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Companies with high fixed costs, low margins, and unstable demand might sound like recipes for disaster. But they’re the types of stocks that could outperform as the economy heats up.
The secret sauce may be operating leverage—the idea that operating margins could rise sharply on relatively modest gains in revenue. A company with $100 of revenue and $90 of costs, for example, would generate a 10% profit margin. But if revenues increase by10% to $110 on the same $90 of costs, the margin hits 18.2%.
It’s never that simple, of course, but as the economy gains momentum, companies with operating leverage should benefit more from rising demand than those with higher margins and more variable cost structures, says Jonathan Golub, chief U.S. equity strategist at
“You want very high fixed-cost businesses and you want them in areas with unstable demand,” he says. “What you want is something like a copper mine. Any incremental pickup in economic activity would help it a lot.”
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Stocks with operating leverage tend to congregate in cyclical sectors: materials, industrials, and energy. Financials can also be cyclical, along with segments of technology, such as semiconductor equipment and hardware. And some travel stocks look appealing for their operating leverage, according to Ned Davis Research.
“Super cyclicals” that are closely tied to economic momentum should also have operating leverage, says Golub, benefiting from incremental revenue gains as the economy heats up.
With that in mind, Barron’s found nine stocks that seem to fit the bill:
(ticker: MRO),
(URI),
(DAL),
(LNC),
(RCL),
(EXPE),
(VAC),
(ADS), and
(CC).
Source: FactSet
But remember that operating leverage is just one factor to consider. And cyclicality works both ways; the more investors worry that growth won’t meet forecasts, the harder these stocks will fall.
Moreover, there isn’t much appetite for risk-taking right now, regardless of the sector or stock characteristics. The inflation fears stalking tech and other high-multiple sectors could spill over into value and cyclicals. On the flip side, some inflation should be positive for energy and materials. And higher yields aren’t all that bad for financials either, improving their net interest margins.
Independent oil producer Marathon is expected to report a 42% gain in revenues this year to $4.4 billion. Its net income margin should hit 9%, up from a negative 29.8% in 2020. Marathon’s results will be volatile, however, based on crude oil prices, production rates, and demand.
Wall Street expects construction-equipment rental company United Rentals to boost sales 8% to $9.2 billion. Its net income margin is expected to hit 14.7%, up from 10.4% in 2020. Demand for construction equipment is recovering steadily as the economy picks up. A $2 trillion infrastructure spending bill that President
Joe Biden
is proposing could be a catalyst for the stock if it passes Congress.
Delta is more of a long-term story; revenues are expected to hit $26.5 billion, up from $17 billion in 2020, but the airline isn’t expected to turn profitable until 2022. Margins should improve, though, as planes fill up and international markets reopen. Analysts expect a net income margin of -8.8% in 2021, turning positive in 2022 to 6.7%.
Annuity and life insurer Lincoln National should report revenue growth of 4.3% to $19 billion, according to consensus estimates. Net income margins are expected to nearly double, reaching 9.2%. CEO
Dennis Glass
recently told investors that, based on positive sales and market trends, “2021 is shaping up to be a successful year.” The shares yield 2.5% and trade at seven times estimated 2021 earnings.
Cruise line Royal Caribbean isn’t expected to turn a profit this year. And it’s a 2022 recovery story, when sales are expected to reach $10.1 billion, up from $2.3 billion this year. Margins will take longer to recover, but they should more than triple from 2022 to 2023, going from 3.8% to 13.3%, according to consensus estimates.
Expedia is also riding the travel wave with revenues on track for a 56% gain to $8.1 billion this year. Net income margins are inflecting from negative in 2020 to slightly positive this year; they’re expected to be flat in 2021 and hit 8.6% in 2022.
Timeshare company Marriott Vacations oversees more than 50 resorts worldwide and could be a post-pandemic winner; sales should jump 32% to $3.8 billion. Margins are going from negative in 2020 to 4.5% this year, and more than double in 2022, reaching 9.5%, according to consensus estimates.
Alliance Data Systems sells credit card services and plans to spin off its loyalty business by the end of the year. Its sales are expected to be down 2% to $4.4 billion, but analysts see net income margins jumping from 6.5% in 2020 to 15.2%. The stock is up 57%, but it still only trades at eight times earnings. Estimates are likely to be revised as analysts price in the loyalty business spinoff.
Specialty and industrial chemicals manufacturer Chemours is getting a post-pandemic lift; sales should rise 14.8% to $5.7 billion while net income margins should double to 9%, according to consensus estimates. The company recently raised full-year profit forecasts, expecting adjusted Ebitda—earnings before interest, taxes, depreciation and amortization—of $1.1 billion to $1.25 billion, and increased its free cash flow guidance by $100 million to more than $450 million. “Looking ahead, we continue to gain confidence in our outlook,” CEO
Mark Vergnano
told analysts.
Write to Daren Fonda at daren.fonda@barrons.com
