Archimedes, the Greek inventor and mathematician known for his theories on leverage, said, "Give me a lever long enough, a place to put it and I can move the world." In making investments for our clients, some of our most profitable decisions have come from recognizing the leverage inherent in certain business models.

Leverage is any situation in which some measure of input has an enlarged effect on output. For example, if you buy the Nasdaq 100 tracking stock (QQQ - commentary - Cramer's Take) in a margin account with a 50% maintenance requirement (for every $2 in equities, you have to put up only $1 in cash), your investment is leveraged 2 to 1 to moves in the Nasdaq 100.

In other words, if the index rises 100%, the value of your account's equity will increase by 200%. On the other hand, if the value of the index falls by 50%, the value of the account's equity falls by 100% -- you are wiped out.

Let's consider some other examples of the kind of impact leverage can have in the investing world.

SunTrust Banks (STI - commentary - Cramer's Take) recently reported record earnings, but the stock price is down 29% over the last year. Why? For a bank that focuses on traditional lending activities, the driver of profitability is the net interest margin (lending income minus borrowing expense).

SunTrust Banks Income Statements
	Quarter Ending 03/31/00	Quarter Ending 12/31/99	Quarter Ending 09/30/99	Quarter Ending 06/30/99	Quarter Ending 03/31/99
Interest Income, Bank	$1,610.8	$1,559.3	$1,506.4	$1,452.5	$1,442.0
Total Interest Expense	828.2	763.4	711.5	667.7	672.2
Net Interest Income	782.6	795.9	795.0	784.8	769.8
Net Interest Margin	48.6%	51.0%	52.8%	54.0%	53.4%
Figures in millions of dollars except for percentages.

In this example, overall lending rose over the last five quarters, but the profitability of that lending declined. Why? Because of the leverage inherent in a bank's balance sheet. Banks can effectively lend $7 for every $1 they get in deposits. This magnitude of leverage can translate into a reduction of a bank's stock price of 5% to 7% for every 1% of decline in net interest margin.

So how do we play this leverage? We underweight bank stocks in an environment of rising short-term rates (as we have seen over the last year), which compresses margins, and go back into that sector when short-term rates are stabilizing (as we see now) or falling (as we may see a year from now).

Commodities prices might seem at first glance to be a key source of leverage, but that's not necessarily the case.

Over the past two years, the price of oil fell by half, then tripled. You might casually think that the chart of Exxon Mobil's (XOM - commentary - Cramer's Take) stock price followed that trend. In fact, over the past two years, the stock price has traded in a relatively narrow range, roughly between $65 and $85. Why didn't the stock price move more? Because Exxon Mobil aggressively hedges its exposure to the price of a barrel of gas, so it can make the same profit per barrel regardless of the price. So Exxon's stock price is not leveraged to the price of oil, and therefore is not a vehicle for profiting from moves in oil prices.

On the other hand, Schlumberger (SLB - commentary - Cramer's Take), the oil-services provider, had a huge price swing over the same period, falling from $65 to $35 as oil fell, then soaring to $82 as oil rose, settling recently near $73. Why? As the price of oil fell toward $12, it dipped briefly below the worldwide average cost of production. That shut down many oil rigs because it cost more to extract the oil than the oil sold for. No rigs, no oil services, no revenue for companies like Schlumberger. When oil prices recovered, so did Schlumberger's business.

Well, Well, Well Exxon Mobil, Schlumberger and the Amex Oil Index.

We loaded up on Schlumberger and another oil-services company, Halliburton (HAL - commentary - Cramer's Take), when the cost of oil fell below the worldwide cost of production, reasoning that the dip was a temporary phenomenon. We were well rewarded over the next year.

Software companies offer an interesting example of other types of leverage. One of the attractive characteristics of Microsoft before it ran afoul of the Justice Department was that once a software application like Windows was released, the cost to Microsoft of producing one copy or 10 million copies was effectively zero. How was this possible?

Windows software is copied directly onto hard drives by PC manufacturers from master disks, and the manufacturer is responsible for printing manuals and providing most support. Microsoft simply collects the licensing revenue and is effectively leveraged off the marketing, manufacturing and support operations of the box makers.

In the Internet world, Yahoo! (YHOO - commentary - Cramer's Take) offers a fascinating example of leverage in its Yahoo! Shopping Web site. An online retailer listed only in Yahoo!'s search engine will be buried among thousands of similar sites. To get any priority, a retailer has to be in the shopping site. And for every sale by a retailer in this site, Yahoo! gets a slice of the transaction, with virtually no incremental cost. So it is leveraging the marketing, advertising and fulfillment operations of thousands of retailers. Amazon.com (AMZN - commentary - Cramer's Take), by comparison, has to build out relationships with suppliers, warehouses and delivery firms for every new product line it enters. We like both companies, but if you want to place a bet on e-retailing, leverage makes Yahoo! the better choice.

In performing fundamental analysis of a company's business model:

Identify the key driver of profitability and earnings growth.
Determine how this driver responds to external forces.
Remember that leverage cuts both ways. Pick the wrong direction on the external force and you could get hammered pretty badly.