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The Double-Edged Sword of Operating Leverage
Operating leverage is an important concept to consider when analyzing any business, mainly for its potential to cause unexpected step-changes in the earnings of a company. It is crucial to understand what exactly operating leverage is and the implications that it has for identifying investment opportunities.
The chart below breaks down the elements that combine to create operating leverage within a business. As can be seen, the “operating margin β”, or operating leverage, is driven by both changes in sales and changes in cost. What is key to note from the below conceptual framework is that changes in sales will have different effects on earnings, depending on the nature of that firm’s cost base.
Usually a company will have some proportion of both fixed costs and variable costs; operating leverage can be thought of in terms of the ratio of fixed to variable costs[1].
The below chart helps illustrate how different levels of fixed costs impact operating leverage.
Consider Company A, a software developer with a cost base comprised of 75% fixed costs, and 25% variable costs. Company A has a largely fixed cost base and is represented by the blue line in the above chart. As a software developer, Company A must incur significant expenses to develop software programs. These software development expenses can be thought of as “preproduction costs”, whereby Company A will incur expenses to develop software programs before it can earn any revenue.
Contrast this with Company B (represented by the red dashed line in the above chart), a plumbing business where incremental revenue is earned by a plumber working more hours. Said another way, Company B must pay someone to produce each dollar of revenue, such that there is a strong relationship between revenues and costs.
Referring again to the chart above, the operating margins of both Company A and Company B are 20% when sales are $10m. However, the effects of operating leverage become apparent when there is a change in the sales base for these companies:
Scenario 1 – Sales increase to $25m:
Scenario 2 – Sales fall to $5m:
An understanding of this operating leverage framework is particularly powerful when identifying stock candidates for the Montaka portfolio. For example, industries facing structural headwinds, where there are pressures to revenues that are unlikely to quickly abate, can present opportunities on the short side, particularly when these revenue declines are coupled with a high fixed cost base. Conversely, finding businesses with large organic growth opportunities that require only modest levels of fixed cost investment can also present attractive long investments.
Given the tendency of people to extrapolate the recent past, and to forecast in a relative narrow band of outcomes, the acceleration or deceleration of earnings growth that operating leverage is capable of producing can create stock mispricings. The Montaka team tirelessly seeks to find these opportunities and can take advantage of such situations on both the long and short side.
[1] Operating Leverage: A Framework for Anticipating Changes in Earnings (2016), Michael J. Mauboussin.
This document was prepared by Montaka Global Pty Ltd (ACN 604 878 533, AFSL: 516 942). The information provided is general in nature and does not take into account your investment objectives, financial situation or particular needs. You should read the offer document and consider your own investment objectives, financial situation and particular needs before acting upon this information. All investments contain risk and may lose value. Consider seeking advice from a licensed financial advisor. Past performance is not a reliable indicator of future performance.
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