Financial Market Commentary

David Sowerby of Loomis Sayles gave an interview on CNBC last Friday (12.16.11, video available here). Mr. Sowerby cited the following reason for being bullish on stocks:

. . . if you look at the continued improvement in cash flow margins, that are about 20% today for most companies, still below the 24% peak levels for 2007, I think too many investors are focused on net profit margins, not focused on the statement of cash flows, that’s what can get stock prices higher . . .

Twenty percent free cash flow margin sounded a little high to me, so I decided to take a closer look. I calculated the equally-weighted and capitalization-weighted gross, net, and unlevered free cash flow margins for the S&P 500 from 1994-2011. The graph below shows that the average gross margin expanded dramatically from 1994-2000, after which it levels off and drifts slightly higher. Cap-weighting makes a difference, as large-cap firms have higher gross margins. I found it interesting that gross margins were largely unaffected by the 2000-2001 and 2007-2009 recessions:

Health Care, Telecom and Information Technology have the highest cap-weighted gross margins. Health Care’s cap-weighted gross margin now exceeds 60%:

Average net margins are also trending upwards, although net margins display pronounced declines during the last two recessions. Cap-weighting once again makes a difference, as larger-cap companies earn higher net margins. Further note how the cap-weighted series shows less of a decline during recessions.

The Health Care and Information Technology sectors also have the highest cap-weighted net margins, along with — surprise — Financial stocks. Notice how, until their demise in 2007, Financials squeezed the highest net margins out of their revenues compared with the rest of the S&P 500:

I also calculated the equally-weighted and cap-weighted unlevered free cash flow margin for the S&P 500, depicted in the graph below.

Mr. Sayles definitely gets a few things right. Unlevered free cash flow margins have been in an 18-year uptrend, and the equally-weighted series does indeed peak in 2007. Cap-weighting makes more sense, however, as an equally-weighted series places disproportionate weight on the margins of smaller firms. The graph above shows that the mean cap-weighted free cash flow margin of the S&P 500 is at an 18-year high.

The sectors with the highest cap-weighted unlevered free cash flow margins are once again Health Care, Telecom and Information Technology, ranging between 13%-18%:

Conclusion: S&P 500 gross, net, and unlevered free cash flow margins trend upwards from 1994-2011. Health Care has the highest gross and unlevered free cash flow margin, followed by Telecom and Information Technology. Surprisingly, Financial stocks’ net margins have rebounded sharply.

The mean cap-weighted unlevered free cash flow margin for the S&P 500 is only 12.2%, however, much lower than Mr. Sowerby’s estimate of 20%. One possible explanation for the difference in our findings is that the Loomis Sayles calculations refer to levered free cash flow margin, which we would expect to be higher. I propose that cap-weighted unlevered free cash flow margin is a better measure, however. Levered FCF arbitrarily places more weight on the margins of firms that use more debt, instead of weighting by the more traditional market cap factor.

Datasource: Capital IQ.