The Perils of the Commodity-Type Business

Not All Businesses Make Good Long-Term Investments

The inside of a steel mill

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For long-term investors, the best stocks to hold are concentrated in a handful of industries. Some industries are just inherently better positioned for long-term gains. They may have low overhead costs or provide vital tech services that will only grow in importance with each technological advancement. Their stock values may take an occasional dip, but in the long-run, they'll most likely earn investors money. On the flip side, other industries can't offer that same promise of long-term potential.

Case and 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. 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. The same goes for food companies buying wheat or corn in bulk, or construction companies buying steel for a project. This creates brutal competition, forcing companies to sacrifice shareholder capital to maintain market share.

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-intensity, or significant capital expenditures involving the plants, properties, and equipment required to produce the commodity. 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 presents something known as a peak earnings trap.

Often, you don't have to pour over charts to determine whether 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)?” Most people will pay more for Coca-Cola over the generic brand but not lug nuts. You may have a favorite toothpaste brand, but you probably don't have a favorite bath mat brand.

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. Don't ride out these stocks through good times expecting steady profits and returns. These are not the kind of stocks you want to pass on to your grandchildren. Unless a broker provides you with overwhelming evidence that a company is severely undervalued, it might be best to opt for another company.

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.

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. Dell, a large manufacturer of computers and other technology hardware, has managed to remain profitable because of its cost structure. There were times when Dell started a price war to grow market share, create customer loyalty, and put pressure on the competition. As Dell continued to generate profits, its competitors bled red ink. As a result, its low-cost advantage resulted in enormous wealth creation.

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 its product is virtually identical to the other brands on the shelf. Clorox and Kleenex are two examples of companies that have managed to distinguish themselves on the shelf, but the best example may be Starbucks, which has convinced many Americans that it is normal to pay as much as $5 for a cup of coffee.

Third, major oil producers have historically been an exception to this rule. They have some internal structural advantages and long commodity cycles, which together can produce above-average market returns for buy-and-hold investors. However, these investors have to be willing to build positions over many decades.