Metal Model: Activation Energy
I wrote recently about how we need some new mental models in investing. So, I thought I would write about one today. It is a concept called “Activation Energy”. Straight from Wikipedia, here is a definition:
In chemistry and physics, activation energy is the minimum amount of energy that must be provided for compounds to result in a chemical reaction.
I think growing companies sometimes exhibit the same dynamics. If a company is growing but not making a profit, I view this as the time energy (in the form of $$) is being added to the reaction. Eventually, activation is reached, the company achieves profitability, and the business becomes self-sustaining.
I like to look for companies around this point in their cycle. It is often a period of dramatic improvement in business fundamentals and growth. Let’s explore this transition in more detail. Before “activation” or profitability, the company is putting resources into developing its product or service. This may be in capital equipment, R&D, or human resources. Since they are not making money, they probably watch their spending closely and deploy their limited resources to the highest-value projects. After “activation,” they have more breathing room - they are profitable and generating cash. They have more cash to invest. Additional projects get funding. They can step on the accelerator a bit more. Employees might be excited now that the company is
earning money. This can lead to a positive feedback loop that can drive sustained performance for a long time: the chemical reaction is now self-sustaining.
Some investors use the analogy of a coiled spring: a company is investing money and making progress. The business doesn’t show the results because they are investing for growth. Eventually, the spring is released, and the results show. For me, this analogy falls short. The spring implies that it is a one-time release of energy, and it’s done. Activation, on the other hand, implies that it reaches a steady state where the reaction can be self-sustaining.
I often look at this type of situation in conjunction with evaluating a company’s operating leverage. Companies with high operating leverage can drop a high percentage of their revenues to the bottom line. Imagine a software company with gross margins of 80%. Every incremental dollar of revenue drops 80 cents to operating profit. This can turbocharge growth for companies that achieve profitability. On the other hand, a widget maker with a high COGS (cost-of-goods-sold) will not have the same leverage. Their gross margins may be much lower, say 40-50%. And a significant portion of the cash that they make might be needed for investing in capital or resources to help them grow. I have made investments in companies just reaching profitability with low operating leverage, only to be disappointed in how slowly they were able to ramp up earnings due to the extra investment required to grow. I find that the “activation energy” mental model works best with high operating leverage companies.
It would be remiss of me not to mention that operating leverage can cut both ways. Investors have been shocked by how quickly earnings can disappear from companies with operating leverage with even modest drops in top-line revenue. It is one of the reasons that analysts in the software space can be hyper-focused on growth. When growth unwinds, a company can quickly “deactivate”! One of my old bosses liked to say, “I like to keep my variable costs variable and my fixed costs ‘semi-variable.’” This also does not mean companies with lower operating leverage are “bad” investments. It just means we need a different mental model to consider our investments there.