I have a confession.
During Covid, I’ve spent a shameful amount of time on the couch, which obviously added a few pounds here and there. The welcome byproduct of the lockdown, though, is that I got a puppy who’s an endless source of frantic energy. He makes me move much more.
Businesses haven’t had the luxury to couch it out. To stay afloat, they had to slim down and streamline every bit and piece of their operations—in some cases even flip their business models upside down.
And that is starting to bear fruit.
In the first six months of lockdowns, the productivity of America’s economy jumped the most since 1965. And smart people say that Covid has pushed forward technology adoption by years (in some cases by a decade).
In other words, Covid made corporate America more agile and “fit” than ever. (Sadly, that’s come at the expense of millions of workers.) And I believe this is one of the most overlooked/underrated catalysts (at least among individual investors) that will shape the stock market in this recovery.
Today we’ll talk about that—and a little-known metric that will come in handy when picking investments in a post-Covid recovery. But before we dig into that, let’s discuss the top line.
Americans begin opening their wallets…
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As we discussed before, Covid made America flush with cash. And now that state after state is starting to lift restrictions, we see the first signs of that money entering the economy.
Here’s a recent headline about exploding retail sales:
That’s great news, but sales are just the top line. Before they trickle down to earnings, they must cover two types of costs that every business bears.
The first is variable costs. Things like staff or material that go into the making of goods and services. These costs depend on how much stuff you make. The more stuff you make, the higher variable costs. And vice versa.
Then there are fixed costs (aka overhead). These are things like machinery, buildings, trucks, offices, and all that. They are a fixed expense that the business has to pay to keep the lights on—no matter how many sales it’s making.
Businesses largely built on fixed costs can be a blessing and a curse depending on where in the economic cycle we are. And that brings me to the less-known financial metric called “operating leverage.”
What operating leverage is—and when it works for and against you
Operating leverage tells you a couple of things.
First, it shows you the proportion of fixed and variable costs in the business. The higher the leverage, the more fixed costs the company has.
Second (and more important to investors), it tells you how much earnings growth a percentage increase in sales generates. In other words, operating leverage is like a profit magnifier (or dampener).
Now, whichever it is depends on whether you make enough sales to cover your overhead. Take, for example, Disney’s DIS theme park business.
In the Covid case, you can lay off mascots (variable cost) and cut the supply of the Mickey merch (variable cost). But you can’t pull apart the Cinderella Castle (fixed cost). It’s a fixed expense. The theme park has to bear the cost of maintaining that castle no matter whether it’s entertaining thousands of kids or zero.
To break even on it, Disney has to bring a certain number of people into the park. Until they hit that point, all ticket sales go to covering this cost. And for this reason, growing sales don’t translate to profits. This is when operating leverage is working against you.
But as soon as you break even, bringing an extra person into the park won’t cost you a thing. That extra sale trickles straight down to earnings. And at that point, growing sales lead to a many-fold greater percentage increase in profits. This is when operating leverage is working for you.
Here’s how that works:
In the economy, the positive effect of operating leverage is most visible in the wake of recession. This is when sales recover and those Cinderella Castles begin to pay off. Operating leverage kicks in and sales growth turns into 4X, 5X, or even higher earnings growth.
Take a look at this chart. It shows how a couple of percentage points in revenue growth exploded earnings after the 2008 recession:
Operating leverage will play a key role in 2021
From the projected earnings growth, it looks like Wall Street analysts are confident this recovery will play out like the last. And they think the effect of operating leverage will be one of the surprises in the coming earnings seasons
“Cautious investors may be overlooking the potential for operating leverage to fuel an earnings rebound… Aggressive cost-cutting in a downturn is what creates the powerful operating leverage when the economy recovers.”
Meanwhile, Brian Rauscher, head of global portfolio strategy at Fundstrat, thinks the effect of operating leverage will drive “reopening” stocks in this coming earnings season:
“I think what we’re going to start to see is the operating leverage for these companies [those sectors and stocks that benefit from reopenings] is really underappreciated. The earnings are going to start to come back faster than the revenues. Corporate America has really done a good job in the last year of streamlining their operations, their cost structures and everything else. Revenues could come back 50%, and earnings could come back 100%.”
I think Rauscher is spot on, and we’ll witness the effect of operating leverage very soon. But as you might expect, some companies are going to benefit more from it more than the others.
At your request: the “anti-dangerous” Venn diagram
Last week, I put together a Venn diagram of stocks that are in danger in the post-Covid recovery. I’ve got great feedback from you guys. And some of you requested to do the opposite diagram for the most promising sectors/ stocks in 2021.
So here you go. This diagram has two circles that represent two groups of stocks:
- Companies that will get a good boost in sales in the recovery
- Companies that have high operating leverage
And in the middle, you’ve got stocks that share both traits and have a good chance to shine in 2021’s earnings seasons.
For some sector examples, you could look into energy, financials, materials, airlines, hotels and resorts, and industrials—all of which benefit from reopenings and run on high fixed costs. No surprise, these sectors have been some of the best winners in 2021 so far.
If you are cherry picking specific stocks, working out operating leverage stock by stock is a little trickier.
You see, public companies don’t spell out variable and fixed costs in their reports. But one way to gauge it is to sift through the company’s quarterly reports and see how an increase/drop in revenues affected its earnings.
The formula would be: operating leverage = % change in operating income / % change in revenue
The higher the number, the bigger operating leverage the company has. Which means recovering sales will have a bigger amplifying effect on the company’s earnings.
Anyway, the earnings season is kicking off. Time to start crunching the numbers.
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