There’s a reason why some stocks go up…and up…and up.
This simple strategy underpins share price expansion. Companies and investors ignore it at their peril.
High-flying business leaders pay thousands of dollars in post-graduate course fees to learn this strategy.
You don’t have to spend that kind of money to grasp the idea. Your editor can explain it to you in a single e-letter. Read on, and get ready to change the way you look at stock investing…
We can condense the strategy we’re talking about into two words: operating leverage.
Finance professors have written millions of words on this topic for high-priced textbooks. We’ll keep it simple.
The concept of operating leverage splits a company’s costs into two categories: fixed and variable. We say a firm whose costs are mainly fixed has high operating leverage.
It’s the kind of stock where the more customers it adds, the higher its profit margins…and the more money it makes.
This is what people really mean when they trot out that old cliché you hear on TV shows like Shark Tank: ‘is the business scalable?’
Not everyone really understands what that means. But it’s a cliché for a good reason. The ‘sharks’ want to know if founders can handle more than their initial success, and implement systems for sustainable growth. They want to see a company whose profit margins get larger as the business grows. That’s scalability. And if you invest in this kind of stock at the right time, you can reap sensational profits.
Now you know what defines a scalable business, let’s check in on a well-known stock that some investors thought fitted the bill, but on which the jury is still out…
Toddlers and telescreens
You may have heard of G8 Education Ltd [ASX:GEM]. This billion-dollar stock enjoyed a great run — but its share price has dropped by one third over the past six months (including two dividend payments). Here’s the ride G8 shareholders have been on for the past three years.
Click to enlarge
This firm is a collection of nearly 300 childcare centres. It buys small and sole operators and rolls them into its network — an aggregation story.
Plenty of good companies get better when they buy small competitors at a sensible price. Firms can bag great profits when they successfully consolidate fragmented industries.
But just because a company can get bigger through acquisition, doesn’t mean its business model is necessarily scalable.
It comes back to the idea of fixed and variable costs. When you buy a childcare centre, you can’t just keep an eye on the toddlers through a telescreen. Each centre needs the same number of qualified staff to run it, and you can’t exactly get a discount on the cost of rent and power just because you own lots of buildings.
In short, G8’s cost base is not largely fixed — it’s quite variable. That has kept a lid on the return the company makes on its assets.
What’s more, recently listed peers like Affinity Education Group Ltd [ASX:AFJ] are muscling into the sector with similarly aggressive roll-up strategies. This doesn’t bode well for G8.
Investors have been asking all kinds of high-level questions about G8’s strategy over the last six months and marking down its share price accordingly. But in your editor’s view, it’s as simple as understanding the difference between a truly scalable business, and one that just looks that way at first blush.
So if not in the education sector, where can you find the kind of scalable stocks that turn small stakes into money trees?
Australia’s best growth stocks
The small-cap sector abounds with companies pursuing scalable ideas.
Not all of these succeed. Some fail due to mismanagement, others from lack of access to capital. The difficulty of picking early stage winning ideas is part of the thrill of investing.
When you find a scalable business that shows signs of hitting its straps — take a close look. You might be looking at an investment with huge potential payoff.
We hunt for these kinds of businesses in our small-cap advisory service, Australian Small-Cap Investigator. When your editor comes across a stock that meets our criteria, we research it and tell you exactly how to buy it. And when our plan comes together, the results can be seriously profitable.
Editor, Australian Small-cap Investigator
Editor’s Note: This article originally published inMoney Morning.