Thread by @Sanjay__Bakshi

Three things happened in Q2.

https://twitter.com/rohitchauhan/status/1322222579093000203

One, there was pent up demand in Q2 because of shutdown in Q1. So earnings which would have occurred in Q1 moved to Q2. This is temporary.

Two, many costs were not incurred in Q2 or the money spent on them was much lower than what was spent in Q2 of the previous year. For example, travel and advertising and rents etc. Some of these cost savings may endure. Others won’t.

For example, for many consumer-facing businesses, cutting ad spending may make sense for a short while. Still, it can’t be a long term strategy if one has to maintain unit volume and competitive position.

Finally, input (raw material) prices declined in some industries, which helped manufacturers having low inventory levels of those inputs. Their output prices were not reduced proportionality, so gross margins expanded. Not permanent in my view but there may be exceptions.

Those three factors lead to margin expansion in Q2, which in many cases led to compensation, and in some cases, overcompensation for volume shrinkage as compared to Q2 last year.

When you throw a large rock in a still lake, there are ripples. Over time most of those ripples disappear. In this analogy, Covid is the rock, and the lake is an industry profit pool.

Let the ripples dissipate. Then we will know if the rock altered the lake or not.

One more point which I should have mentioned. There is usually a lag between a temporary expansion of margins and their reversion to the mean in most industries. Competitive actions take time, and response to those actions also takes time.

For any industry where the intensity of competition is high, before extrapolating the current margin expansion into the future, it is a good idea to ask: Why would the margins not mean revert?

This is how mean reversion will work. Some guy in an industry that is enjoying margin expansion will cut prices to gain market share. He will basically play spoilsport.

Now each of the other industry players will have to make a difficult choice: cut prices (option A) or hold ground (option B). Option A will reduce the margin but may help in regaining lost market share. Option B will result in the continuous loss of market share.

As one player after another cut prices (Option A), the players choosing Option B will face pressure to capitulate. And when all do, industry margins will revert to the mean.

If you agree with me (you don't have to), you will assign a very low multiple for that part of incremental earnings that won't last because of the force of the reversion to the mean model.