Operating Leverage Gone Bad 😷

by 28 Jul, 2020

Operating Leverage Gone Bad  

The virus is still here. It’s important to stay vigilant, but what with all the masks, hand sanitizers, plexiglass, and temperature guns, safety isn’t cheap. The Invstr community will notice a new line item under expenses released by many companies this earnings season; under PPE!

This is a challenge for small businesses rather than larger ones, but investors will also find that stocks of companies in industries with thin profit margins and lots of customer interaction will suffer. The prime examples are car dealerships, day cares, care homes.

In fact, schools and care homes are in huge trouble, because a breakdown of their normal expenses reveals exceptionally high operating leverage. This means more fixed costs than variable costs, more fixed costs that are the same no matter how many customers show up, than variable costs that edge up with each incremental new customer.

A care home could be operating at full capacity and its cost-base would be much the same as if it were empty, so each new resident brings in revenues that put distance been profits and costs. In other words, profit margins widen with scale. It’s great, until the residents stop paying…

There are tight markets with big operating leverage that have boomed in recent years with soaring stock prices, but now stocks are diving. Their cost-base can’t be cut back. The masks, hand sanitizers, and plexiglass costs all make it worse, so short-sellers are in there!

G8 Education, Sienna Senior Living, and Ventas are good places to start to familiarize yourself with this effect!

I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand.

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