Month: June 2016

If you are not fluent in Latin, ceteris paribus means “everything else being held constant” like in

After leaving Southampton on 10 April 1912, the Titanic is heading west to New York. The weather forecast is favourable and the passengers and crew will arrive in New York on the morning of April 17, ceteris paribus.

In economists parlance, it recently went like this:

The collapse in oil prices will provide a substantial and lasting break to consumers around the world which, ceteris paribus, will help boost discretionary spending which, ceteris paribus, will translate into faster world GDP growth rates.

The Citigroup Economic Surprise Index has been in negative territory for 16 months, the longest stretch since its inception in 2003. Economists have continually overestimated the economy’s potential since early 2015. And by a lot!

Economists have been so much off the mark, they can’t even downshift fast and low enough to allow for any positive surprise. These hopelessly hopefuls seem to be completely incapable to figure out what’s going on, relying on old models while the world outside their ivory tower offices has changed so considerably.

• Millenials are living very differently from their parents and grand-parents at the same age.
• Many Americans are still struggling to emerge from the financial crisis.
• ZIRP policies have totally deflated retirement incomes and expectations.
• The dearth in demand coupled with the developing sharing economy result in excess capacity seven years into the recovery.
• Digitization has modified consumption patterns away from “things” towards “software intangibles”.

We seem to have entered a torqueless economy whereby previous economic multipliers are no longer effective.

Before, when labor income rose, consumers bought apparel, cars, houses, lawnmowers. They had babies, bought cribs and toys. They bought larger or second homes, golf clubs, bicycles.

Now, many must first pay down their debts, mortgage or education. Others buy smart phones and/or tablets to bypass “out things” like newspapers, books, CDs, radio stations, television networks and play games or watch movies. Retirees no longer buy or rent in the countryside to get into gardening and relaxing. They instead need to supplement their pension and/or interest income greeting people at Wal-Mart or becoming cashiers or baggers in a grocery store. This extra income is not meant to buy “things”, rather to pay the rent, the grocery or the utility bills.

Jobs are more plentiful and wages are rising but ceteris non paribus. The times, they are really a-changing, oblivious to the elite.

The old, faithful economic multipliers are broken!

Even the more “fortunates” sport different behaviours: there is no more second car (if even a first one) or second home. Frugality means minimalism on the number of owned things. Sharing is in. Accumulating and wasting are out.

Otherwise, software reigns. Pew Research reveals that 73% of Americans go online at least daily with 21% “almost constantly” and 42% “several times a day”. What are they doing online?

• They communicate.
• They shop.
• They sell.
• They read.
• They play games.
• They watch/listen to music.
• They watch movies.
• They bank.
• They invest.
• They visit.

And more…Doing so, they don’t use their car, the roads or the transit systems as much. They are not physically at the mall, browsing, drinking and eating. They don’t buy printed stuff, physical games and toys as much. They don’t go out as much, etc., etc.

To be sure, they use smart phones, tablets, computers and broadband a lot but the digital world multiplier effects are smaller and more gradual than the old fashion manufacturing multipliers.

Even with tepid growth in capital expenditures since 2000, U.S. industries are presently operating at only 75% of their capacity.

Here are some industries with their current operating rates and their 1972-2015 average (which, by the way, includes 6 recessions):

• Primary Metals: 70% (79%)
• Machinery: 71% (78%)
• Computers & Electronic: 73% (78%)
• Food: 79% (82%)
• Textiles: 72% (79%)
• Apparel: 64% (78%)
• Printing: 65% (80%)
• Chemicals: 74% (77%)
• Utilities: 79% (77%)

No wonder corporate America is not spending on capex. The last thing companies need is more capacity.

Low interest rates therefore have no impact on corporate spending. They do impact M&A activity however.

