Operating Leverage Explained

I am writing this because not too many people I speak with have any idea about operating leverage.  Everyone knows about financial leverage (debt), but somehow operating leverage slips under their radar.  This article is meant to be an introduction, rather than an all-encompassing tome, on how best to evaluate firms on the basis of operating leverage.

I was first introduced to this concept by Phil Fisher.  He wrote one of the most important books ever written on understanding businesses and the examples I use will be similar to those used in his book, “Common Stocks and Uncommon Profits”.  Check this book out if you haven’t already.

To best illustrate this concept, I want you to consider two firms.  We’ll call them “Company A” and “Company B”.  Both companies are in the same business of producing packs of gum.  These two companies are identical in every way, except Company A makes gum at a cost of 1 cent per pack, whereas Company B makes gum at a cost of 3 cents per pack.  Packs of gum are selling in stores today for 8 cents.  Here is how profit currently looks:

  • Company A: $.07 profit per pack
  • Company B: $.05 profit per pack

Although this may at first seem elementary, take a look at what happens when there is a market disruption and prices fall to 4 cents per pack:

  • Company A: $.04 profit per pack
  • Company B: $.02 profit per pack

You’ll notice something peculiar here.  Although both companies slashed their prices by the same nominal amount (2 cents), Company A’s profits fell roughly 43%, whereas Company B’s profits fell by 60%.  Company B has a higher cost of producing their packs and would be considered the company with higher operating leverage.

Contrast this with the subsequent rise when packs of gum jump up to sell for 10 cents:

  • Company A: $.09 profit per pack
  • Company B: $.07 profit per pack

Company A has a 125% jump in profits, whereas Company B sees their earnings grow a full 350%.

Even though Company B may have substantially increased earnings from the prior period, they are still not getting the full efficiency out of their sales dollars. For whatever operational reason, they have higher costs associated with manufacturing their product and cannot operate as efficiently as Company A.  Company A is actually earning more money per dollar of sales, even with a lower growth rate from the prior period.  Lower-cost producers will, over time, actually earn much more money, even if it doesn’t look like they are increasing profits as much on a year-to-year basis.

One of the main things to consider in looking at businesses are the margins of the company.  The more these fluctuate over the years, the more you can be certain that the company is either in a highly cyclical industry or they are not a low-cost producer.  In either case, you probably don’t want to invest in them unless they are at incredibly distressed prices.  These businesses are often highly erratic and are very difficult to value.  However, it is much easier to identify low-cost producers than you might think.  All it takes are slightly higher operating margins (in most cases, unless they rely on high turnover of their inventory) than the industry average and their margins will decrease much less during bad periods in relation to their competitors.  Using Value Line as a tool, it is easy to find these companies by looking over their fundamentals of the last 10 years.

One last principle that I think should be addressed: inflation.  No, I am not going to tell you to buy gold (actually, I would tell you to avoid anyone who recommends it as an investment).  Owning businesses can be one of your best hedges against inflation.  They will continue to earn money as the value of the dollar declines.  They earn this money in real-dollar terms and can adjust their prices accordingly.  Care to take a guess at which type of business I would recommend buying to help limit the effect of inflation?  Yep, you got it.  Low-cost operators.

I once heard Warren Buffett discuss the idea of buying into a business that can adjust prices for inflation and completely negate inflationary effects, but there are very few, if any, businesses that can accomplish this.  Although Coke may come to your mind as one of these special businesses, if Coke raises its prices too high, consumers would simply switch to drinking iced tea or other flavored beverages.  Consumers can switch from one product to another if they accomplish similar goals.  Campbell’s Soup may also have a great business and domination over their competitors, but if their prices rise too high, people will just start eating more sandwiches and stop buying their canned goods.  The list goes on.  The idea is that it is most likely not possible to select an investment that can perfectly adjust its prices to negate the effects of inflation.  (If you find one, please let me know, I’ll be more than happy to hear about it).

