US profit margins might not be all they seem

Profitability of US firms in aggregate has been quite healthy post-2009, as margins bounced back and reverted to pre-crisis levels. However, breaking down profitability of firms by their market capitalisation shows that the aggregate picture is masking weakness in smaller firms.

This chart splits the universe of Russell 3000 firms, representing about 98% of the entire US equity market, into quintiles by their market capitalisation and looks at the aggregate profit margin for each of these quintiles.

The 1^st quintile, corresponding to the smallest firms, has an average market cap of USD 200 million, while the large cap firms in the 5^th quintile have an average market cap of around USD 24 billion (and a maximum around USD 1trillion). While there are a few interesting dynamics, one that is especially worth highlighting is the growing dispersion between the profit margins of small versus large firms, indicated by the blue shaded region. While it is not surprising that large firms are more profitable than smaller firms, it is noteworthy that the spread between the profit margins is growing. Typically, the spread is around 10%, except during recessions when it can widen significantly, as small firms struggle to remain profitable during a downturn and large firms benefit from scale and global exposure. However, since 2012 this spread has grown despite continued economic expansion. Thus, while large firms may be able to weather margin contraction or a meaningful economic slowdown, smaller firms, especially the smallest 40%, are at substantial risk.

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