Leverage and success

What drives success?  Everyone who succeeds credits something different for their success.  Some credit hard work.  Others credit being in the right place at the right time.  Some credit parents, friends, a boss, a wife, the list goes on.  The problem with success is that it's hard to duplicate.  No two people live the same lives and no two situations are identical.  I've always enjoyed studying failure because there are clear failure patterns.  People fail in many of the same ways.  Failure can be avoided and studied.  Sometimes the absence of failure can results in success, but success is more complicated.

It's bothered me that there is no formula for success.  Of course if there were a formula then everyone would follow it and the formula would stop working.  As I've thought about successful individuals and successful businesses a pattern started to emerge, a recurrence of leverage.  I've been thinking about this idea for a few months and I finally decided that sitting down and typing it out might help me finally solidify my thoughts.

About a year ago I wrote a post on scalable businesses and growth.  Looking back at that post it was the first time I'd really thought about this idea of leverage.

Why is it that some companies start and fail to grow, or take decades to grow?  Why is it that other companies begin to grow and their results compound exponentially?  Is it the managers involved? The business model?  Some secret no one else has discovered?

Most small businesses stay small businesses forever.  A local plumber with a single van isn't likely to grow his business into a plumbing empire with a nationwide network of plumbers.  But why is it that some companies that start small such as a software company can grow large quickly?  The business model has a lot to do with this growth, but that's not all.

Leverage is a misunderstood concept.  When many investors think of leverage they immediately think of financial leverage, that is taking on debt to purchase an asset.  Financial leverage can work in an investors favor, but there are other types of leverage as well.

Think about the plumber and their business.  The plumber makes service calls and charges an hourly fee per service call.  They also sell parts for a small markup.  If the plumber wants to double their income they either need to double their hourly rate, mark up parts, or work double the hours or some combination of all three.  Another alternative is to hire a second plumber.  The problem with hiring a second plumber is part of that plumbers earnings go towards their salary.  For the initial plumber to double their salary they might need to hire two or three additional plumbers.  At this point the original plumber is probably going to be doing less plumbing and more administration, finding additional clients, advertising and working with their accountant.  To make up for this loss of billable hours they might need to hire an additional plumber or two.

Notice in this example each additional plumbers marginal profit for the company shrinks.  This is because each worker incurs overhead that accumulates across all workers.  Eventually if the company grows large enough the owner will need to hire managers to manage plumbers.  These managers aren't billable and aren't selling parts so they are almost a pure expense.  If the company continues to grow managers will need to be hired to manage the managers who manage the plumbers and on and on.  In the business of selling time (billing hourly) a company faces a natural size limit.

Let's consider a different type of business, a company that manufactures shoes.  This company starts out and buys a shoe machine.  Workers throw in raw material and the machine creates a completed shoe.  The machine can be purchased for $1m.  The company purchases some raw material, fires up the machine and starts producing shoes.  Until the company has produced and sold shoes for $1m plus their raw material and labor costs they are operating at a loss.  Their shoe sales have not covered the cost of their expenses yet.  For each additional shoe sold the marginal loss shrinks as they get close to $1m.  Once they hit $1m the company starts to earn a very tiny marginal profit per shoe sold.  If the shoes are popular and they sell tens or hundreds of millions the marginal profit will continue to grow as long as the single machine can keep up with demand.

For the shoe company the way they can increase profits is by increasing sales and maximizing output on their shoe machine.  When the machine's output is maximized they'll need to buy a second machine which will decrease their profits until throughput can be maximized on that machine as well.

The shoe company is ultimately limited by consumer demand for their product.  The capacity to create shoes is much higher than their costs and their cost structure rewards them for output.  They will run out of customers before they run into scaling problems.

I used these examples to illustrate the idea of operating leverage.  The plumbing company has very little operating leverage whereas the shoe company has significant operating leverage.  Operating leverage can come in a few varieties.  One is the shoe company that might make a small profit on many items compared to a business that sells very few items with very high margins.  The best type of operating leverage is a company that sells a lot of products with high margins, a company such as Apple.

Let's take this concept one step further.  Consider an individual working for someone else; the classic cube dweller.  They have the least amount of leverage.  If they double their hours worked their pay remains the same.  Regardless of the amount of effort put into the system they receive the same output.  The office worker has the least leverage because like the plumber they're simply selling their time to a company.  The difference is the plumber can grow their business and hire other plumbers.  Even if the plumbers business is ultimately limited by overhead they have a small amount of leverage whereas the office worker has none.

