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Profit margin doldrums: Are we having fun yet?

While smart investors always keep an eye on their portfolio, new things pop up each day to distract us from our holdings.

It's easier to play games on your iPhone than keep up with Apple Inc.'s developments, or to read breaking news on your BlackBerry rather than see how Research In Motion Ltd. is doing.

But a new report from Pavilion Global Markets suggests that you'll start seeing more movement within your portfolio to steal your attention.

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Not for the greatest of reasons, though: Global profit growth is at a crawl, and the likelihood that lacklustre return on equity (ROE) is locked in for the medium term has Pavilion's economists warning investors to look out for companies finding creative ways to keep their attention.

First, let's look at how they reached the unfortunate conclusion that ROE isn't going to make us very happy for a while.

Rather than using the simplest measure of ROE, the ratio of a company's net income over total shareholder equity, Pavilion uses the three-step DuPont formula to assess returns. That measure breaks ROE down into three components of profitability, multiplied against each other: profit margins, asset turnover and financial leverage.

Here, we find our culprit. "Globally, profit margins have retraced about half their post-recession gain," the authors write.

By the way, do you own any U.S. stocks? "The United States is an exception as margins have just started to roll over," Pavilion's economists write. "In other words, margins have much further to fall in the U.S."

Looking at the other components of the DuPont formula – asset turnover and leverage – there's little evidence to show they're to blame.

While companies have focused on deleveraging since 2009, Pavilion's data, compiled from Datastream, show that leverage has remained stable over the past two years. It's the same with asset turnover, which Pavilion's data suggest has been stable in Asia and steadily declining in both Europe and the Americas for decades.

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So, if profit margins keep falling, particularly in the lagging United States, then it's likely we won't be seeing global ROE trend back upward any time soon.

That's why Pavilion says investors will soon see companies vying for their attention. In a world of poor returns, "companies will have to be creative to keep investors interested in their stocks," the authors write.

That means you'll see more instances of bumping up dividends, making acquisitions, expanding operations – anything that lets them keep the money that you let them play with.

Which is easier for everybody than staying distracted by the godforsaken long tail of economic recovery we're stuck in.

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About the Author

Josh O’Kane is a reporter with The Globe and Mail's Report on Business. Since joining the paper in 2011, he has told stories from New Brunswick to Nairobi. In his spare time, he writes about music and the industry around it. More


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