Let’s talk operating leverage—or as I like to call it, gearing. Think of your car, you start in neutral, shift up to first, then second. The real speed is when you hit fifth. It takes time and momentum to get there. Gearing is where the real money is made.
When you are investing in little companies, you want to look at rapidly growing businesses. Earnings growth is what creates upside. Unfortunately, most companies find it hard to grow a business quicker than 40% a year. I don’t know what it is, but when you start to grow at rapid rates, problems develop. You need middle management. You need more complex accounting and reporting systems. You need better infrastructure. It’s hard to race ahead and eventually companies that grow too quickly stumble. Usually, these ‘growth stocks’ are priced for perfection. When they stumble, their share prices implode. So how do you get lower risk growth?
For starters, remember that investors pay for earnings growth—not revenues. Where does earnings growth come from? Gearing. Think of a business. There are a lot of fixed costs. Then there are the variable costs that increase based on revenues. If incremental revenues carry very high margins, small increases in revenues can have a very big impact on earnings. Let’s look at how this works.
There’s an internet company that sells a product with a 50% gross margin. It costs $20 million a year to run the company. That money covers management’s salaries, servers, research and everything else an internet company does. Look at how the pre-tax income line explodes with small changes in revenues. All numbers in millions.
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Notice how a 20% increase in revenues to $60 million led to a doubling in profits? Notice how when revenues increased by 50% to $90 million, the profits more than doubled? This is gearing. In four years, our company has less than doubled the size of the business in terms of revenues. However, the income has gone up five-fold. That’s powerful earnings growth. More importantly, it’s low risk growth.
Investors repeatedly get burnt buying into hot growth stories that falter. However, the company above is growing a bit over 20% a year. That’s manageable. It is less likely that management will screw it up. They have time to plan ahead and think about the needs of their company.
In my decade of investing, it is these gearing businesses that have made me the most money. I am always stunned by just how well a business can sometimes gear. All businesses gear to some degree. However, there are some businesses that gear a whole lot better than others. I will talk about a few of these in the future. Just remember, operating leverage works both ways. If revenues start dropping, profits will decline even faster.