The Perils of the Commodity-Type Business

The inside of a steel mill

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When it comes to stock-picking, some sectors simply don't perform as consistently as others. There may be opportunities in every sector, but finding those opportunities may be harder in some areas than others.

Case in point: commodity-type businesses.

Unlike products, which develop brands that entice customers to become loyal, commodities are basic goods, and competition between commodity brands is usually based solely on price. That can make it difficult to successfully choose investments in the sector. Keep reading to learn more about the pitfalls of investing in commodity-related businesses.

Spotting Commodity-Type Businesses

A commodity-type business is relatively easy to spot. From a financial standpoint, these firms are normally characterized by high asset concentrations or significant capital expenditures involving the plants, properties, and equipment required to produce the commodity. In other words, these companies are non-diversified, and their entire operations may be limited to a single industry or product type.

You can also look for low-profit margins and intense competition in the industry. These factors become more apparent during down-cycles when things are getting tough. During boom times, however, the illusive prosperity of these companies can create a peak earnings trap and lure in investors with misleadingly good earnings that may not be maintained in the long term.

A Simpler Definition

Often, you don't have to look at the balance sheet to determine whether a business is operating in a commodity environment. It can be much more simple to just consider the way you think about the company.

For instance, think about the last DIY project you did around the house. How much did brand play into your choice of nails? Chances are, you simply picked up whichever pack was cheapest. This creates brutal competition in the nail-producing industry, forcing companies to sacrifice shareholder capital to maintain market share.

The same thing happens on a business-to-business level, as well. A food company doesn't care where it's buying wheat or corn in bulk, and construction companies don't particularly care where they get the steel for a project; they just want the cheapest prices they can get without sacrificing quality.

If you can't figure out whether a business is a commodity-type business or not, pose the following question to yourself and a few friends: “Am I willing to pay more for (insert product name here)?” Most people will pay more for Coca-Cola over the generic soda brand, but they wouldn't care what brand lug nuts they buy.

The Best Time to Buy Commodity-Type Businesses

In most cases, investors would do well to avoid commodity industries entirely unless prices are so low that stocks in the area are selling for practically nothing. Even then, with a few exceptions, the holdings should be sold once a more reasonable valuation has returned.

Some investors buy commodities and commodity-type businesses to hedge their portfolios. However, in these cases, the investments are made with careful consideration of how they fit into an overall portfolio.

Exceptions to the Rule

While you should avoid commodity stocks at (nearly) all costs, there are three exceptions that investors may view as opportunities for a buy-and-hold opportunity.

Low-Cost Producers in Their Field

First, a company operating in a commodity-type industry may be a good investment if it is the low-cost producer in its field and has a reasonable probability of holding onto this distinction.

Commodities are all about price, and if one company can consistently offer the lowest prices, it has a good chance of being a long-term success in its field. Consider also the size and balance sheet. If a company is big enough and on stable enough financial footing, it may be able to cut prices and bleed red ink whenever a competitor threatens its dominance. Once the competition is beat, it can raise its prices again and resume making profits.

Unusually Popular Products

Second, you may consider an exemption for a company that has managed to create franchise value — or popularity — for an ordinarily indistinguishable product. These companies can charge higher prices than their competitors and increase profits, even though the chemical composition of their products is virtually identical to the other brands on the shelf.

Clorox and Kleenex are two examples of companies that have managed to distinguish themselves from nearly identical products on the shelf. However, the best example may be Starbucks — some coffee drinks at Starbucks cost roughly as much as an entire bag of coffee grounds would at a grocery store.

Oil Producers

Third, major oil producers have historically been an exception to this rule. They have some internal structural advantages and long commodity cycles (called supercyles), which together can produce above-average market returns for buy-and-hold investors. That's why companies like Chevron are a part of major stock indexes like the Dow Jones Industrial Average.