The Perils of the Commodity-Type Business

Not All Businesses Make Good Long-Term Investments

The Perils of a Commodity-Type Business
Commodity-like businesses can result in huge windfalls of wealth under the right circumstances but they can also pose serious challenges to your long-term investment portfolio if you don't understand concepts such as operating leverage, commodity cycles, the importance of low-cost-per-unit leadership in a given industry, and similar concepts. WIN-Initiative / Getty Images

It's no secret that academia has proven time and time again that for long-term investors, the best stocks to own long-term are concentrated in a handful of industries due to inherent advantages found in the operating structure of those industries.  This basic fact - certain industries are more conducive to building wealth than others - has a flip side.  Other industries are often not great for investors who stick with them for many decades because the companies themselves earn sub-par rates of return on invested capital.

 Consider the case of distilled spirits versus steel mills.  The former has historically produced some of the richest families in the world, regardless of country, political environment, or tax regime.  People come to prefer a specific brand, pay premium prices, and the resulting returns on equity are breathtaking.  The latter, on the other hand, are subject to brutal competition and are forced to reinvest massive portions of shareholder capital in order to maintain market share.  

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 are forced to compete to no small degree on price.  If the product is largely the same, nobody cares if they get Brand [XYZ] steel but people care very much if they are denied Jack Daniel's or Johnnie Walker when that's what they desire.

Spotting the Commodity-Type Business

It’s usually easy to spot a commodity-type business. From a financial standpoint, these firms 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 uncover during down-cycles, when things are getting tough (indeed, investors should be wary of the illusive prosperity these companies seem to posses during boom times as it presents something known as a peak earnings trap).

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)?”  Most people will pay more for Coca-Cola over the generic brand but not lug nuts; for Colgate toothpaste but not copper piping; for Johnson & Johnson Band-Aids but not bath mats.

It's Best to Buy Commodity-Type Businesses When They Are Undervalued and Earnings Look Terrible

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 for practically nothing.  Even then, with a few exceptions, 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; one of those times when buy and hold doesn't work. In fact, if your broker ever suggests investing in a commodity or 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: No.

 It's inappropriate for your situation.

Exceptions to the Rule

There are three 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, managed to remain profitable because of its cost structure. There were times when Dell started a price war to grow market share and create customer loyalty, able to generate profits while competitors bled red ink.  As a result, it turned out to be one of the best investments in history; it's low-cost advantage resulting in enormous wealth creation.
  • A company such as Clorox, which has managed to create franchise value for an ordinarily indistinguishable product, can be exempted from the restriction if you deem it prudent. 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 (to be fair, concentration is not - Clorox typically contains more actual bleach that competitors, which is one of the reasons people pay more for it; they know what to expect). Starbucks is another example.  The Seattle-based coffee chain has convinced many Americans that it is normal to pay $3 to $5 for a cup of coffee.
  • Shares of the oil majors are another exception, which I explained in-depth on my personal blog in an essay exceeding 6,000 words.  They have some internal structural advantages that, when coupled with their long commodity cycles, can result in historically above-average market returns for buy and hold investors who are capable and willing to build positions over many decades.