Now as of writing this article, we are in a major bear run. The stock markets along with the economy is coming down like a house of cards:
- Unemployment rate is slipping at a very high rate, the likes of which were only seen in the 2008 financial crisis.
- Interest rates are already at an all time low. So it is even harder to give the stimulus the economy needs.
- Covid-19 is still a mystery and no one knows by when the world will be back to normal.
Now at this point of time, it is very important for you to choose the right company. It’s because in this scenario a correct decision can create you a huge amount of return in a short period of time. On the flip-side a wrong decision can take away your hard earned money just within few days.
Okay so we know that the current scenario is clearly not a typical one…so lets move on to have a look at a very effective way to decide which share to buy.
Before reading ahead you should understand that not all businesses are impacted in similar ways due to economic events and Operating Leverage is key in understanding business risks and choosing the right stocks to invest.
Now the question is what is operating leverage?
Operating leverage is a accounting formula that measures the degree to which a firm can increase operating profits by increasing revenue.
Don’t worry I’ll simplify the above statement.
It’s simply about the fixed and the variable cost incurred by the company.
- Variable Cost – A variable cost is a company’s cost that is associated with the number of goods or services it produces. A company’s variable cost increases and decreases with its production volume. When production volume goes up, the variable costs will increase. On the other hand, if the volume goes down, so too will the variable costs.
- Fixed Cost – A fixed cost is the other cost incurred by businesses and corporations. Unlike the variable cost, a company’s fixed cost does not vary with the volume of production. It remains the same even if no goods or services are produced, and therefore, cannot be avoided.
So there are two types of companies which we are going to focus on…one with “high operating leverage” and the other one with “low operating leverage”.
When we say “high operating leverage”, it means a company with high fixed cost and low variable cost.
For eg: A movie hall. Here there is a huge fixed cost involved. High maintenance of the hall, the sound system, snack bar etc. But the variable cost is quite low which means that if there 3 people in the movie hall vs 300 people in a movie hall there is not a huge difference in cost because most of the cost is fixed.
When we say “low operating leverage”, it means a company with low fixed cost and high variable cost.
For eg: A biscuit manufacturer like Britannia. So here every packet of biscuit they produce needs certain amount of ingredients like flour, oil, butter etc. Which means that to produce every unit they have to spend on the ingredients. Also this a lot more labor intensive which is also a variable cost.
Okay…so now you know what do I mean when I say high/ low operating leverage.
The next question is how to use this metric to better select a stock according to the stock market cycle?
As proportion of fixed costs to total costs increases (high operating leverage), the volatility of the net profits of the company becomes a lot more volatile. This is because during economic expansion where everyone is making a lot of money, and consumption is increasing by the day. These companies can make a lot of money as the extra cost to meet the demand (variable cost) is very low.
But what happens when the economic situation gets bad?
Yup…you got it right! The companies in high operating leverage perish.
So in these times the best is to choose a company with low operating leverage, so that they can go through this downturn comfortably. These companies can easily reduce production which significantly reduces their cost, which inturn helps them to survive the economic slowdown easily (maybe even making higher profits).
In a market downturn, we need to focus on businesses with low operating leverage, and thus stable profits. As the business cycle turns up, reallocate your portfolio to businesses with greater operating leverage.
Understand the business and analyse the cost structures before you put your hard earned money on it.
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