"Give me a place to stand, and I shall move the earth with a lever"
That’s what Archimedes said over 2000 years ago. He showed how the simple lever can multiply our strength, seemingly to infinity. His comment was about mechanical leverage, but we’ve also learned about financial leverage recently: banks that are levered ten times can turn a 1% return on assets into a 10% return on equity. But a 10% decline in values will lead to a 100% loss of equity, wiping the bank out. The lesson is that leverage is powerful, but it can be dangerous.
In many ways, the financial crisis was a crisis of leverage. Levered banks held levered instruments based on levered consumers. No wonder a hiccup in sub-prime market threatened the $30 trillion world economy!
Operational leverage works the same way, multiplying our strengths but magnifying our errors. Think of it like riding a horse: minor hand movements affect the bit and can radically alter the direction of a 1500-pound animal. This power allows you to steer the horse, but can get you in trouble if you aren’t careful.
When we invest, we look for companies with operational leverage that can turn a minor social trend into a major source of free cash flow. But with great power comes great responsibility. The lever can give, but the lever can also take away. Wise management knows and respects this.
Douglas R. Tengdin, CFA
Chief Investment Officer
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