One of the biggest lessons that investors learned from the 2007 meltdown was to stay away from companies with huge gearing.
It was gearing that got the banks into so much trouble. They had spent years ratcheting up debts in a bid to outperform each other. And when the crisis began, investors quickly realised just how little cover the banks had.
That fear about heavy debt loads has put a lot of investors off heavily geared companies since then – from utilities to banks to my bugbear, retailers.
But the truth is that gearing is not well understood by investors. Because not all gearing is the same.
Today I want to show you how operational gearing, when used well, can make for outstanding investment opportunities. And I’ll show you one sector that is looking poised for excellent returns from it right now.
Is gearing really that bad?
Most businesses have borrowings – and it’s usually not a bad thing. It can spice up returns, and there are some tax advantages too. In most cases financial gearing isn’t going to rot the business.
On the other hand, what can really bring down a business is operational gearing. And this little known demon is all to do with fixed costs.
Fixed costs are a massive danger area for businesses. These are the expenditures that are – as the name suggests – fixed. We’re talking about rent, business rates, capital equipment, and key staff.
If you’ve ever set up a business, you’ll know just how important all of these overheads are. You can’t just drop these costs if things take a turn for the worse. Variable costs like stock can be fine-tuned depending on how sales are going. But your overheads can literally get over your head…
Just look at high street retailer HMV. It’s stuffed full of fixed costs. It pays around £165m in rent and with nearly 14,000 staff, HMV is shelling out big time. As sales have tailed off they can’t cut costs quickly enough. And even where they can trim down, they find that it actually costs money to achieve reductions. In the short run, store closures and redundancies cost more than the savings created.
It’s interesting to see that HMVs financial leverage (borrowings) is only costing them £5.1m in interest. That’s peanuts compared to £165m in rent. Put in other fixed costs like business rates, staff and all the rest of it and I think you get the picture. The financial gearing is merely the last straw loaded on top of an operationally faltering camel.
Get on the right side of operational gearing
So, fixed costs can act like a drag on a tired and aging business. But surprisingly a business with high fixed costs, can still be in great shape. That’s because as turnover grows, the fixed costs remain steady – profits start to ramp up.
In fact, it’s usually attractive that a business has fixed costs – these costs give it what the economists call a ‘barrier to entry’. If competitors need to pump in say £100m to set up shop, they’ll probably stay away.
The problem is that in the early days, fixed costs can mean that great businesses look dreadful on paper. And that’s why we need to find out if the business is going to grow turnover enough to overcome the fixed costs.
Because once the business has critical mass, then high fixed costs come as a godsend. When these costs stay fixed BUT profits ramp up, the company can quickly reverse all the dreadful years of losses.
Pharmaceutical stocks are typical. They invest heavily in research to find a wonder cure – and if they get the formula right, sales drop straight through to the bottom line.
It’s all about operational gearing. If you spend £300m developing a drug and it passes all the tests and goes into production, your costs are all in the past and they’re fixed. Costs of production (variable costs) are minimal. And that’s why your sales figures drop straight through to the bottom line.
It’s a great position to be in – and one you should hunt out as an investor. Today, I want to show you one sector where it can work brilliantly.
The best operationally geared sector right now
You may have picked up on my general distaste for high street retailers – variable costs are marching upwards while turnover is getting hit by online competition and penniless consumers. Then to top it all, they’re stuck with backbreaking fixed costs.
But there’s another sector that I love – even though it’s just as encumbered by high fixed costs. The great thing is that in this case rising demand and prices mean that fixed costs work in our favour.
I’m talking about the mining and exploration sector.
This sector typically has massive operational gearing. Explorers invest in land and licences for the production of key commodities. Having established that they’ve got reserves in the ground, they’ve then got to put in place infrastructure to extract and process them.
There are serious fixed costs involved here – and it’s a great barrier to entry. Not just a cost barrier, but a time one too. And this massive time delay is one reason why the commodities market is so cyclical.
When China demands iron ore or gold, she demands it today.
Many investors miss the crucial point – massive fixed costs and operational gearing can lead to a profit explosion!
And if you really want to see the theory in action, then I think gold exploration and miners are a great bet.
Gold has been hitting new highs in recent weeks. And gold miners stand to benefit from operational gearing – the share price may move up many times the increase in gold bullion.
Of course, it’s high risk stuff – but the rewards can be staggering. So you might want to consider putting a little speculative cash into this type of stock. With the gold market looking set for continued strength, these companies could do very well.
Here’s a great idea to get you started
If you want to get involved, check out my colleague Tom Bulford‘s brand new report. Tom’s been looking into the gold mining and exploration sector and reckons he’s uncovered a real gem.
• This article was first published in the free investment email The Right side. Sign up to The Right Side here.
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Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
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