Second quarter earnings have largely been reported and the results have been strong. Moreover, management commentary suggests increased optimism about the outlook for the remainder of the year and performance sustainability beyond 2021. Risks are always present — most notably rising COVID-19 infections, potentially higher taxes, supply chain challenges and rising inflation — but all should be manageable. The one factor that gives me confidence that these headwinds can be managed is record operating margins. The margin story is one of the biggest developments in corporate America post-COVID and is attributable to the changes made in response to the pandemic. While the story hasn’t been entirely written and will evolve along with changes in consumer and employee behavior and preferences, I think the shift higher in margins will prove durable.
This week’s chart shows that operating margins across the S&P 500 Index have increased over 100 basis points above the five-year average since 2016. The margin performance has been evident across almost all sectors. There are a variety of factors driving this, including the work-from-home phenomena and lower expenses related to lack of corporate travel. While some of the pandemic-driven changes will reverse, there has been a steep learning curve on what corporate activities can be curtailed or eliminated, such as how job functions can be modified, how technology can be better utilized and an overall reassessment by management teams on all aspects of their businesses. In other words, there has been a surge in productivity, which is a positive development for corporate profitability.
Structurally higher margins have important implications for credit investors. Higher margins translates to more robust free cash flow, increased financial flexibility, higher equity multiples and valuations and an improved ability to weather downturns. Free cash flow has been very notable in 2021 as higher margins have been accompanied by capital expenditure discipline, a trend I expect will continue. This should enable continued deleveraging and ratings momentum over the course of the current business cycle.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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