Climbing a Wall of Perfection

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.
 
Heartland Advisors Value Investing Operating Earning Profit Margin Chart
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Economic predictions are based on estimates and are subject to change. Recession periods: December 1969 to November 1970, November 1973 to March 1975, January 1980 to July 1980, July 1981 to November 1982, July 1990 to March 1991, March 2001 to November 2001, and December 2007 to June 2009.
 
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.
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Author

Heartland Advisors Value Investing Portfolio Manager Bradford A. Evans

Bradford A. Evans

Evans, CFA, is Senior Vice President and Portfolio Manager of the Value Plus Fund and its corresponding separately managed account strategy. He has 22 years of industry experience, 19 at Heartland.

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