Low-cost operators can best bear the burden of the higher costs needed to produce their goods.  They tend to earn higher margins than their competitors and can allow for their costs to rise without raising their prices for a longer period of time.  This short-term waiting period will benefit them over the long run.  As inflation starts to affect other companies in a similar fashion (as their cost of producing goods rises as well), there will be a general overall rise in prices and the company will have successfully waited out the storm. The competitors to these low-cost firms often are hit much harder in inflationary times.  Their profitability will decrease even further or they will lose market share if they raise their prices.  Inflation puts the higher cost producers into a squeeze that is very difficult to get out of.

Also, keep in mind that low-cost operators have a lower breakeven point on their sales.  They can do quite well with surviving recessionary periods when less of their goods are being sold or when prices are lowered.  It is in the bad, recessionary times that low-cost operators have more flexibility to hurt their competitors.

Advantages to holding companies with lower-cost operations:

  • Better consistency of earnings & margins over time
  • Earn more money over time per dollar of sales
  • Better bear the cost of inflation
  • Survive recessionary periods better than competitors

The thing I find most entertaining are the newspaper articles written about companies growing their earnings.  Although low-cost operators are earning more money per dollar of sales, high-cost operators will steal the spotlight with a headline like, “GM grows profits 350%”.   This is an absolute absurdity and does not take into account the difference between return to profitability and true growth in earnings.  Granted, most people may be aware of this on the extreme examples like 350%, but with a difference between Pepsi growing profits by 6% and Coke growing by 12%, who’s to say they know which is a better growth investment for the future?  The answer, of course, is to not look at short-term changes in earnings to determine future growth.  That is why I love watching the research analysts on Wall Street get excited when a company releases earnings; they always seem to focus on how much profits increased from the most recent prior period.  This can sometimes lead to pricing inefficiencies if you watch carefully.  Try not to get trapped into the “Wall Street mentality”.

My above discussion is an overview of operational leverage.  It is almost impossible to identify the individual costs with manufacturing specific products; businesses most likely won’t list them and there are often shared resources in manufacturing different products. You can easily check the profit margins across industries, however, to determine the low-cost operator, consistency is the key.  You don’t always have to pick the best one; often, there are two or three per industry that have similar operating metrics.  Don’t feel the need to buy the absolute highest-margin company every time.  My list of “Great Businesses” on my blog has been put together with operating leverage in mind as I analyzed them.  They may not all have the same margins, but they all share the one common trait: they are low-cost operators with high consistency in their margins.

Operating leverage ties directly into my discussion of working capital.  The more consistent the earnings, the better idea you can get about how much money it will require to operate the business over time.  You also start to trust the company more and can reasonably predict a similar trend for the future (assuming their fundamentals are backed by a durable business model).  There is no chance you would trust a business whose operating margins are so erratic that they look like a roller coaster ride.  There is no telling where they will be next year.

I have listed 3 companies in the same industry below to have you compare between them on an operating leverage standpoint.  Take the time to do glance over their margins; it will show you how operating leverage applies in reality.

Here are the 3 companies with varying operating leverage (ValueLine reports):

I think these three companies are pretty self-explanatory.   I selected a low-cost provider, a middle of the road provider, and a an extremely highly operationally leveraged company.   You should be able to tell the difference. If you do the exercise and have trouble determining the low-cost provider, please, comment below.

Here is the pdf: Operating Leverage

Enjoy!

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About Andrew Schneck

I am a value investor focused on misunderstood securities and industries, with an eye for long-term stock ownership.
This entry was posted in Investment Principles and tagged , , , , . Bookmark the permalink.

3 Responses to Operating Leverage Explained

  1. Parth says:

    Posco=low cost
    Gibraltar Industries=middle of road
    US Steel=highly operationally leveraged

    is that right?

  2. Parth says:

    yea it makes sense. So I should use this and working capital to find good companies? How do you determine if the stock is overvalued or undervalued if the P/E is not the right indicator?

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