Operating Leverage Doesn’t Start in the Income Statement
Spotting operating leverage before it’s obvious
I love writing about investing topics that just make sense.
Sure, I enjoy backing these ideas up with case studies, and I’ll continue doing that. But every once in a while, I like writing about concepts that don’t require a spreadsheet full of historical data to make a point. They’re simply rooted in how businesses work.
Operating leverage is one of those concepts.
Simply put, operating leverage is what happens when revenue starts growing faster than a company’s cost structure, allowing earnings to grow much faster than sales. The trick isn’t just recognizing operating leverage after it shows up in the numbers. The real edge and talent is recognizing the conditions that make it likely to happen before everyone else does.
Operating leverage can show up in two ways. Gross margins can expand as manufacturing becomes more efficient, and operating margins can expand as SG&A expenses (selling, general & administration costs) grow much more slowly than revenue.
When both are happening at the same time, earnings can accelerate much faster than sales.
Waiting For Confirmation
One of the biggest mistakes we can make is waiting for operating leverage to show up in the income statement.
By then, the stock has often already had its first big move, especially if the progress is slowing building before the “big inflection.”
Spotting operating leverage early is one of the most important multibagger factors I look for when evaluating companies for our Microcap Quality Index.
Why? Because when you find the right situation, you don’t need explosive revenue growth to drive exceptional returns.
Read more about our Microcap Quality Index here.
I love companies growing revenue 10%, 15%, or even 20% a year where earnings per share can compound 30%, 40%, 50% or more because fixed costs have already been absorbed. Those are the kinds of businesses I want to own all day long.
They’re often more durable than companies trying to grow revenue 50% or 100% just to justify their valuation, as they report losses or fail to grow earnings. If you invest before the market fully recognizes what’s happening, operating leverage can fuel some incredible short- and sustained-multibagger runs. These are also better companies to hold when the market finally does correct.
Early on, this is one of those ideas that completely changed the way I look at companies.
I feel that too many investors wait until they actually see margin expansion, when the operating margin jumped from 8% to 14%, or EPS suddenly inflected. And I get it; it’s uncomfortable to invest before knowing that management is going to come through. But it is what it is.
While you can kind of get away with this in the microcap world, where information discovery is less efficient, in general, I think it’s a lazy way to invest.
The problem is the market usually doesn’t wait, even increasingly in microcaps, where we’re starting to see a lot more young people invest and more place focus on microcaps.
If operating leverage is obvious in the financial statements, there’s a chance the market and stock screeners have already spent months figuring it out.
So where do you look instead?
Early Operating Leverage Signals
I spend far less time looking for operating leverage in one income statement than I do looking for the incremental conditions that create it.
Things like:
Backlog accelerating while costs remain relatively fixed.
Backlog accelerating into higher gross margin area (a favorite of mine)
Capacity expansions that allow significantly more production without a proportional increase in overhead.
Hiring that suddenly slows after years of building the organization.
Gross margins stabilizing after periods of pressure.
A sales mix shifting toward higher-margin products or services.
Management becoming noticeably more confident about incremental margins and profitability.
Notice that I spend a lot of time looking at qualitative factors versus quantitative factors. This is just another way to gain an information arbitrage edge before they show up in the numbers.
None of these guarantee operating leverage. But together, they often tell a story: The company has already made meaningful investments required to support growth, and where every additional dollar of revenue has a much easier path to operating income.
The beautiful part is that these clues often show up several quarters before the financial statements fully reflect what’s happening.
That’s one of the reasons I spend so much time reading earnings releases and conference call transcripts.
I’m not simply looking for whether earnings beat estimates.
I’m looking for evidence that the economics of the business are changing.
Sometimes it’s a single sentence buried halfway through a conference call, or it could be that management casually mentioned that hiring has slowed because the team is finally built; a comment that a new facility is now fully operational, or an increase in backlog that doesn’t seem significant until you connect it with a largely fixed cost base.
Individually, these comments might not move the stock. Collectively, they can tell you a business is about to become dramatically more profitable.
P.S. This obsession with finding subtle clues in earnings releases and conference calls is one of the reasons we built the InfoArb Press Release Application, in collaboration with MicrocapHound. The goal wasn’t to replace research. It was to make it easier to spot the signals that often precede operating leverage and other inflection points.
You can read more about this application here.
Thanks for reading…
If you’ve read this far, then you probably agree that spotting operating leverage before it becomes obvious is one of the most powerful multibagger factors an investor can identify.
Operating leverage is just one of the many multibagger factors we evaluate when selecting companies for our Microcap Quality Index.
Right now, I believe there are two companies in the Index where this particular factor is beginning to emerge… One is also one of our highest-conviction Spotlight stocks.
The first is a telecom and AI connectivity solutions company that recently posted a breakout quarter, reaching an important operating leverage inflection point as gross margins expanded while operating expenses remained well controlled.
The second is an industrial defense company where years of investment are finally beginning to pay off. Revenue is accelerating, gross margins are expanding significantly, operating expenses have remained flat to lower, and the CEO has built a remarkable track record of creating shareholder value.
I believe both companies have the potential to become multibaggers if these trends continue.
Paid subscribers get access to the names, our research, and ongoing coverage of all 144 companies in the Microcap Quality Index. If you’d like to see how we apply concepts like operating leverage before they become obvious to the market, I’d love to have you join us.
See the two companies below…