June 8, 2018 / 11:03 AM / in 2 months

Investors focusing on profit margins as rising prices, wages start to bite

NEW YORK (Reuters) - For years U.S. inflation has been the dog that did not bark, but rising prices and wages are now showing signs of squeezing profit margins across corporate America, leading investors to punish companies whose results are deteriorating.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S., May 18, 2018. REUTERS/Brendan McDermid

Investors have long focused on rewarding companies that can multiply sales in a relatively slow-growth U.S. economy like Netflix Inc (NFLX.O) and Amazon.com Inc (AMZN.O), but they are now paying more attention to figures further down the income statement like expenses and pre-tax margins.

So far this year companies with high operating leverage, which allows rising revenue to boost earnings while costs stay low, have seen their share prices rise 15 percent, beating their peers by nearly 6 percentage points, according to Goldman Sachs Group Inc (GS.N) data.

Investors have also been rewarding companies with high and stable gross profit margins, according to the data.

But a shift in investor focus may now be occurring as the impact of U.S. corporate tax cuts encourages more spending and 10 years of ultra-low interest rates have stimulated economic growth and finally begun to push up prices and wages.

Large corporate tax cuts enacted last year boosted already hefty corporate profits, making most companies’ results look better by after-tax measures, but the benefit of the tax cuts also enabled companies to spend on talent and market share, sometimes raising expenses.

The other driver for investors’ increased focus on pre-tax margins may be inflation as industrial companies are forced to pay more for raw materials and companies dependent on consumer demand pay more in wages.

Tom Dorsey, co-founder of Dorsey, Wright & Associates LLC, said today’s market dynamics remind him of those in the mid-1970s when he started in the investment business. U.S. inflation skyrocketed during that decade, with oil prices spiking higher.

“The same kind of thing is beginning to happen,” Dorsey told Reuters.

Investors, he said, “could easily lose a lot of equity in stocks they want to hold on to because of (their dividends).”

Take the case of Campbell Soup Co (CPB.N) which has seen its stock fall 30 percent so far this year on concern that packaged goods companies are struggling to pass on higher costs to consumers through powerful distributors like Walmart Inc (WMT.N) and following the departure in May of Chief Executive Denise Morrison.

In its most recent quarterly earnings, the canned-soup company reported “higher supply chain costs and cost inflation including higher transportation and logistics costs.”

Another example is provided by Stanley Black & Decker Inc (SWK.N) whose stock is off 14 percent year-to-date despite beating Wall Street earnings estimates. The power-tool manufacturer’s chief financial officer, Donald Allan, said in April that steel, batteries and base metals prices were going to take more of a bite out of earnings than they had warned though they hope to offset those impacts by adjusting prices.

Airline stocks also sank this year with crude oil prices up about 9.0 percent this year, pushing up jet fuel costs. Airline stocks tracked by Thomson Reuters Corp .TRXFLDGLPUARLI are down more than 7.0 percent this year.

By contrast, companies who have managed to widen profit margins such as Zoetis Inc (ZTS.N), which makes medicines for animals, Calvin Klein apparel maker PVH Corp (PVH.N), and agricultural product manufacturer Monsanto Co MON.N, have been rewarded with higher share prices this year.

U.S. headline consumer price inflation was 2.5 percent year-on-year in May and hourly earnings for private sector employees were up 2.7 percent from a year-ago, the Labor Department reported recently.

In its May “Beige Book” on business conditions, the Federal Reserve reported moderate price rises in most regions of the nation and noted rising materials costs in some districts that are putting pressure on transportation, construction and manufacturing.

The Fed is expected to raise interest rates again at its policy meeting next Wednesday as inflation and unemployment have come closer to the central bank’s targets but it will likely also keep an eye on corporate profit margins.

Tough talk on tariffs on imported goods by U.S. President Donald Trump, and potential retaliation by China and other countries, may also push up consumer prices further.

A stronger U.S. dollar so far this year may restrain imported inflation, but a rising greenback typically does more to curtail exports by making them more expensive than it does to tamp down inflation by cheapening imports, according to 2015 Boston Fed research.

“Everyone is focused on interest rates. Everyone is focused on trade. But the risk everybody isn’t paying attention to is inflation,” said Charles Bobrinskoy, vice chairman and head of investment group at Ariel Investments.

“There’s a large class of investors who have never invested in inflationary environments.”

Reporting by Trevor Hunnicutt; Editing by Jennifer Ablan and Clive McKeef

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