The corporate world has experienced spikes of mergers and acquisitions in the past, but nothing like the recent wave of deal-making. In 1990, there were 11,500 M&A deals whose combined value was equivalent to 2 percent of world GDP. [Between 2008 and 2014], there have been some 30,000 deals a year totaling roughly 3 percent of world GDP. (McKinsey)

J.P. Morgan adds that global M&A deals jumped 36% per year in value in 2014 and 2015 to reach 6% of world GDP in 2015. Companies are taking advantage of central banks ZIR policies to grow through mergers and acquisitions, cutting and pruning expenses to quickly realize expected synergies, perversely hampering economic growth in so doing. See the irony? The Fed doesn’t.

Now that the cyclical demand for cars has been satisfied in the U.S., low interest rates will have little impact on the automotive industry going forward. Given that capital spending is off and that exports are weak due to the strong dollar, this leaves housing as potentially benefitting but low mortgage rates have not proven very potent so far. Meanwhile, low rates continue to seriously hinder demand from the 80 million Americans aged 55 and over, not to mention younger workers worried about their future pensions.

When will the Fed realize there is not even a string left to push on!

Demand for software services is increasing swiftly however and businesses are obliging by boosting related investments. The fact remains that each new software download only requires bandwidth availability, unlike during the good old multiplier years when each new purchase, be it a book, music, a game or a car required another manufacturing pass with associated tooling, real estate and distribution demand, let alone labor.

While the “goods economy” tries to manage its excess capacity, the “new economy” keeps expanding digitally, piling up the cash like never before given its lesser capital intensity.

Using Factset numbers, I calculate that IT companies generated $2,200 billion in operating cash flows during the last 10 years and spent $520 billion in capex. or 24% of their OCF. The other S&P 500 companies (ex-Financials) generated $10,240 billions in OCF and invested $4,800 billions in capex, 47% of their OCF to sustain their businesses. Unsurprisingly, the IT sector, which accounts for 25% of the S&P 500 Index ex-Financials, is sitting on $580 billion in cash and short-term investments, 40% of the total for the S&P companies ex-Financials.

IT companies thus utilize only 24% of their cashflow on capex. All other non-financial companies plowback 47% of their cashflows, keeping more than half as free cash nonetheless.

McKinsey & Co. looks at this somewhat differently but concludes similarly:

Intellectual property–based businesses now account for 32 percent of corporate profits but only 11 percent of capital expenditures—around 15 to 30 percent of their cash flows. At the same time, businesses with low returns on capital, including automobiles, chemicals, mining, oil and gas, paper, telecommunications, and utilities, have seen their share of corporate profits decline to 26 percent in 2014, from 52 percent in 1989. While accounting for only 26 percent of profits, these capital-intensive industries account for 62 percent of capital expenditures—amounting to 50 to 100 percent or more of their cash flows.

Hence the impressive buybacks and M&A activity which, as explained in Certain Uncertainties, has contributed to increased business concentration and higher returns on capital for American companies. This largely explains why corporate profit margins remain at record high levels while the U.S. economy seems stuck in low gear.

The key question for equity investors is whether current profitability levels are excessive and doomed to mean-revert as many have been predicting for several years. Labor’s share of national income reached an all-time low in recent years and seems poised to rise thanks to a seemingly tighter labor market. But there nevertheless seems to be a big secular change underway. Labor’s share of national income has generally jumped during previous recessions as profits collapsed. This did not happen during the financial crisis even though labor’s share had dropped significantly between 2002 and 2006. This downshift continued between 2009 and 2011 taking labor’s share to a 70-year low.

The powerful rise of the digital economy since 2000 seems responsible for much of the recent downshift making it dangerous to forecast that the tide has turned and that profit margins will collapse. How corporations react and adapt to the current push towards higher wages will be interesting. Not only will the digital trends continue, but recent advances in robotics and artificial intelligence suggest that automation will continue and should, in fact, accelerate (e.g.: Former McDonalds CEO Crushes The Minimum Wage Lie: “It’s Cheaper To Buy A Robot Than Hire At $15/Hour”).

