Beware: Confronting the perils of leverage

For professional investors, mistakes are not a rare occurrence. Common wisdom holds that if you get six out of 10 correct, you’re doing pretty well. The key is learning from your mistakes, so you can avoid repeating them. Edward Rosenfeld, Portfolio Manager at the Lazard Global Small Caps Fund, says one of the most salient lessons he’s learned has been the perils of combining operating leverage with financial leverage. Operational leverage occurs when a large part of a business’ costs are fixed, meaning additional revenue can flow directly through to profits. But what goes up, must come down. As many Australian mining services companies discovered in the mining bust, the combination of both types of leverage can be poisonous to share prices when things go wrong. You can learn more about leverage in this short video.

“The problem is, leverage is a lot of fun on the way up, but less fun on the way down. The decremental margins can be painful.” 

Key points:

• Even investors with outstanding track records only get it right about 60% of the time.
• Being a successful investor requires learning from your mistakes.
• Combining operating leverage with financial leverage (debt) is not generally a risk worth taking.
• Scepticism is important; always demand confirmation of what management tells you from a third party.
• Operating leverage is the result of fixed costs and variable revenues. If costs are fixed, incremental revenues fall straight to the bottom line.
• Operating leverage can be exacerbated by labour rigidity; it’s hard to cut labour costs if you can’t reduce your work force.

To learn more about the Lazard Global Small Cap Fund, visit their website