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You don’t believe it is possible. Profit by investing in bad companies sounds pretty stupid and naive. But it is possible.
To be more precise, sometimes it is possible to make notable investment returns by buying the stocks with minimum chances. The key is to recognize the companies which will grow in the future.
There is some math behind. The point is to make a difference between business and stocks.
Let’s be more clear!
For example, you have some money aside and want to invest in some cheap stocks. But you find two similar companies in the same industry, say gold.
Company ABC is a large one. Gold is currently at $100, its exploration and other costs are $60, that is a $40 profit. Not bad.
Company XYZ is a disastrous business. It’s exploration and other costs of $90, which is only $10 in profit at the current gold price of $100.
Which one to choose?
The logical answer would be ABC but the wrong one.
Let’s assume the hypothetical situation.
The price of gold suddenly rise in the market, and the current it is $300, for example.
Let’s see the numbers for those companies.
Company ABC offers $240 in profit.
$300 gold price – $60 in expenses = $240 profit
Company XYZ offers $210 in profit
$300 gold price – $90 in costs = $210
But here is where the math has the greatest influence.
Company ABC earns more money for any reason, its profit rose 600% from $40 to $240. But, compare it with company XYZ which grew its profit 2,100%.
Moreover, there is a phenomenon
It is very reasonable to assume that company XYZ will experience a multiple expansion, meaning added increase. The possible final result: company XYZs stock price is raising exponentially more, much more than the stock price of company ABC.
What to say? Company ABC is maybe a healthier business, but company XYZ is better as a market choice.
How is possible to profit by investing in bad companies?
This is recognized as operating leverage.
Operating leverage describes a company’s level of fixed costs in comparison to its revenue. Companies with high operating leverage have large fixed expenses. They are obliged to cover them as first. If fixed expenses are exceeded, the revenue will fall. Such a situation may cause great difficulties for the company, from large cuts to lower profits, even bankruptcy.
You can find companies with high operating leverage in almost all sectors and industries. Gold miners, airlines, crude oil companies, are some examples. Actually, you may find these companies where the business has enormous changes in revenue. You will notice enormous profitability fluctuations. That comes because fixed costs can’t always adapt as quickly as the market value.
But you have to know that investing in bad companies carry a lot of stress and risk. Investing in some of these companies can make you rich but it is almost impossible for them to provide you a constant profit.