Value investors are sensible enough to identify commodity type
business and never invest on such companies due to its disadvantage. There are
various reasons why one should evaluate the business style before investing on
its shares and stocks. Identifying a commodity business is simple by evaluation
some common factors of the business.
Here are the reasons why value investors are not investing in
commodity business. These are the disadvantage of any commodity type business.
What are the Commodity Type Businesses?
A commodity-type business is not a specific industry or company type, but rather a term used to describe businesses that sell products where several key characteristics apply:
- Standardized Products: The goods or services offered are largely uniform and interchangeable with similar products from other companies. There may be minimal differentiation in quality or features. Examples include:
- Oil (different grades exist, but within a grade they're interchangeable)
- Wheat (various wheat types, but within a type they're similar)
- Copper (wiring or sheets may have different uses, but the copper itself is the same)
- Price Driven by Market Forces: Prices are primarily determined by supply and demand in the broader market, with little control by individual companies. Businesses have limited ability to set their own prices significantly higher than the market dictates.
- Focus on Cost Efficiency: Due to the competition and standardized nature of the products, these businesses heavily focus on reducing production and operational costs to remain profitable. Efficiency is paramount.
Here are some examples of industries that often contain commodity-type businesses:
- Agriculture: Producers of wheat, corn, soybeans, etc.
- Basic Materials: Companies that mine or refine metals like copper, iron ore, or aluminum.
- Energy: Oil and gas producers.
Key Points to Remember:
- Not all businesses within these industries are commodity-type businesses. For example, a company that produces a unique brand of wheat flour with special milling techniques might have more control over pricing and wouldn't be purely a commodity-type business.
- The term "commodity-type business" is often used in contrast to businesses that sell differentiated products or services. These differentiated products have unique features or branding that allows companies to charge a premium price and have more control over their pricing strategy.
Major Disadvantages of Commodity Type Businesses?
1. Market Position or Superiority Disadvantage
Any commodity type company generally does not have monopolistic product
or service in the market. It also leaves lots of room for its competitors to
come with various products or similar products.
Due to this disadvantage, market
competition will be high for the company to sustain. This will automatically
force such companies to reduce the price of its products to attract customers
by compromising its profit.
As I have mentioned in my various previous articles, when
there is competition happens, companies will not be able to sell its products
to the right price and that would affect the earnings of the company.
If company not
making profits, investors also get affected with less appreciation to their
investments.
2. Inflation Disadvantage
Commodity type businesses are not able
to beat the inflation by raising or reducing product price
because of the existence of huge competitions in the market. This is another
major disadvantage for such businesses to fail or being debt ridden over a
period of time.
In a nutshell, commodity business can be easily identified by looking
into the debt such company has.
3. Earnings Disadvantage
Another method to identify the commodity business is through its earnings
inefficiency. Any business that have no consistency with per share earnings for
last 10 years, probably have a commodity type business. Such businesses
generally have huge bad debts.
Any company have a debt more than two times of
its yearly net profit, should not be considered as a good investment candidate
as per the strategy of legend investor Warren Buffett of Berkshire Hathaway.
4. Issuance of New Shares
If you look into the cash flow of commodity businesses, the cash flow through financing activities will be high and this may happening through issuing new shares time to time to raise fund for the business activities. Such action would further add debt to the business and reduce the value of investments made on the business.
In other side, good companies would offer buyback of its
shares from public and that can be considered as the company performance is
very good and they are out of debt.
Building an Intelligent investing strategy is the only possible solution to avoid investment traps due to ignorance. I have a very crispy and handy personal investment framework to identify right businesses to invest and that framework would be very helpful for you too, identify and invest on right company shares and stocks.
Investment meant timely appreciation to the money than sinking the value of your invested amount through investing on businesses that are not relevant to invest.
Building an Intelligent investing strategy is the only possible solution to avoid investment traps due to ignorance. I have a very crispy and handy personal investment framework to identify right businesses to invest and that framework would be very helpful for you too, identify and invest on right company shares and stocks.
Investment meant timely appreciation to the money than sinking the value of your invested amount through investing on businesses that are not relevant to invest.
