Investor Education: Operating Leverage
Operating leverage is a concept that relates to the relationship between fixed and variable costs. Fixed costs are fixed expenses such as rent, loan payments, memberships, etc. Variable costs are non-consistent expenses such as gas prices, equipment repairs, etc. Another good way to think about it is that fixed costs remain the same regardless of sales and variable costs change based on sales volume. Operating leverage shows the effect on operating income as sales grow.
Read our overview on Operating Leverage Here
What Worked Then
“Fear is the foe of the faddist, but the friend of the fundamentalist.” —Warren Buffett
Are we heading for recession? Stagflation like the 1970s? Another financial crisis like we saw in 2008-2009?
You can find those headlines all around. Facts and data are presented to make an author’s case. And then recommendations for how to invest based on that information is given.
But what worked in the past may not work today. The conditions for a stagflation or financial crisis in one era may produce something different in this era. Fear and worries remain the same, but macroeconomics tends to surprise.
We discussed Hindsight earlier this year, and recently came across some timeless wisdom from Walter Schloss that made similar points to that article. In an interview with Outstanding Investor Digest that took place around the end of 1988 and was published in March of 1989, Schloss touched on the topic of remembering the past, but also making sure you don’t miss opportunities:
In the last 15 years, it's been a remarkable stock market. But people forget what things were like during the 1930s. I think [Ben] Graham - because he lived through that period - remembered it, was scared it would happen again and did everything he could to avoid it.
But in the process of avoiding it, he missed a lot of opportunities. That's one of the problems you always have - you don't really lose, but you don't really make, either. I believe you should remember what took place - even if you weren't around at the time. One of the problems of a lot of the people who went through the Depression - Ben Graham, Jerry Newman and others - is that they keep on thinking that things will always be like that.
Even Graham used to say - and quite correctly - that you can't run your investments as if a repeat of 1932 is around the corner. We can have a recession and things can get bad. But you can't plan on that happening. People who did missed this tremendous market.
Some people can do it. Most people can't and I don't think they should try
When looking at the yearly performance table at the beginning of that interview, one can see that Schloss had some down years and some underperforming years, and a whole lot of good years that ended up producing a great 33-year track record. That span saw recessions and inflation and wars and yet, apparently, buying things for less than they are worth was a good strategy.
If you invest based on macroeconomic analysis, we suggest some caution when extrapolating from one period onto the current period. But if you invest like Walter Schloss did—fundamentally and with a margin of safety—then what worked then has a pretty good chance of working again.
“We just try to buy cheap stocks. That’s really all. We try to buy things that are out of favor - stocks that others don’t want.” —Walter Schloss
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