McKinsey & Co. sees a lot more potential for digitization:

The MGI Industry Digitization Index examines sectors across the economy through the lens of digital assets, digital usage, and digital workers, compiling 27 indicators to capture the many possible ways in which companies are digitizing. (…)

The index shows that the US economy is digitizing unevenly, with large disparities among sectors. Beyond the ICT sector, which often sets the standard for the highest level of digitization on various indicators, the most highly digitized parts of the economy are media, professional services, and financial services.

The index also highlights where there is room for growth in digital capabilities. Utilities, mining, and manufacturing, for example, are in the early stages of digitizing and connecting their physical assets, and they could be at the forefront of the next wave of digitization. Labor-intensive industries such as retail and health care are expanding digital usage, but substantial parts of their large workforces do not use technology extensively. Industries that are both highly labor-intensive and localized, such as construction, leisure, and hospitality, also tend to rank lower in usage, notably in the way they conduct customer transactions.

Lagging sectors could experience catch-up growth if the long tail of smaller and less digitized businesses begins to close the gap with leading companies. Thousands of small retailers have few if any digital operations beyond accepting credit cards, for example, in striking contrast with Amazon, Walmart, or Zappos. In manufacturing, many smaller firms use only basic enterprise software for administration, and they are years behind the largest aerospace or machinery manufacturers in their use of analytics.

And look at what’s happening elsewhere:

• Robots Taking Over: Foxconn Terminates 60,000 Employees, Hires Robots!

In one of the largest terminations ever recorded in human history, iPhone manufacturer Foxconn has decided to fire 60,000 employees in one single go. Earlier this factory based out of Kunshan in Jiangsu province of China had 110,000 employees, but now, it will only have 50,000 human employees. (…)

And the interesting aspect is that, almost all of the 600 major manufacturing companies based in Kunshan are about to fire humans, and assign their tasks to robots. In fact, 35 biggest manufacturing companies from Taiwan, including iPhone’s main manufacturer Foxconn have spent a collective 4 billion yuan or HK$4.74 on improving and optimizing automation.

Earlier this year, we reported that top Indian IT companies hired 24% less employees; and automation is the reason for this sharp decline. Cognizant Technologies was the company which was impacted to the max, as they hired 74.6% less employees in 2015, solely due to rise in automation.”

Today, Adidas announced the first ever 100% robot-made shoe. (…) Six subcontractors of Adidas in China declined to comment or said they were not aware of the new production sites in Germany, news agency AFP reported. (…) The sportswear and equipment company also plans to open a second Speedfactory in the United States in 2017, with similar ones to follow in Britain or in France. (…)

In effect, the rise in profit margins is a global phenomenon. Using its database on more than 28,000 firms around the world, each with more than $200 million in annual revenue, including nearly 17,000 publicly listed firms and 11,400 privately held firms across 42 countries and 18 sectors, the McKinsey Global Institute says that

corporate earnings before interest and taxes more than tripled from 1980 to 2013, rising from 7.6 percent of world GDP to almost 10 percent. Corporate net incomes after taxes and interest payments rose even more sharply over this period, increasing as a share of global GDP by some 70 percent. (…)

Today sectors such as pharmaceuticals, media, finance, and information technology have the highest profit margins, and Western firms remain the dominant players within these industries. Asset-light, idea-intensive sectors accounted for 17 percent of the profits generated by Western companies in 1999. Today that share is 31 percent. Value is increasingly created from patents, brands, trademarks, and copyrights rather than industrial machinery or factories.

Many of these industries have developed a winner-take-all dynamic. The gap between the most profitable firms and everyone else is growing—and the top performers are significantly more R&D- or brand-intensive than median firms.

They are also much bigger. The most profitable firms in pharmaceuticals, medical devices, IT services, and technology hardware, for instance, are 40 to 110 percent larger than the median firm in these industries. Size does not guarantee market position for long, however, particularly in fast-moving fields such as technology. Over the past 15 years, the list of top tech firms by revenue share has continued to turn over.

