Why Marshalls plc Seems A Better Bet Than Lloyds Banking Group plc & Rio Tinto plc

Shares in Marshalls (LSE: MSLH) have been shooting up. Why is that, and is there more to come?

A late-stage cyclical

Marshalls reckons it is the UK’s leading hard landscaping manufacturer, and supplies natural stone and concrete products to the construction, home improvement and landscape markets.

As such, Marshalls produces products that add value to raw materials. That fact puts the firm in a stronger trading position than other cyclical firms buffeted by macro-economic events, such as a miner of raw materials like Rio Tinto (LSE: RIO).

And Marshalls is in a stronger trading position than a commodity-style banking firm such as Lloyds Banking Group (LSE: LLOY) that functions as a business and personal finance facilitator with products and services undifferentiated from other banks’ offerings.

The added-value product that Marshalls produces also means that the firm’s trading cycle tends to peak later in the general macro-economic cycle than cyclicals such as Rio Tinto and Lloyds Banking Group. Marshalls customers only invest in capital expenditure for landscaping products when personal and business finances have improved, some time after emerging from a recession.

Appreciating Marshalls late-cycle credentials goes a long way towards understanding why the shares are flying now.

Operational gearing — the magic ingredient

The shares have shot up, true, but there’s a powerful reason to suppose that they have further to run — perhaps much further to run: according to the firm’s directors, Marshalls has high operational gearing.

Operational gearing is concerned with the way a company’s fixed and variable costs affect its profits.

Fixed costs might take the form of staff, buildings, machinery and plant etc — all things that Marshalls’ business is loaded with. Meanwhile, variable costs move up and down with sales and might take the form of input materials, outsourced contracts and services, equipment on short lease, etc.

If fixed costs are a high proportion of total costs operational gearing is high, such as with Marshalls.  If fixed costs are a low proportion of total costs, operational gearing is low.

Fixed costs are hard to reduce if turnover slips, such as when the macro-economic cycle falters and we see recessions. Variable costs, though, are more flexible, and firms can run them down at short notice.

So, firms like Marshalls that have high operational gearing see their profits and their share prices swing by an exaggerated amount through a full macro-cycle compared to firms with low operational gearing whose profits and share prices move between narrower extremes.

The opportunity with Marshalls

Right now, the opportunity with Marshalls hinges on the current up-leg of the firm’s trading cycle. Profits are rising because the firm’s customers are becoming sufficiently flush with spare cash to invest in landscaping and associated projects. Marshalls sells to businesses, public sector organisations and individuals, so when the time is right demand can be very high with the potential size of all those customer budgets.

The turbo charger is that Marshalls’ rising profits are overcoming the firm’s fixed costs, and much more revenue is finding its way to the bottom line of profits. Profits are rising, yes, but that rise is accelerating too.

That’s the beauty of investing on the ‘right’ side of a high operational gearing, and it’s another reason that I think Marshalls’ share price may have much further to travel upwards in the current macro-economic cycle.

Risk and reward

However, we should bear in mind that Marshalls is still a cyclical firm and that high operational gearing works just as efficiently on share prices such as Marshalls’ on the down-leg. Marshalls is not for buy-and-hold-forever investors!

Marshalls looks attractive right now, more attractive than Rio Tinto and Lloyds Banking Group in my opinion. However, I also want to flag up a free Motley Fool wealth report called "1 Top Small-Cap Stock From The Motley Fool."

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Kevin Godbold owns shares in Marshalls. The Motley Fool UK has recommended Marshalls. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.