Commodity businesses are generally low-returning businesses and their product is no different from other’s. They compete only on the basis of price, that reduces their profit margins. The only way to make a commodity business profitable is to be the low cost provider. Commodity businesses are unable to achieve meaningful product differentiation even upon having huge advertising budgets.
Wild swings in earnings are characteristics of a commodity business. To spot a commodity-based company, Buffett looks for these characteristics:
- The firm has low profit margins (net income divided by sales);
- The firm has low Return on Equity (earnings per share divided by book value per share);
- Absence of any brand-name loyalty for its products;
- The presence of multiple producers;
- The existence of substantial excess capacity;
- Profits tend to be erratic; and
- The firm’s profitability depends upon management’s ability to optimize the use of tangible assets.
Example 1: The paper business is challenged; high capital intensity, low margins and cyclical. It is a brutal business; No one cares who made the box their Dell computer came shipped in. In general, commodity businesses, even you’re the low cost producer, are difficult. Source: 2005 Tuck School of Business Trip
The average company does battle daily without any means of protection. As Peter Lynch says that stocks of companies selling commodity-like products should come with a warning label: “Competition may prove hazardous to human wealth.”
Example 2 : Warren Buffett on His Own Textile Business
The textile business, which is a terrible commodity business; one day, the people came to Warren and said, “They’ve invented a new loom that we think will do twice as much work as our old ones.” And Warren said, “Gee, I hope this doesn’t work – because if it does, I’m going to close the mill.” And he meant it. Advances in commodity businesses go to buyers alone. So you keep buying things that will pay for themselves in three years. And after 20 years of doing it, somehow you’ve earned a return of only about 4% per annum. That’s the textile business.
And it isn’t that the machines weren’t better. It’s just that the savings didn’t go to you. The cost reductions came through all right. But the benefit of the cost reductions didn’t go to the guy who bought the equipment. It’s such a simple idea. It’s so basic. And yet it’s so often forgotten.