A few weeks ago, I discussed some of the warning signs that investors should be on the lookout for when analyzing companies. One particularly important red flag that came up was excessive leverage - companies that are saddled with large amounts of debt that they have trouble paying back rarely end up being winning investments, no matter how compelling the "story" behind the stock.
However, this doesn’t mean there aren’t legitimate reasons for a management team to seek to increase their leverage. Today, I want to look at why a business might want to take on debt, and in particular why the concept of operating leverage is so important.
What is it?
There are many different ways to define operating leverage, but in straightforward terms, operating leverage refers to the relationship between a company’s fixed and variable costs. Some companies, like hotel operators, have high fixed costs (the cost of the real estate that they own or rent) and relatively low variable costs. It costs a lot to run a hotel, but once enough rooms are filled that the hotel breaks even, every additional room sold goes straight to the bottom line.
There are some variable costs that scale with each additional sale (for instance, paying cleaners for more hours worked), but the ratio of fixed costs to variable costs is high. Hotels, therefore, have high operating leverage: they do very well when they are selling a lot of room space, but can fail disastrously when business slows down.
Why does it matter?
Businesses with high operating leverage will have more volatile business results than those with low operating leverage because their profits will rise more during good times and fall more during bad times. Operating leverage is an extremely important metric for value investors to consider because it provides essential context for understanding earnings.
A business that posts a 50% increase in year-over-year earnings can seem impressive, but if this is achieved due to high operating leverage, it will be at risk of an equally big loss if the economy underperforms. In other words, these seemingly impressive results are actually a lot more ephemeral than you might think.
This doesn’t mean you should avoid businesses with high operating leverage - far from it. You should want to invest in businesses that can translate revenue down to the bottom line. But you also have to be cognizant of the fact that these kinds of companies are much more vulnerable to downturns than companies who don’t benefit from leverage. Understanding this will help you to construct a portfolio that won’t get blindsided when economic fundamentals begin to deteriorate.
Read more here:
- Warren Buffett: How Do Businesses Build an Economic Moat?
- The Value Investor’s Handbook: More Warning Signs to Look Out For
- Bill Ackman on Becoming an Activist Investor
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