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The Temptations of Leverage

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Businesses with asset-driven operating leverage lend themselves to an enormous temptation for debt.

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This article was written by Minyan Peter, author of other popular articles such as Still in the Cards and The Courage to Choose.


Happy New Year to everyone!

Two quick things this morning:

First, and I don't know if anyone else noticed this, but our New Year's stock market decline was neither triggered nor helped by bad news coming out of the financial services sector. I'm not sure that I know what that means, but I wanted to share the observation.

Second, Prof. Lance Lewis offered the following in his Buzz and Banter piece yesterday:

"Regarding gold shares, some in the financial media don't seem to understand how these shares work. You have a gold miner that takes gold out of the ground for $4540 and sells it for $700. He makes $250 an ounce on each ounce he sells.

If the price of gold rises 29% to 900, this same miner sells gold at $900 minus $450 costs for a profit of $450 an ounce, or an increase of 80%. That's why the shares went up so much last week relative to the metal. They have leverage to it!"

To be clear upfront, I don't have a position in gold up or down, but I think Prof. Lewis' message is worth thinking more about.

At the core of his point is operating leverage – a company with a relatively fixed cost asset being able to sell that asset at a higher and higher variable price.

And with those higher prices comes exponential profit growth and earnings per share growth for the company.

And, for that company's shareholders, comes significantly higher stock valuations due to both higher earnings per share as well as a higher earnings multiple (because the underlying earning's growth rate has significantly increased).

And, for that company's suppliers, likely comes big increases in capital expenditure purchases and a similar multiplier effect on the supplier's earnings per share and stock price.

But, over time, for that company's management likely also comes increased pressure to continue to deliver exponential earnings growth. And, as we have seen in many industries, one way that management teams can achieve higher EPS growth is by borrowing money (based on the company's strong earnings growth) and buying back stock.

Further, and at the same time, the company's shareholders, foreseeing nothing but continued earnings growth into the future, might consider doubling down on their investment, or buying more shares on margin, or even altering their lifestyle due to their perceived increase in wealth.

Now Prof. Lewis' message focused on mining companies and gold, but I would recommend that you reread his message thinking about home builders and land, US consumers and their homes, hedge funds, private equity and other money managers and their assets under management, and even Middle East countries and their oil – situations where you have tremendous operating leverage driven by higher and higher underlying asset values.

Stand-alone, and at certain times in the cycle, businesses with asset-driven operating leverage make great investments. But I would also caution that, as the early LBO firms first realized, these businesses all lend themselves to an enormous temptation for debt.

On the way up, asset driven operating leverage coupled with financial leverage is as close to perfection as you can get. But as we have seen already with more than a few home builders, the way down is not nearly as pretty.

I don't profess to know if gold goes to $900, $9,000 or $90,000 and ounce, but I do know it won't go up forever. And when it stops going up, please remember, that for the underlying mining stocks, "They have leverage to it!" And very likely, judging from what I see, so too do their lenders, their suppliers, their shareholders, and even their governments.

Position in DUG
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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