In his seminal work “The Wealth of Nations”, 18th century Scottish economist Adam Smith wrote:
the rate of profit does not, like rent and wages, rise with the prosperity and fall with the declension of the society. On the contrary, it is naturally low in rich and high in poor countries, and it is always highest in the countries which are going fastest to ruin.
Yet, here we are today with US profit margins at new highs approaching 12% of sales. What gives?
I think this is a big question — existential even, because, as the Adam Smith quote suggests, it goes to the heart of what makes for a functioning and equitable society. I have two takes below. One interpretation is about inequity, and implicitly about corporatism masquerading as liberty. And the other is about network effects creating an age of winner take all in the marketplace. You choose which one you believe best describes what’s going on.
We were told profits mean revert
So, here’s the deal. A decade ago, we had the largest global financial crisis in three quarters of a century. And as the crisis unfolded, it ravaged corporate profits. But soon afterwards, corporate profits recovered, soaring to new highs.
This made a lot of people nervous. Analysts were wary of getting too optimistic about the economy given the depth of the crisis. And so, a debate unfolded about “profit mean reversion”, whose underlying economics are encapsulated in the Adam Smith quote.
The basic economic idea is that in a truly competitive marketplace, high profit margins invite competition. Businesses making a lot of money draw the attention of other entrepreneurs who set up shop and then compete for the same business. And the result is that high profit margins are considered “unsustainable”. They are “competed away”.
You can take this same economic idea to a country as a whole. In good times, profit margins are high as consumers, flush with cash, bid up the prices of everything. But once a recession comes, profits come crashing down — and profit margins with them. Eventually, the recession passes and profits re-emerge.
So profits go up and then they go down and back up again, “reverting to the mean” as they fall or recover.
Profits may not mean-revert until a recession
We were talking about overvalued stocks and profit margin mean reversion in this cycle as early as 2011. But profits have not reverted to the mean despite the angst.
A recession should bring margins down though, just as they have always done. And I think the worry about profit margins declining into a recession has increased due to high oil prices and tenuous signs of the re-emergence of wage growth .
But some people don’t see profit margins ever going down. Value investor Jeremy Grantham seems to have thrown in the towel on expecting a mean reversion to ever occur. Sure they might go down in a recession. But will they actually revert to the historical mean?
Google, Facebook and network effects
This is where the ‘existential’ questions come into play. Economists tell us that market entrants eventually compete away profits in a truly competitive marketplace. That’s why Grantham once said:
Profit margins are provably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.
But what if we have entered a “new era” in which a small cadre of companies have what Warren Buffett calls “economic moats” which make them almost impossible to dislodge atop their industries?
I’m talking about the Internet here, of course. Companies like Facebook, Google and Apple have created ecosystems that have huge network effects which keep out competitors. They can forestall competition easily because of the economic moat of network effects, where a company’s installed user base is a top draw for still more new customers. And that means the ‘Winner Takes All’.
Look at the operating systems for mobile handsets. That’s a space dominated by two manufacturers now: Apple and Google. It’s not like other tech companies didn’t try and break into this space. Microsoft famously did try and got beaten back.
The same thing is true in social media with Facebook. Once Facebook reached a critical mass, where people felt like almost everyone they wanted to reach out to was on Facebook, it became much easier to add to Facebook’s user base. And that’s a powerful draw for advertisers when they have to decide where to spend their money online. Even the most recent privacy scandal at Facebook hasn’t irreparably damaged that appeal.
So all of this suggests that the world we live in is dominated by companies with high economic moats. And high economic moats mean high profit margins.
But what about anti-competitive practices?
There’s another explanation here. And it goes back to Adam Smith’s quote again.
The essence of the Scottish economist’s quote is this: “the rate of profit… is always highest in the countries which are going fastest to ruin.” And by that he means that the high rate of profit is a de facto marker for cronyism and corruption. He was saying in no uncertain terms that high profits must always be competed away. And if they aren’t, something anti-competitive is going on.
Let me give you an example that I used last year. Since 2012, Amazon has had a patent called “Physical Store Online Shopping Control” to prevent in-store shoppers from using store-supplied wi-fi for online price comparisons.
The patent abstract is outlined below:
Systems and methods for controlling online shopping within a physical store or retailer location are provided. A wireless network connection may be provided to a consumer device at a retailer location on behalf of a retailer, and content requested by the consumer device via the wireless network connection may be identified. Based upon an evaluation of the identified content, a determination may be made that the consumer device is attempting to access information associated with a competitor of the retailer or an item offered for sale by the retailer. At least one control action may then be directed based upon the determination.
Now one could argue that this patent is purely a ‘defensive’ weapon Amazon can wield to defend itself against future patent trolls. But it doesn’t look that way. To me, it seems like an offensive weapon that Amazon can now use as it builds out its brick-and-mortar presence via Whole Foods and Amazon stores. This is anti-competitive.
But that’s the world we live in now. In our world, businesses create jobs and the prevailing economic ideology is that government needs to reduce regulation as much as possible so that they can create more of them. The Trump Administration has been very aggressive in making this argument to justify a large number of regulatory moves.
The upshot of this anti-regulatory approach is that businesses have more leeway in doing things to suppress competition. In the Amazon case, the patent system has actually enabled the company to potentially suppress future competition.
This is a world, then, not of ‘Winner Take All’, but of Corporatism, where government tilts the playing field in favour of existing, large businesses at the expense of potential entrants.
Europe and the US taking different approaches
I would call this a big experiment. The US under Donald Trump is doubling down on an approach where regulations are seen as impediments to business and job creation. Meanwhile, in Europe, the big tech companies with the highest profit margins in the US, are facing a tougher regulatory environment. The EU is taking them on regarding profit avoidance, favouring their own products, and violating customer privacy.
Moving forward, I believe this dichotomy between the US and the EU will help reveal whether permanently high profit margins represent a new era or simply corporate-government collusion.
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