Friday, December 11, 2020
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Next year will be all about operating leverage.
As readers of The Morning Brief know, we’ve been reading a lot of previews about what Wall Street thinks 2021 has in store for investors.
And while some price targets and growth forecasts will turn out to be more right than others, there’s one concept that has come up several times we think deserves a bit more discussion — operating leverage.
“While we expect a recovery in both sales and margins, margins account for the majority of our above-consensus 2021 EPS estimate,” said Ryan Hammond and the equity strategy team at Goldman Sachs in a note published Tuesday.
“In terms of margins, our forecast is based on three drivers: (1) operating leverage, (2) moderating costs (e.g., labor, T&E), and (3) the growing weight of high margin industries in the S&P 500. We expect S&P 500 net profit margins will rise to 11.1% in 2021, just below the peak of 11.3% in 2018, before reaching a record high of 11.5% in 2022.”
Operating leverage can be defined many ways and with a variety of particulars, but the simplest explanation is that operating leverage dictates how much a company can grow sales without increasing expenses.
Firms with lots of operating leverage are able to grow sales without increasing expenses; firms without much operating leverage are not.
And so the better a firm’s operating leverage, the higher future profit margins are expected to be as incremental revenue grows more profitable over time.
“Given the fixed vs. variable cost structure, companies carry a degree of operating leverage,” Hammond adds. “Operating leverage means that margins — and therefore earnings — are more volatile than sales, falling more than sales during recessions and rebounding by much more than sales during recoveries. The economic and sales recovery we forecast during 2021 should therefore support a sharp rebound in net profit margins.”
With economic growth expectations for 2021 continuing to rise as bullishness around the deployment of a COVID-19 vaccine builds, strategists expect companies will be able to convert more of the sales growth that comes with this economic rebound into profits. And while we’re flagging Goldman’s comments on operating leverage from this week, strategists on Wall Street have been buzzing about this idea for some time.
Back in July, we highlighted work from Mike Wilson at Morgan Stanley who cited this idea as underwriting the summer’s market rally. Then in a note published in August, Wilson added, “earnings will likely far surpass investor forecasts over the next year due to sharply increasing operating leverage as companies cut costs while massive fiscal stimulus has created personal disposable income growth in 2Q that has never been higher, protecting the consumer’s income statement and balance sheet.”