Did you know that it is sometimes possible to make money by owning bad companies? To be more specific, it is occasionally possible to generate significant investment returns by purchasing the least attractive stock in a particular sector or industry if you believe that sector or industry is due for a turnaround. This may seem counterintuitive, but once you understand the mathematics behind the phenomenon, it makes perfect sense not only as to why it happens but how it is possible for a shrewd investment analyst to make a lot of money if their hypothesis turns out to be correct.
Imagine it is the late 1990’s and crude oil is $10 per barrel. You have some spare capital with which you wish to speculate; money outside of your core portfolio that you are willing to risk and that you do not need to survive. It is your belief that oil will soon skyrocket to $30 per barrel and you’d like to find a way to take advantage of your hunch. Ordinarily, as a long-term investor you would look for the company with the best economics and stick your capital in the shares, parking them for decades as you collected and reinvested the dividends.
However, you remember a technique taught in Security Analysis and actually seek out the least profitable oil companies and begin buying up shares rather than investing in the oil majors.
Why would you do this? Imagine you are looking at two different fictional oil companies:
Company A is a great business. Crude is currently $10 per barrel, and its exploration and other costs are $6 per barrel, leaving a $4 per barrel profit.
Company B is a terrible business in comparison. It has exploration and other expenses of $9 per barrel, leaving only $1 per barrel in profit at the current crude price of $10 per barrel.
Now, imagine that crude skyrockets to $30 per barrel. Here are the numbers for each company:
Company A makes $24 per barrel in profit. ($30 per barrel crude price - $6 in expenses = $24 profit).
Company B makes $21 per barrel in profit ($30 per barrel crude price - $9 in expenses = $21).
Although Company A makes more money in an absolute sense, its profit increased 600% from $4 per barrel to $24 per barrel compared to Company B which increased its profit 2,100%. On top of this, when times were rough, Company A probably had a higher price-to-earnings ratio than Company B so when things recovered, it is quite possible the latter experienced something known as a multiple expansion, adding an additional boost. The result would be the stock price of Company B increasing more, perhaps exponentially more, than the stock price of Company A.
In other words, Company A is the better business but Company B is the better stock.
Reasons Why This Works
What you've witnessed in our hypothetical scenario occurs because of something known as operating leverage. Operating leverage is a term used to describe a company's level of fixed expenses relative to its revenue. For companies with high operating leverage, fixed expenses --things that have to be paid for it to stay in business--are tremendous. Until they are covered, the company loses money or breaks even. When those fixed expenses are exceeded, a huge part of each additional dollar in revenue falls to the bottom line.
This can be a double-edged sword because it means that when revenue falls below the fixed expense threshold, either painful cuts, including mass layoffs and facility closings, have to take place to "rightsize" the organization. On the flip side, when the fixed expense threshold is exceeded, profits flood down to the bottom of the income statement and drown the owners in a disproportionate percentage of cash.
Companies with high operating leverage tend to be found in either:
Asset-intensive industries - Airlines and steel mills are quintessential examples. When things get bad, they tend to fall all over themselves on the race to bankruptcy court, wiping out investors along the way. When things are good, the share prices explode upward, making a lot of people (often temporarily) rich.
Commodity-dependent industries - Copper producers, gold miners, oil exploration companies; these businesses have huge fluctuations in revenue that result in wild profitability swings due to the fact the fixed costs can't always adjust as rapidly as the market value of the commodity..
There are many easier ways to make money in life. A bad business can be a constant headache, disappointing you at every turn while providing the occasional illusion of progress. It's a lot easier to find a good collection of wonderful enterprises and let time and compounding work their magic, including allowing you to enjoy the leveraging effects of deferred tax liabilities. If history is any guide, you're likely to end up a lot happier getting your hands on one of these types of operations and holding on like a pit bull, refusing to let it out of your grasp.
Add in diversification for any misfortune along the way and it isn't terribly difficult to build wealth.