While profits are flowing to idea-intensive sectors, a very different story is playing out in capital- and labor-intensive sectors. Margins are being squeezed in industries such as automobiles, machinery, and retail. Emerging-market firms with massive scale have intensified price competition, driving down marginal costs throughout whole industries. In 1990, Chinese aluminium producers made up only 4 percent of global production; by 2014, their share had increased to 52 percent. As this unfolded, marginal costs fell by 32 percent, driving more than half of Western producers out of business.

Slow capex and cash accumulation are prevalent across the developed world.

Companies once reinvested most of their earnings, but they are increasingly holding on to their profits. Since 1980 corporate cash holdings have ballooned to 10 percent of GDP in the United States, 22 percent in Western Europe, 34 percent in South Korea, and 47 percent in Japan. With low borrowing costs and plenty of available cash on hand, companies in some industries have engaged in a massive wave of mergers and acquisitions. The biggest names are getting even bigger. (…)

The mean reversion of profit margins may thus not be underway just yet, ceteris paribus…

Hmmm…the tides of change are numerous and varied, however. Maybe this is not ceteris paribus.

• Wage pressures are getting acute in the digital world as the pool of skilled workers is shrinking while worldwide demand keeps booming.
• At the other end of the skill spectrum, the growing pool of low-skilled workers is also getting more expensive as governments boost minimum wages and as opportunities for global labor arbitrage become more limited.
• Interest rates are more likely to rise than to decline further in coming years. Companies with high debt levels will feel the pinch.
• Statutory and effective corporate tax rates have also likely reached their low points as governments react to income inequalities that have spread throughout the world.

But it is beyond the operating ratios that things can get tougher for corporate profits. McKinsey data and analysis paint the changing global competitive landscape:

• Formidable emerging-market companies and fast-moving high-tech and tech-enabled firms both bring an agility and aggressiveness to the game that many long-established names will struggle to match. Many companies with their roots in emerging economies now rank among the world’s largest. Their track record is uneven, but their presence—in sheer size and numbers—is game-changing. Chinese firms already make up some 20 percent of the Fortune Global 500, while the share of US and Western European companies dropped from 76 percent in 1980 to 54 percent in 2013.
• Ownership structures directly influence the growth strategies and operating style of these emerging-market companies. Half of the world’s largest state-owned firms are in China, and another quarter are in other emerging economies. In contrast, most of the world’s widely held public companies are found in North America and Northeast Asia. Emerging markets are also home to many large family-controlled firms in which the founders’ influence remains strong. A firm with a controlling shareholder—whether family, founder, or state—is more likely to focus on building a leading position and is able to take a longer-term view about the growth and investment needed to accomplish that goal. In contrast, widely held public firms must answer to shareholders every quarter and are more focused on maximizing earnings in the immediate term.
• These new emerging-market competitors tend to put revenue growth and scale ahead of maximizing returns on invested capital. Some of these firms are national champions that benefit from government support in their expansion. Many others are family-owned, diversified conglomerates that enter new businesses at a rapid pace, taking access to talent and capital while allocating family assets across several industries.
• This new breed of company takes a hardy, risk-taking, and hard-nosed approach to competition. Having cut their teeth in difficult operating climates, these companies value agility and have a natural advantage in other, fast-growing emerging markets. In the past decade, the 50 largest firms from emerging economies have doubled their share of revenue from overseas activity from 19 percent to 40 percent.

Here’s a fascinating chart from McKinsey. On the one hand, it illustrates the strong expansion in corporate profitability since 2000, particularly in North America and Western Europe.

On the other hand, it also reveals why North American and European firms will face increasing competition in coming years. Returns on capital in the 15% range are unsustainable. Low cost capital will naturally migrate towards the highest return markets, intensifying competition and gradually “normalizing” margins and returns. It has already happened indirectly in basic industries such as metals and steel where low costs Chinese SOEs have grabbed large market share and driven many Western competitors out of business and seriously reduced industry ROIC.

