Warrant Buffett has achieved great success thanks to his way of classifying the world economy. In the eyes of this investor, the business world splits into two different types of companies: commodity-type businesses and franchises. The term commodity-type business refers to those companies that can only be competitive in the market if they manage to reduce the prices of its products. The price is the only factor that will make a consumer switch from one company to the other. Franchises, on the other hand, are companies whose products or services are needed or desired, have no substitutes and are not regulated. Therefore, as they are consumer monopolies, price variations will not affect the demand for their products, making them sources of long-lasting profits.
If your goal is to become a successful investor, Buffett recommends avoiding commodity-type business and investing in franchises. Let’s explain in deep what a commodity business is to understand his viewpoint.
As stated before, commodity-type businesses’ main characteristic is that, as the products they offer are identical to the products of their competitors, the only way they have to reach a certain level of competition in the marketplace is by reducing the prices of their products. How? By lowering its costs of production, which consequently increases the margin profits. But as Buffettpoints out, although profit margins may be improved through this mechanism, in the long run, profits will plunged again because competitors will also find a way to reduce their prices and become competitive again. That is why Buffettbelieves these businesses are so unappealing; they cannot offer durable profits to their investors.
To understand this idea let’s look at an example. In 1960 car manufacturer Stevenson & Johnson reported sales of $2.6 billion and sold for an adjusted-for-splits price of $15 per share. Between 1960 and 1980, the company made capital expenditures of around $1.5 billion to make improvements to the manufacturing process. And, although in 1980 the company had sales of $3.7 billion it had lost sales volume in inflation-adjusted dollars. Moreover, it was also reporting much lower returns on sales and equity than it did in 1960. By 1980, the price of the share was only a little bit higher. The company invested $1.5 billion and, in 20 years, it could only offer a small increase in the value of its shares. Stevenson & Johnson has one of the greatest management teams. However, the industry in which it is immersed is fiercely competitive in terms of prices; therefore, profit margins are constantly pushed down, disappointing shareholders.
To spot a commodity-type business is actually quite easy. The basic characteristics of a commodity-type business are:
• Low profit margins. These companies tend to post low profit margins due to the huge competition. In order to succeed in this market, companies are forced to reduce their prices to attract consumers.
• Low returns on equity. Low return on equity indicates that the company is a commodity type. In order to consider investing in a company, always look at its return on equity. If it is lower than the average return on equity for an American corporation, now at 12%, you are looking at a commodity type business.
• Absence of any brand-name loyalty. Commodity-type businesses sell products whose brand is not meaningful to their consumers.
• Presence of multiple producers. A great number of companies selling just the same product is a clear indication that you are looking at one of these companies.
• Existence of substantial excess production capacity in the industry. In an industry where there is excess production capacity profits cannot be improved and prices raised until excess production capacity is exhausted. And even when prices rise, managers usually tend to use the shareholders money to expand production which drives them back to the position of overcapacity, price competition and lower margins and profits.
• Erratic profits. These companies present erratic profit margin numbers. Have a look at the earnings per share for at least the past ten years. If they show any boom-or-bust patterns you are dealing with a commodity-type business.
If your goal is to become a successful investor, Buffett recommends avoiding commodity-type business and investing in franchises. Let’s explain in deep what a commodity business is to understand his viewpoint.
As stated before, commodity-type businesses’ main characteristic is that, as the products they offer are identical to the products of their competitors, the only way they have to reach a certain level of competition in the marketplace is by reducing the prices of their products. How? By lowering its costs of production, which consequently increases the margin profits. But as Buffettpoints out, although profit margins may be improved through this mechanism, in the long run, profits will plunged again because competitors will also find a way to reduce their prices and become competitive again. That is why Buffettbelieves these businesses are so unappealing; they cannot offer durable profits to their investors.
To understand this idea let’s look at an example. In 1960 car manufacturer Stevenson & Johnson reported sales of $2.6 billion and sold for an adjusted-for-splits price of $15 per share. Between 1960 and 1980, the company made capital expenditures of around $1.5 billion to make improvements to the manufacturing process. And, although in 1980 the company had sales of $3.7 billion it had lost sales volume in inflation-adjusted dollars. Moreover, it was also reporting much lower returns on sales and equity than it did in 1960. By 1980, the price of the share was only a little bit higher. The company invested $1.5 billion and, in 20 years, it could only offer a small increase in the value of its shares. Stevenson & Johnson has one of the greatest management teams. However, the industry in which it is immersed is fiercely competitive in terms of prices; therefore, profit margins are constantly pushed down, disappointing shareholders.
To spot a commodity-type business is actually quite easy. The basic characteristics of a commodity-type business are:
• Low profit margins. These companies tend to post low profit margins due to the huge competition. In order to succeed in this market, companies are forced to reduce their prices to attract consumers.
• Low returns on equity. Low return on equity indicates that the company is a commodity type. In order to consider investing in a company, always look at its return on equity. If it is lower than the average return on equity for an American corporation, now at 12%, you are looking at a commodity type business.
• Absence of any brand-name loyalty. Commodity-type businesses sell products whose brand is not meaningful to their consumers.
• Presence of multiple producers. A great number of companies selling just the same product is a clear indication that you are looking at one of these companies.
• Existence of substantial excess production capacity in the industry. In an industry where there is excess production capacity profits cannot be improved and prices raised until excess production capacity is exhausted. And even when prices rise, managers usually tend to use the shareholders money to expand production which drives them back to the position of overcapacity, price competition and lower margins and profits.
• Erratic profits. These companies present erratic profit margin numbers. Have a look at the earnings per share for at least the past ten years. If they show any boom-or-bust patterns you are dealing with a commodity-type business.
