Operating leverage: A key ingredient in identifying multibaggers

Authored by Neha Agarwal, Vice President Research at SageOne Investment Managers LLP.

A chemicals manufacturing company D incurs very high fixed costs comprising land, plant and machinery, and relatively low variable costs comprising raw material, labour cost, selling and other expenses.

How would one rate such a business on risk-reward metrics? One might argue that with a high fixed cost, it is a high-risk business with a large downside potential. The answer depends upon the stage of the business cycle one is looking to invest in a company. At the initial capital expenditure (capex) stage, company D may appear to be a high-risk business due to high upfront costs.

However, if one is looking to invest in D post the capex and once all fixed costs all already incurred, subsequent growth in operating profits for every percentage increase in revenue (assuming revenue growth is led by volumes with constant product price) could be significantly more. This is called operating leverage. This can also be observed by operating margin expansion in businesses.

During an investment journey, particularly in sectors which have a high fixed cost model, there are three stages of creating multibaggers:
1. Initial capex stage of high fixed cost and getting the product ready when execution risk is very high

2. Production ramp-up stage when execution risk is largely behind and operating leverage is expected to play, and

3. Lastly, the cash flow reinvestment stage is when risk of identifying future high-return opportunities is high.

Among the above, stage 2 is generally the least risky one as high fixed cost is already priced in and medium-term growth is expected to be driven by production ramp-up and operating leverage. Surprisingly, this is also the stage where the likelihood of outperforming broader markets is significantly high. In other terms, this is a low-risk-high-reward zone for investors.

We studied the financials of 1000+ companies (above INR 500cr market cap as of March 2018) over the past 6 years from FY2018 to FY2023. While 29 per cent (289 out of 1009) of the universe companies showed some degree of operating leverage, more than 70 per cent out of these 289 companies outperformed markets.

Notes:
1. Change in Operating profit/Change in Gross profit from FY2018-FY2013 (we consider gross profit instead of revenues to avoid extreme revenue changes due to only product price change esp. in case of commodities)
2. Universe considered of above 500cr Mcap as of end of FY2018 comprising 1009 companies

Source: Ace Equity, SageOne

As investors, identifying such businesses require a deep understanding of costs incurred by companies and the sensitivity of such costs with growing production volumes.

Further, we should consider the maximum production capacity a business can reach with the existing capex and the possibility of further expanding capacity through a smaller subsequent capex. This is called brownfield capex (the capex at the onset is called greenfield capex). Companies use their existing land, building and common infrastructure and expand capacity by only adding relevant types of machinery (If company D incurred x capex for y capacity, it could expand to 2y capacity by incurring only 0.3x additional capex, leading to overall 1.3x capex for 2y capacity).

Several companies also have the potential to leverage their existing capex by increasing worker shifts from 1 to 2 to even 3 or reducing maintenance time from a few days to a few hours (by introducing superior technology).

In a nutshell, operating leverage is a definite key to creating superior returns with low risk. The investment horizon for such companies can further keep expanding with additional levers of brownfield capex and technological efficiencies. At SageOne, our endeavour is to identify and invest in such businesses closer to the end of their initial capex phase with the objective of generating superior returns in their journey of operating leverage.

Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ.