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Why high operating leverage firms are outperforming the broader market

In Tuesday’s Morning Brief, Myles Udland writes about how 2021's buzziest phrase — operating leverage — has already been a winner.

Video Transcript

JULIE HYMAN: I want to get back to markets now because we are seeing a mixed picture for the Futures here this morning. But we saw-- we're still near record levels for the major averages and for the Russell 2000. As we look ahead to 2021, one of the themes that, Myles, you have been watching closely, and you wrote about, once again this morning, revisited the topic in the morning brief, is the idea of operating leverage, and how much companies are going to be able to benefit from an economic recovery this year at a time that they can maybe keep their expenses in check. And that does seem to be your impression on this point because it does seem to be something a lot of-- a lot of strategists are talking about right now.

MYLES UDLAND: Well, of course, Julie, we all stand on the shoulders of giants. But look, you know, operating leverage as analysts have been writing for some time now is a classic early cycle phenomenon. And Goldman Sachs in a note over the weekend once again bringing up not just the idea of operating leverage being a positive for companies in the year ahead, but noting that the basket of stocks they follow that they believe can unlock this balance sheet trick, I guess we could call it, they've outperformed the S&P 500, this basket has, by 9 percentage points over the last couple of months.

And just a refresher-- operating leverage basically how much each incremental dollar of revenue can be converted into profits. A company that Goldman puts in their basket is Disney. Disney, we've seen-- they've laid off tens of thousands of workers. Their revenues are down significantly.

Profits have actually held in OK. And the theory here would be, as the world reopens, Disney, maybe they'll bring some of those workers back, maybe not necessarily all of those workers back. And their expenses will remain in check as a result of that. Therefore, Disney should be able to convert more and more of those incremental revenue dollars that they earn in 2021 and 2022 into profits.

And Brian Sozzi, when we wrote about this about a month ago, you and I talked about it. I know, as a former analyst, it's a concept that you are quite enthused by. I think management teams like to say operating leverage, even when they don't actually have it.

But it is notable to see the market actually responding to what Goldman and others-- you know, Mike Wilson at Morgan Stanley, Nick Colas at DataTrek-- folks have been writing about this for a couple of months because, again, it is an early economic cycle-type phenomenon.

BRIAN SOZZI: Yeah. And Miles, I'm glad you continue to stay on this because I think this operating leverage concept will become increasingly important as something that will be highlighted by many management teams this earnings season, which is about to kick off later this week with the big banks. And then going forward with industrial companies and even retailers, I expect those themes to continue in the second quarter, too, and perhaps even accelerate.

A lot of executives that I talk to off the record, they are somewhat bracing me to hear more large-scale layoffs. It's going to be-- it could be potentially ugly. But, again, that will only improve some of the operating leverage that these companies will have over the next couple of quarters as demand starts to come back. And what does that essentially mean?

You can see pretty potentially powerful earnings growth in the second half of this year. I that's what the market is sniffing out. But also, two, with strong earnings growth like that, you could see more cash flow generation. You could see more money dumped back into buybacks. You could see the return of higher dividend increases later this year. I think, guys, that's what the market is positioning for right now and why we're seeing this market melt up.

MYLES UDLAND: Yeah, Sozzi. And I'm glad you mentioned that layoffs point. That is something that I would note we wrote about a few times the morning brief during the beginning of this pandemic. That has not really panned out at all. White collar layoffs have really not been a part of this economic story. So we'll keep our eye on that very closely to see how that unfolds as we get into the next earnings season.