the most recent data available (Q2 2021), we are at all-time peak levels of after-tax corporate profit as a percent of US GDP (10.7 percent).
- What happens when US GDP growth goes to zero (as it inevitably will)? Will US corporate profits decline? It seems like they should … How can we expect companies to hold peak profit “take rates” of GDP when economic momentum slows?
Or, put more succinctly: American companies are currently earning an all-time record 10.7 cents after tax on every dollar of GDP, which feels dangerously unsustainable especially as we get past the initial phases of an economic recovery.
We will use the following chart to discuss the issue; here is what it shows:
- Pretax US corporate profits as a percent of GDP (red line) as well as after tax profits/GDP (black line) from 2011 – Q2 2021 (latest data available). The numbers here comes from the US Bureau of Economic Analysis, and we use their definition of “profits from current production”.
- We’ve also included S&P 500 per share earnings for 2011 to 2021, noted in blue (courtesy of FactSet).
- Lastly, we have highlighted that in 2018 US corporate tax rates declined, which is why the gap between the red (pretax) and black (after tax) lines are closer to each other after that year.
Three observations on this data:
#1: It is absolutely true that the share of GDP which ends up as corporate profits is cyclical. In the last cycle, the peak occurred quite early (2012, as shown above). Over the three prior cycles, peak profit/GDP tended to come in the middle to later parts of the expansion (1985, 1997, 2006).
Also, profits/GDP do always revert to a longer-run mean after a top. In the time series we’ve highlighted in the chart above, they went from 12.6/10.6 percent (pre- and post-tax) in 2012 peak to a more sustainable average of 11.3/9.5 pct from 2013 – 2019.
Takeaway: it is perfectly reasonable to expect profit/GDP ratios to decline from here, especially when you consider the many challenges US companies face (labor shortages, supply chain issues, etc.)
#2: To make this analysis useful in terms of making money as an investor, we now need to tie it to public company earnings per share trends through a cycle. Using the S&P 500 EPS data noted in the chart, we see that:
- S&P 500 earnings per share managed to grow even after profits/GDP peaked in 2012. No, it wasn’t a lot of growth: +6 pct in 2013, +7 pct in 2014, flat (-0.2 pct) in 2015, and +0.5 pct in 2016. But some … And enough to keep US stocks trending higher; there were no down years for the S&P 500 from 2011 – 2017.
- From 2011 – 2019, US GDP grew by 47 percent, but S&P EPS grew by 63 percent. We assume the difference stems from both non-US profit sources (the S&P is 40 pct non-domestic revenues) as well as the unique nature of the companies in the index. There are no mom-and-pop versions of Apple or Google, after all.
- From 2011 – 2021, US GDP grew by 51 percent, but S&P EPS grew by 104 percent.
Takeaway: the companies of the S&P 500 can – and reliably do – buck larger trends in corporate profit generation. Economies of scale and scope combined with non-US growth opportunities allow them to do so. The last point above neatly tells the story: from 2011 to 2021 S&P earnings per share grew twice as quickly as US GDP.
#3: Extending the conversation to tie the BEA data to equity valuations, it’s important to keep in mind that markets capitalize earnings depending on their source and also discount cash flows based on prevailing interest rates:
- When the average company in the Financials sector earns a marginal dollar of profit, that’s worth a 15x multiple to the stock price.
- When a Technology company earns an incremental dollar, the market values that at a 27x multiple – 80 percent more than for Financials.
- When Treasury yields decline, every dollar of future corporate earnings, regardless of its source, becomes more valuable.
Takeaway/Final thought: when it comes to public market equity valuations, every dollar of corporate profit is different. Aggregate data, such as the BEA profit/GDP ratio ratios, is instructive in that it accurately captures the macro operating environment American businesses face. Translating that into an accurate picture of large cap public company profitability is trickier. These companies have a proven track record of earnings per share growth that exceeds baseline US economic growth. Layer on how markets discount those earnings, and the connection between macro corporate profits and where stocks go weakens somewhat.
We remain positive on US large caps and profusely thank our client for prompting us to look at this data.