A business owner has leverage regardless of the size of their company.  This is because they have the ability to hire additional employees if their workload grows.  If a business is selling a product operational leverage is created.  For the office worker looking to increase their income I'd encourage them to set up some sort of size business selling something other than their time.  Any additional amount of leverage can be financially beneficial.

When most people think of leverage they think of financial leverage in the form of debt financing.  Most of the time financing assets doesn't make sense unless the asset has appreciation or cash flow potential.

Non-investors love to talk about how much money they made on their house.  The problem is most don't realize the only reason they made money is because they purchase was highly levered.  Take for example a person purchasing a $100,000 house with $20,000 down.  Presume the house appreciates 2% a year for 10 years before the owner sells it for $120,000.  The final sale price is 20% higher than the purchase price, but for the leveraged individual they approximately doubled their money.

Many of you would point out that home ownership isn't always a guaranteed return.  A lot of homeowners lost money on their houses and their levered investments came to haunt them.

Leverage cuts both ways, both financial and operating leverage.  A company with significant operating leverage can realize large losses the moment their sales volume slides below break-even.  The further the slide the larger the losses.  This isn't true for a business built on selling time.  For a business with no leverage sales scale linearly with hours billed.  If 50% less hours are billed revenue is 50% lower.

Financial leverage enables us to buy more than we can afford with cash, and increase our returns, but if interest payments can't be met it's all for naught.

What does all of this have to do with success?  As I've looked at successful people a theme has become clear, all have leverage in their life.  Some have achieved success through financial leverage, others through operational leverage, but always leverage.

To illustrate this point consider two investment managers, one with $1m in AUM and one with $1b in AUM.  Both work hard and earn 15% for their fund.  The manager with the smaller AUM earned $150,000 for their investors whereas the manager with $1b earned $150,000,000 for their investors.  The exact same return yet vastly different nominal results from asset size.  Incentives reward managers who have larger funds regardless of performance.  This incentive is simply the leverage effect.  Smaller amounts of capital with less leverage require higher returns.

One thing about the leverage effect is it isn't fair.  In the above example both managers might have worked equally as hard but the manager with a larger asset base earned more due to their size.  This is the same in business, in real estate, and in life in general.

I've noticed that sometimes people will look at someone who has used leverage explicitly (such as Buffett's insurance float) and try to discount that factor.  The Economist wrote an article a year or two ago trying to calculate Buffett's returns unlevered.  They weren't anything special, but that's the point.  If one doesn't include some sort of leverage in their life it is hard to get above average results.  I'd go as far as saying that above average results can only be achieved through the use of leverage.  It's impossible to do it unlevered.  Levered results should be rewarded and credited to the individual because the individual who used leverage successfully managed their risk.  For every Warren Buffett there are dozens of investors who levered their portfolios and blew up because they disregarded risk management.

The question then becomes "how do I incorporate leverage into my life?"  The first thing most think of is "I need to better utilize financial leverage, more debt, a bigger mortgage etc."  This is the wrong conclusion.  Financial leverage for individuals is only really acceptable to purchase appreciating assets.  That means financing a house (maybe), or financing a business purchase.  Otherwise leveraging up for depreciating assets (cars, TVs, vacations), or assets that don't generate cash flow limits individual financial success.  But as I discussed above there are other ways to incorporate leverage into ones life.  What about selling a product on the side or starting a business?

I believe it's possible for employees to obtain a slight amount of leverage without starting a business.  One way to do it is to negotiate a pay package based on personal performance.  This is the traditional sales model, a salesperson is paid for the revenue they generate.  But why can't other employees be paid for the impact they make on their business?  Employees who work harder should reap larger rewards.  Part of the reason companies are fearful of doing this is that it exposes that some employees don't work that hard at all and there is likely a lot of fat that could be cut.

Leverage doesn't always need to be obtained through financing or outside investment either.  It's possible to create a business with sweat equity where operational leverage is created through hard work.  If possible this is the best type of leverage to look for.

While there isn't a formula for success one thing is clear.  Abnormal success doesn't occur without some sort of leverage.  The trick is finding how to best incorporate leverage as well as manage the risk.