This overlooked trigger could explode the stock market very soon

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I have a confession.

During Covid I spent a shameful time on the couch which obviously added a few pounds here and there. The welcome byproduct of lockdown, however, is that I have a puppy who is an endless source of frenzied energy. It makes me move a lot more.

Businesses haven’t had the luxury of developing it. To stay afloat, they have had to slim down and streamline every element of their operations – in some cases even reverse their business models.

And it is starting to pay off.

In the first six months of the lockdown, the productivity of the U.S. economy surged the most since 1965. And smart people say Covid has advanced the adoption of the technology by several years (in some cases by a decade). ).

In other words, Covid has made American businesses more nimble and “fit” than ever. (Unfortunately, this has come at the expense of millions of workers.) And I believe this is one of the most overlooked / underrated catalysts (at least among individual investors) that will shape the stock market in this reprise.

Today we’ll talk about that – and a little-known metric that will come in handy when selecting investments in a post-Covid recovery. But before we dig into that, let’s discuss the top line.

Americans are starting to open their wallets …

As we discussed earlier, Covid made America burst with cash. And now that state after state begins to lift restrictions, we are seeing the first signs of this money entering the economy.

Here’s a recent headline on the explosion in retail sales:

This is great news, but sales are only the first line. Before turning into profits, they must cover two types of costs borne by each business.

The first concerns variable costs. Things like personnel or equipment that go into making goods and services. These costs depend on the amount of things you manufacture. The more things you do, the higher the variable costs. And vice versa.

Then there are the fixed costs (i.e. overhead). It’s things like machines, buildings, trucks, offices and all that. This is a fixed expense that the business has to pay to keep the lights on, no matter how many sales it makes.

Businesses based largely on fixed costs can be a blessing and a curse depending on where we are in the business cycle. And that brings me to the lesser-known financial measure called “operating leverage”.

What is operational leverage – and when it works for and against you

Operating leverage tells you several things.

First of all, it shows you the proportion of fixed and variable costs in the business. The higher the leverage, the more fixed costs the company has.

Second (and more important for investors), it tells you the profit growth generated by a percentage increase in sales. In other words, operating leverage is like a profit magnifier (or a shock absorber).

Now, whatever it is, it depends on whether you are making enough sales to cover your overhead costs. Take, for example, Disney’s
Dis
theme park business.

In the case of Covid, you can lay off mascots (variable cost) and cut off the supply of the Mickey product (variable cost). But you can’t dismantle Cinderella’s Castle (fixed cost). It is a fixed expense. The theme park has to bear the cost of maintaining this castle, whether it is entertaining thousands of children or zero.

To break even, Disney must bring a certain number of people into the park. Until they reach that point, all ticket sales are used to cover that cost. And for this reason, sales growth does not translate into profits. This is when the operating leverage works against you.

But as soon as you hit the breakeven point, bringing an extra person into the park won’t cost you anything. This additional sale goes directly to profits. And at this point, the growth in sales leads to an increase in the percentage of profit several times higher. This is when operating leverage works for you.

Here is how it works:

In the economy, the positive effect of operating leverage is most visible in the aftermath of the recession. That’s when sales pick up and these Cinderella castles start to bear fruit. The operating leverage kicks in and the sales growth turns into 4X, 5X or even higher profit growth.

Take a look at this table. It shows how a few percentage points of revenue growth blew up profits after the 2008 recession:

Operational leverage will play a key role in 2021

Based on earnings growth forecasts, it looks like Wall Street analysts are confident this recovery will play out like the previous one. And they think operating leverage will be one of the surprises in coming earnings seasons

Last July, Morgan Stanley’s
MRS
The chief US equities strategist told Bloomberg:

“Cautious investors may ignore the potential for operating leverage to fuel a rebound in earnings… Aggressive cost cutting during downturns is what creates powerful operating leverage as the economy recovers.”

Meanwhile, Brian Rauscher, head of global portfolio strategy at Fundstrat, believes operating leverage will cause stocks to “reopen” in the next earnings season:

“I think what we’ll start to see is the operational leverage of these companies. [those sectors and stocks that benefit from reopenings] is really underestimated. Profits will start to come back faster than income. Corporate America has done a really good job over the last year streamlining their operations, their cost structures, and everything in between. The income could come back 50% and the income 100%. “

I think Rauscher is perfect, and we will see operating leverage very soon. But as you can imagine, some companies will benefit more than others.

At your request: the “anti-dangerous” Venn diagram

Last week I drew a Venn diagram of stocks that are at risk in the post-Covid recovery. I have very good comments from you. And some of you have asked to do the reverse diagram for the most promising sectors / stocks in 2021.

So this is it. This diagram has two circles that represent two groups of actions:

  • Companies that will benefit from a good boost in sales during the takeover
  • Companies with high operating leverage

And in the middle, you have stocks that share both characteristics and have a good chance of shining in the 2021 earnings seasons.

For a few industry examples, you can look at energy, finance, materials, airlines, hotels and resorts, and industrials, all of which are benefiting from reopening and operating with high fixed costs. No surprise, these sectors have so far been among the top winners in 2021.

If you choose specific stocks, it is a bit trickier to determine the stock operating leverage per share.

You see, state-owned companies don’t specify variable and fixed costs in their reports. But one way to assess it is to sift through the company’s quarterly reports and see how an increase / decrease in revenue has affected its profits.

The formula would be: operating leverage =% change in operating profit /% change in revenue

The higher the number, the greater the operating leverage of the business. This means that the resumption of sales will have a greater amplifying effect on the company’s profits.

Either way, the results season begins. It’s time to start analyzing the numbers.

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