The global positioning is underway. From Dealogic database:

• 2015 was a landmark year for total US targeted M&A, with volume surpassing the $2T mark for the first time on record ($2.46T).
• Chinese firms have struck $110.8B in overseas deals this year, already surpassing 2015’s $106.8B and more than triple 2014’s YtD total. Another 15 offers totalling $24B by Chinese companies have failed this year.
• With $48.3B, US targeted cross-border M&A volume so far in 2016 stands at the highest YTD total since 1999 ($80.9B).
• Volume from Chinese acquirers into the US already stands at an annual record high of $23.5B (23 deals) in 2016.
• For the first time, China is the top acquiring nation globally for Technology M&A with $34.7B in 2016 YTD (222 deals) and accounts for a record high volume share (49%).
• Whereas Chinese overseas deal-making was previously driven by government policy, private companies completed 76.8% of overseas takeovers last year, against just 20.3% by state-owned enterprises. There is active encouragement within China for companies to look abroad for growth and to access expertise, know-interest has shifted from narrow commodities and raw materials to a much wider range of sectors. (The Telegraph)

I don’t pretend to know the future and I do not want to get into a digression on how things might evolve due to this and that. The point is that ROIC is now so high, especially in certain industries, that it is vulnerable as more capital naturally flows into the higher return sectors. What also always happens is that the marginal capital eventually becomes less efficient which causes returns to decline across the board. McKinsey warns:

(…) the shift to a more digital economy is an empowering moment for entrepreneurs. The barriers to entry have never been lower, as new businesses of all stripes can piggyback onto larger platforms and immediately tap into a substantial customer base. They can instantly recruit specialized help on a project basis, access
computing power via the cloud, and connect with a wide range of suppliers.

Prepare for tougher, 360-degree competition. Geographic and sector boundaries mean very little in a more digital world. New competitors that look nothing like traditional industry leaders can become market leaders practically overnight. In particular, the pooling of thousands of small players in the largest marketplaces and ecosystems, such as small Chinese manufacturers on Alibaba, represents a new competitive force. Many of these small enterprises have the advantage of being “born digital.” Unburdened by legacy systems, they build digital into their business models from the outset rather than retrofitting it onto existing processes.

China’s Alibaba Group is an Online and Mobile commerce company—the company runs a platform for third parties and does not take part in direct sales, hold inventory, or compete directly with its merchant base. Alibaba’s retail marketplaces platform (Taobao, Tmall, and Juhuasuan) currently serves 367 million active buyers (AMZN = 250 million) and 8.5 million active sellers. Alibaba also operates wholesale marketplaces (Alibaba.com, 1688.com), a global consumer marketplace (AliExpress), and provides cloud computing services (Aliyun).

Alibaba’s platform provides the technology, infrastructure, and marketing tools to help businesses of all kinds create an online presence and conduct online wholesale and retail commerce. Buyers and sellers benefit from virtuous network effects and the company’s scale. Additionally, the company’s ecosystem features third-party service providers—including logistics providers, retail operational partners, marketing affiliates, and independent software vendors. (RBC Capital)

Testimony of Alibaba’s power: Wal-Mart-JD.com: Leaving China Complications to the Locals

The partnership is more a case of Wal-Mart pulling back from China’s fiercely competitive online shopping scene than it is a huge shot in the arm for JD. Wal-Mart hasn’t generally had a smooth journey in the Middle Kingdom, struggling to expand its footprint quickly or generate meaningful profits there. (…)

JD’s stock has taken a beating this year and has decoupled from rival Alibaba’s as growth in JD’s so-called marketplace business slowed. JD started off like Amazon, selling directly to customers, but has moved toward an Alibaba-style marketplace model, acting as a platform between merchants and shoppers. In theory, the marketplace model allows for higher margins and lower inventory risks.

JD’s growth in this area, however, slowed in the first quarter, dimming hopes that the company would continue to take market share from Alibaba.

Almost all (90%+) of Alibaba’s Gross Merchandise Volume of more than $400B has been generated in China to date but BABA is now going global:

In terms of globalization, we aim to help small-to medium-sized businesses around the world expand beyond their borders by leveraging the power of e‑commerce, Internet financing, big data, and marketing and logistics platforms. We believe the experience of Alibaba Group in China can be applied globally, giving all SMEs the opportunity to participate and compete in a transparent and fair marketplace. We further believe that future economic globalization will allow consumers everywhere to access a truly global purchasing experience. (Chairman Jack Ma in BABA’s 2015 annual report, my emphasis)

Daniel Zhang, CEO of Alibaba Group is more specific:

We have set ambitious goals for ourselves. Over the next five years, Alibaba Group aims to become the world’s first platform to surpass US$1 trillion in GMV. Over the next 10 years, Alibaba Group will establish an ecosystem that serves two billion consumers, supports 10 million businesses and creates 100 million job opportunities. This ecosystem will allow SMEs around the world to fully participate in fair, free, open and equitable commercial trade.

In the future, Alibaba wants to help consumers and businesses buy and sell globally. In past years we undertook a great deal of planning and exploration, and 2015 is the inaugural year of Alibaba’s globalization. We are aggressively developing cross-border e-commerce, bringing high-quality Chinese goods to overseas consumers while helping international companies introduce their products to the Chinese market. (…)

Alibaba has a dominant 80% share of China’s ecommerce market of $580B or 13% of total retail sales according to iResearch. Revenues have grown 53% annually over the last 5 years and 33% last year. Asset-light Alibaba has a return on assets of 11.7% (AMZN: 1.9%), a return on capital of 14.4% (AMZN: 5.7%) and a ROE of 22% (AMZN: 9%).

On eBay, more than 90% of commercial sellers export goods to customers in foreign countries, compared with less than 25 percent in the case of traditional small businesses in most countries. Even individuals can position themselves to sell to global customers. Etsy, a digital market for goods made by artisans and small producers, supported $2 billion in sales in 2014, more than one-third of which were international.

Don’t think the disruptive forces are solely focused on the end-user.

Xiaomi, which vies with Huawei Technologies Co. for the title of China’s biggest mobile brand, has begun selling phones in emerging markets, but its lack of a wide-ranging mobile patents portfolio has been perceived as a stumbling block to expansion into regions such as Europe or the U.S. However, on June 1, 2016: China’s Xiaomi Buys Microsoft Patents to Spur Global Forays

Or that it’s only coming from China: Germany’s Kion Makes Logistics Push With $2.1 Billion Dematic Buy

Germany’s Kion Group AG, a supplier of forklift trucks and warehouse equipment, is buying Dematic Corp. of the U.S. for roughly $2.1 billion in cash to grab a share of booming, e-commerce-driven demand for automated logistics centers.

Although the Chinese are not far behind:

The move by Kion could help give its largest shareholder, China’s state-owned Weichai Power, a foothold in the U.S. Kion’s largest shareholder is Chinese diesel-engine maker Weichai Power, with a 38.3% stake. The remainder trades freely on the Frankfurt Stock Exchange and it is included in Germany’s MDAX midcap index. Dematic equipment and software have been used at production facilities of companies including Ford Motor Co. and Harley-Davidson Inc.D ematic is also involved in automating warehouses and distribution centers of Amazon.Com and Wal-Mart Stores Inc. (…)

Together, Kion and Dematic would have had revenue of €6.7 billion ($7.6 billion) last year, an adjusted operating profit margin of around 9.4% and a global workforce of 30,000, Kion said.

The merged company should be able to cut costs and boost revenue by combining the two firms’ geographical reach in key markets such as Europe, China, Brazil and the U.S., the Wiesbaden-based firm said.

In effect, most industries are likely to get attacked, directly or indirectly. Think of manufacturing with robots, 3-D printing and the Internet-Of-Things. Think of transportation with driverless vehicles. Think of services with robots and fintech. Think of data transmission with Li-Fi. And think of just about everything with Artificial Intelligence and Machine Learning.

