Why Favour Companies With High Operating Leverage?

In the context of an improving economic backdrop, companies with high operating leverage are expected to benefit from higher profitability. For these companies, rising sales will imply higher profit margins and thus higher earnings. We recommend a stock selection based on this quantitative criterion.

A bottom-up approach

Unlike our other investment themes, this one is based on a bottom-up approach and relies on the selection of stocks using an explicit quantitative criterion: operating leverage. This financial concept is crucial for companies’ profitability. Operating leverage measures the change in operating profit as a function of the change in sales. It is high when a company shows a large change in operating profit for every euro of change in sales. Inversely, it is low when changes in sales do not impact largely operating profits.

 The cost structure of a company is decisive in the operating leverage effect. A company with high fixed costs benefits from high operating leverage. If sales accelerate, its fixed costs weigh less on its operating margin which should rise more than for a company with variable costs. On the other hand, when sales shrink, a high operating leverage may drag on a company’s profits.
 

A more favourable economic background

Over the past few years, US and European companies have not enjoyed growing revenues owing to low economic growth and low inflation.  Their sales growth has even contracted in recent quarters. 2017 should offer the opportunity to deviate from this unfavourable trend as reflationary effects are expected to be supportive in developed economies.

Against this macro-economic backdrop, companies should benefit from rising demand while revenues should rebound from their current lows. Companies with a high operating leverage could take advantage of this improving macro-economic environment.

Stocks with a high operating leverage can be identified in any sector or industry, but some of them have a high structural operating leverage. Fixed costs are high in the Industrials, Telecoms equipment, Materials, Utilities and Energy sectors.  

So far, profits have been weak, particularly in Europe. The rise in the European equity markets from 2009 lows has been almost entirely driven by valuation expansion, not by an earnings improvement.

Profit margins are historically low. In this context, industries with a high operating leverage benefit from any improvement in sales in Europe.

Risks to our base case

The absence of a sales momentum in developed economies may negatively affect this theme. Any reversal in trend in our macro-economic scenario for 2017 would be unfavourable. Another deflationary spiral or recession scenario should be particularly negative for high operating leverage companies.