Article written by Sherin Dev
Most of us might have heard the term Commodity-type businesses, but not sure how many investor teally know what it really means. A good understanding about what is a “commodity-type” business would help investors to identify them easily and avoid investments on it to book huge losses later. This article would help you to understand what is a commodity-type business and the basic characteristics of such business for investors to identify and avoid such business from investing in it.
In a simple sentence, if price is the single important motivating factor in the purchase of a product, then you are most likely dealing with a commodity-type business. As such, the company probably will present you at best with only average results over the log term.
What really a ‘commodity-type business’ mean?
Generally, a business that doesn’t have any competitive advantages to any of its products or services comes under the category of commodity type business. From the word of Warren Buffett ‘ A commodity business sells products or services that are indistinguishable from the competitors. Commodity businesses have little or no economic goodwill. The only distinction in a commodity business is price.” Owning a commodity business is dangerous as its competitors always use the weapon of fewer prices to attract customers. This would force any company to reduce its product or service price and later the product may sell under the production cost. Thus the business will get doomed later.
How to identify a sick commodity business to avoid invest in it
Identifying a commodity type business is not that much difficult. They usually are selling something that a lot of other businesses are selling. Low profit margins, low return on equity (ROE), no brand name loyalty erratic and unpredictable profits, existence of number of competitors are the basic characteristics of any commodity-type businesses.
Basic characteristics of a commodity-type business
Low Profit Margins – commodity businesses generally post low profit margins due to the huge competitor existence. This would force the company to reduce its product or service price to a maximum low to attract customers and compete with other companies. Naturally this behavior affect to the profit margins to a great extend.
Low Return on Equity (ROE) – One of the best way to identify a commodity business is possible to checking its Return On Equity for a period of time. Low ROE clearly indicates that the business is a commodity type. A good company required to post an average growth of 15% ROE in each year to consider investing on it.
Absence of Brand Name Loyalty – Any product that you see which doesn’t mean lot to its brand name or have no brand name loyalty clearly indicates it is a commodity type business.
Presence of multiple competitors – Presence of multiple competitor take away from having competitive advantage to any product or services that a company offers. Competition breed lower price, lower price breed lower profit margins and lower profit margins breed lower earnings to shareholders!
Erratic Profit Numbers – a best way to understand that you are dealing with a commodity-type business is through learning the erratic profit margin numbers. Have a look at the earning numbers for at least last 10 years including the present, to confirm whether it is a commodity type business or a business have competitive advantage to consider investing. If yearly per share earnings is in question with erratic changes, then confirm you are dealing with a commodity type business.
More over the above, if any company has existence of substantial excess production capacity in an industry, no one can really going to profit from the demand of the product. If a product frequently available in the market to over cater its original demand, it would be impossible to raise its price and thus profit from the market demand. If found such products, remember it is a commodity-type business.
Also, if a business doesn’t have ability to utilize its tangible assets such as plant and equipments, and not on such intangible assets as patents, copy rights and brand names, no doubt the company is in a commodity-type business.Identify and avoid such business through using commonsense. Always invest on businesses that have superior economics working on their favor and are selling for the right price. Always remember the rule, the price you pay would determine the return on your investments.
Further reference: Disadvantages of Commodity Business