Why care now? Because it is happening now and fast.

Part of the slowdown in profit growth will stem from the competitive forces unleashed by two groups of hard-charging competitors. On one side is an enormous wave of companies based in emerging economies. The most prominent have been operating as industrial giants for decades, but over the past 10 to 15 years, they have reached massive scale in their home markets. Now they are expanding globally, just as their predecessors from Japan and South Korea did before them. On the other side, high-tech companies are introducing new business models and striking into new sectors. And the tech giants themselves are not the only threat. Powerful digital platforms such as Alibaba and Amazon serve as launching pads for thousands of small and midsize enterprises, giving them the reach and resources to challenge larger companies.

New competitors are becoming more numerous, more formidable, and more global—and some destroy more value for incumbents than they create for themselves. (McKinsey)

So, one more reason to refrain from using forward earnings when valuing equity markets. Ceteris non paribus and things can change rather rapidly. The chart below shows the correlation between trends in profit margins and operating rates. Since 2000, the downward drag from declining industrial operating efficiency has been more than offset by the rising importance of higher margins, often digitized, sectors and, perhaps, by the relentless pursuit of corporate synergies. However, it is doubtful that this upward trend can be maintained in light of the arguments above .

While the shift away from traditional manufacturing will likely continue, the upward pull on total profit margins from higher returns sectors is coming under intense pressure as more capital flows in and competition grows 360-degrees from both large and small operators and both domestic and foreign competitors.

This chart, courtesy of CPMS/Morningstar, plots the S&P 500 Index Return on Equity (black) and its Reinvestment Rate since 1980. The spectacular long-term uptrend in ROEs came to a screeching halt in 2008. The Financial Crisis was brutal but its aftermath did not allow ROEs to return even close to their previous peaks. Same thing for RRs which have clearly broken their long-term range. (The RR is a measure of profitability, similar to ROE with the exception that paid dividends are subtracted: RR = ((EPS – DIV) / BV). It measures the rate at which earnings are reinvested to grow book value.)

This explains why growth in the S&P 500 Index book value has completely stalled since 2014 after slowing measurably in 2012-2013 following 3 periods of sharp acceleration (note the log chart).

Operating EPS don’t seem to have been impacted much when looked at conventionally. In effect, EPS appear to remain on their long-term trend line, merely mean-reverting for now:

But check the downshift when appropriately using a log scale. EPS growth is slowing appreciably.

During the 4 years between 2012 and 2015, EPS growth slowed for 4 of the S&P 500 Index sectors (3 negative) but the slowdown hit 6 sectors in the most recent 2 years, four of which displayed negative growth. If we include mid and small caps and look at the entire S&P 1500 Index, we find similar trends but with worse numbers indicating that smaller companies are struggling even more.

Interestingly, the sectors still displaying healthy profit growth are Consumer Discretionary, Health Care, Industrials and IT which host many of the digitized companies or those active in M&A’s.

Consumer Discretionary companies have steadily grown assets (red), sales (blue) and earnings per share since 2010…

…but their rate of return on sales has been flat. A 50% increase in leverage (D/E in black) was needed to keep ROEs (blue) rising in recent years.

Similar trends in Health Care assets, sales and EPS…

…where higher leverage also sustained ROE.

Same trends in IT…

Notice that in both Health Care and IT, recent trends in ROA and ROE are downward. (All charts courtesy of CPMS/Morningstar)

These 3 sectors (CD, HC and IT) are currently selling at 25, 35 and 32 times trailing EPS and 4.7, 5.4 and 4.2 times book values respectively. Such high valuations on increasingly levered balance sheets are vulnerable if, for some reason, ceteris non paribus. These sectors help keep overall P/Es high while the majority of industries are seeing their margins and returns erode owing to slow real growth, benign inflation, rising costs and 360-degree competition.

The old saying “Let the winners run” only works if ceteris paribus.