Enterprises such as domestic airlines, textile companies, and as previously mentioned, steel producers, owe their sub-profitability to the commoditization of their industry. Hence, they are called commodity-type businesses because, much like wheat or corn, they compete primarily on the basis of price (you don’t go to the supermarket to buy bread made from Farmer Joe’s wheat).
Spotting the commodity-type business
It’s usually easy to spot a commodity-type business. From a financial standpoint, they are normally characterized by high asset-intensity, significant capital expenditures in relation to plant, low profit margins and intense competition. They are usually easier to spot in down-cycles, when things are getting tough (indeed, investors should be wary of the illusive prosperity these companies seem to posses during boom times). Often, it takes little more than common sense to realize a business is operating in a commodity environment. For a quick check, pose the following question to yourself and a few friends: “Am I willing to pay more for (insert product name here)?”
Only buy when undervalued
In most cases, investors would best be served by avoiding commodity industries entirely unless prices are so low that the respective companies are being given away (even then, the holdings should be sold once a more reasonable valuation has returned. These are not the kind of stocks you want to pass on to your grandchildren). In fact, if your broker ever suggests investing in a commodity type business without providing overwhelming evidence the company is severely undervalued, I recommend you respond the same way you would if a thirty-five year old divorcee asked your sixteen year old daughter to the prom.
Exceptions to the rule
There are two exceptions to this avoid-them-at-all-but-ridiculously-low-valuations rule. They are:- A company operating in a commodity-type industry may be a good investment if it is the low-cost producer and has a reasonable probability of holding on to this distinction. Dell, a large manufacturer of computers and other technology hardware, manages to remain profitable because of its cost structure. Recently, Dell started a price war to grow market share and create customer loyalty. At the same time, the company is still reporting profits while the competition bleeds red ink.
- The second exception is a company such as Clorox, which has managed to create franchise value for an ordinarily indistinguishable product. The company can charge higher prices than its competitors, even though the chemical composition of its product is virtually identical to the other brands on the shelf. Starbucks is another example; they’ve convinced many Americans that it is normal to pay $3 for a cup of coffee.
