Charts of the Month - October '22

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Operating Leverage

Most of the finance world is currently focused on the big macro and geopolitical themes playing out around the world in a seemingly non-stop flood of negative events – global inflation, rising interest rates, defending currency pegs, wars, geopolitical posturing, etc. These are dominating headlines, and for good reason, the world we’ve lived in for the past 30+ years is structurally changing at a rapid pace.

But sometimes, when everyone is hyper-focused on one side of the equation, it can be beneficial to take a step back and refocus on the fundamentals (the analyst in me will never, ever, die).

Operating Leverage is one of those fundamentals that most people who entered the world of investing more recently likely haven’t heard of (TikTok influencers may have missed this topic in their extensive CFA studies), but it's one of the most critical factors to forecasting a company’s profitability (or lack thereof) and understanding a base case for a ‘buy’ or ‘sell’.

Operating Leverage is defined as “the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high Gross Margin [Revenue – Cost of Goods Sold] and low variable costs has high operating leverage.”

Basically, a company with high operating leverage will see most of an increase in revenue flow through to operating profit given its low level of variable costs. But the inverse is true as well - decreasing revenues will drive larger operating losses.

• An easy example would be a gold miner, who has, for the most part, a fixed cost base business (the equipment and the workforce to mine gold), and which benefits from operating leverage as gold price increases – more revenue coming in with little change to the cost structure of the business (equipment and workforce stay the same) which means higher operating profit.

This chart is just something to think about as we go through this prolonged pullback (which is likely to continue) and to understand sector-specific operating leverage and its effect on future profitability.

Supermajors

Speaking of fundamentals, we thought it would be useful to start bringing you some of the stuff we’re looking at on a regular basis from more of a bottoms-up (as opposed to top-down) approach. This is not, and never will be investment advice, but since we’re in the trenches looking at this stuff, we’ll start publishing some of our findings here.