Understanding the power of operating leverage

If a business can grow its revenues, but also grow its operating profits faster than those revenues, it creates an effect known as Operating Leverage. This is an extremely powerful force on share prices and vital to understand.

If a company's costs are mostly fixed, then its variable costs may be lower. This means that if the sales grow, costs can grow slower than sales - which means profits grow faster.

If we look at Games Workshop, we can see here that during its extremely growth period, its gross margins were stable (in blue below), but its operating margin (in red below) was significantly increasing. The operating margin went from something like just 10% up to an astonishing 40%. It almost quadrupled. This was a very powerful driver of the share price during that time.

We found that the Top 10 Multibaggers almost all benefited from this power of Operating Leverage. The Operating Margins across the ten, on average, grew from about 3.4% percent to 12.4% through the study. It didn't happen to all of them, but in many of them it did occur in. So this key idea of accelerating operating profit growth as revenues grow is a powerful driver of net profits, and ultimately share price returns.

Some other case studies

Now, not all businesses benefit from Operating Leverage. As businesses mature you may find that their operating margins become steady. Apple is a much more kind of established business, and you see that with Apple, which has also been a big multi bagger during the study period, its operating margins were mostly stable through that period. So it didn’t benefit from Operating Leverage. Its share price growth was mostly driven through other financial drivers as we’ll see (namely, sales growth, multiple expansion and buybacks).

Let’s compare a more recent small-cap example - Cerillion, which wasn't in our top ten Multibaggers because it floated after the study period. But we can see in the image below that revenue was growing, but the operating profits growing faster.

And here we can see the operating margin, which was about 13% and then suddenly started rocketing up to 28%, 32%, 36% percent. That led to some really stellar share price returns.

So looking out for businesses that have got the potential to increase their operating margins is a really key thing to look for when stock picking. The above graphic is taken from Stockopedia’s StockReports in the financial summary section. So it's a really helpful place to eyeball those sorts of improvements.

Spotting Operating Leverage Potential

So, how do you spot a business’s potential to benefit from Operating Leverage? Well margins may need to start out moderate or even low. Sometimes businesses have gone through a tricky patch, just like Games Workshop where it was changing its strategy. But there are a few indicators of potential:

• Try to snuff out companies that have got Low Variable Costs or mostly Fixed Costs, so they may have the potential to expand their sales without actually increasing those costs too much.

• You also want to see a Scalable Operation - and ideally the ability to replicate the business model as it grows. A classic example of both these points in the UK market that went through a significant growth phase was Domino's Pizza UK from 2004 to 2014. They created distribution centres, which had a fixed cost in building out, but they could add more and more franchisees and service them all from that single distribution center. That created a really significant amount of operating leverage.

• You also need Market Demand and Pricing Power. Can the business drive sales volumes, through a market opportunity with more sales staff and channels, or developing more services, but also doing so without actually reducing prices. Ideally, you want to see a company that can keep those solid prices as it grows. Apple being another classic example that never discounts.

How to spot Operating Leverage inflection points

Now, even if you haven't read all the company reports and you aren't aware of what's going on strategically, there are news flow indicators that something may be going on in the business.

This is about spotting inflection points, and one of the ways to do that is to read trading statements that may well say that the company is trading “ahead of expectations”. This means the company is about to beat the broker forecasts.

In late 2016, Games Workshop actually said it was ahead of the board's expectations on two different occasions, October, November, and then again in January 2016. These signified to the market that the company’s profits were going to be significantly ahead or likely to be above market expectations.

This went on and on and on through the next twelve months, which drove the share price significantly upwards. Often when we look back at multibaggers, we wonder when could we possibly have “got in”? But these “ahead of expectations” announcements are excellent indicators that we should do a lot more research on a company and find out what's really going on under the hood. They can really power the share price. Games Workshop started at about 500p and in less than eight months, it had already more than doubled.

So let’s recap on the last couple of articles in this series. Potential multibaggers ideally have Sales Growth Runway, the potential to significantly increase revenues, but also Operating Leverage - the ability to increase their profits faster than their revenues.