The near-record margins large companies have enjoyed the past few years highlight just how favorable the climate has been for many businesses. Slow wage growth, benign inflation and historically low interest rates have kept a lid on costs and helped boost profit levels, as shown. Not surprisingly, investors have cheered this phenomena and have been willing to pay a premium in hopes that the good times will never end.
But as the S&P grinds higher, we believe piling into companies with margins at historic peaks—and trading at elevated multiples—sets the stage for disappointment. Raw material prices are on the rise, interest rates are up and likely headed higher and wages are poised to climb in an already tight labor market. Any one of these developments alone could pinch operating margins, but together, the effect could be significant. Once margins come under pressure, we expect multiples will follow.
A more prudent approach, in our view, is to seek companies where margins are at or nearing an inflection point. Fortunately for investors, many of those names have been overlooked and are trading at discounts.