Core Concepts: Computers and Office Supplies

Gateway: Margin Leverage

Investors often make the mistakes of overweighting the importance of sales leverage and underweighting the importance of margin leverage. It's terrific when a company can grow sales by, say, 15% per year. Compounded at that rate, sales will double in five years. The problem is that investing in these sorts of companies is popular. As a result, the sales lever is generally already discounted in the stock price.

The margin lever, though, is often overlooked. Ironically, that happens despite the fact that it can be an easier lever to pull. For a company that is underperforming operationally, at trough profitability -- for example, at 1% or 2% net margins -- it often does not require heroic measures to ratchet net margins up to 2% or 4% (a 100% gain). Even better, huge margin gains can be achieved over a period of several quarters instead of several years, as in the case of the sales lever.

Gateway is one company for which the margin lever represents low-hanging fruit. The new management team doesn't have to do anything heroic to double the net margins. Even without reaching the operating levels of competitors, there is sufficient margin leverage in this model to justify an $8 stock valuation over the next two to three years. That represents a stock value at 50% of sales, up from 20% of sales currently. The stock closed Thursday at $2.06.

Gateway (GTW)

Office Depot: Patience Pays

To be a great investor, you have to be not only a great stock picker but also a great stock "owner." The latter is much more difficult than you might imagine. Six years ago, I highlighted Office Depot (ODP Quote) in my Top 10 Turnarounds column for RealMoney (and in several other columns). Since then, the stock is up six-fold.

On paper, it looks like it should have been easy: Load up at $6.94 and ride it above $40. The reality is much more difficult. In fact, it might be harder for a professional investor to harvest a six-bagger than it is for an amateur investor. The pros are under pressure to perform on a year-over-year basis, while amateurs can buy a stock and forget about it.

Look at the chart of Office Depot below, which begins in December 2000 when my Top 10 column was published. As you can see, the stock saw no gains for three consecutive years. It's difficult for a pro to hold fast with a nonperformer for that long because of the short-term pressure to perform.

Office Depot (ODP)