Tips From Warren: Commodity vs. Monopoly Business

Tips From Warren: Commodity vs. Monopoly Business October 5, 2010

The Buffettology Workbook is a great tool to start understanding how Warren Buffett invests.  Here’s a quick summary of some of the points the authors make.

Before Warren Buffett invests in a company, he starts by identifying the sick/commodity type business and the healthy consumer monopoly.  He suggests staying away from the commodity type business and clings to the consumer monopoly businesses.

Sick/Commodity Business Characteristics:

    o Sells generic product or service where price is the most important motivating factor in the consumer’s decision to buy.

o Airlines, Gas/Oil, Paper, Automobile Manufacturers

People buy these products primarily because of price, not brand loyalty.  When gas is $0.05 cheaper across the street, you usually drive right over.  If you like flying American, but Southwest can save you $300, you’ll probably book your flight with Southwest.  If you’re a ‘Ford guy’ but you can get a Chevy truck for $15,000 less…you get the picture.

In a commodity type business, the lowest cost producer will win.  In order to stay competitive, the producer has to maintain their profit margin and can increase profits by improving manufacturing techniques – until they are forced to lower their prices because the other manufacturers have improved their resources.

Warren avoids these businesses because when their profits are kept low – due to price competition – the businesses often cannot reinvest funds to expand their business or create new ventures.  These businesses often carry a load of long term debt and would be in trouble if they were forced to pay it back in a short period of time.

Warren provides these tips for identifying the Sick/Commodity Businesses

  • Low profit margin and low inventory turnover.
  • Low return on shareholder’s equity
  • No brand name loyalty
  • Multiple producers of same product
  • Organized labor
  • Overcapacity – too much inventory
  • Unpredictable profits
  • Profitability relies almost entirely on management’s ability to efficiently use resources

The Healthy Consumer Monopoly Business

Businesses that have a monopoly on services and products can charge higher prices – which mean higher profit margins.  Companies like Wrigley’s gum and Coca-Cola have unique products that require the consumer to return to their brand in order to obtain the quality product.  The stock prices of these companies are still subject to the downward slopes that ‘bad news’ in the market can cause.  The trick is to identify the companies that have the strong economic framework that can propel them out of the downturn.

There are eight questions that can guide us to thinking like Warren Buffett when looking for a consumer monopoly.

1. Is this a consumer monopoly? – Walk into a convenience store and walk down the drink aisle.  Name a few drinks the owner would be crazy not to sell in the store – Coca-Cola, Gatorade, Pepsi – this is a simple start to viewing a consumer monopoly product.

2. Do the historical earnings show a strong upward trend? – Use or Yahoo Finance to view the per share earnings.   If earnings are generally increasing and suffers a year of a sharp decline, it’s worth looking into and asking if it’s an opportunity to profit.

3. Is the company in major debt? –  A major indicator of a strong company is its ability to pay off long-term debt in the shortest time possible. If the company holds a large amount of long-term debt, it can be subject to failure…as we’ve recently.

4. Is there a high rate of return on shareholders’ equity? – Shareholders’ equity is defined as the company’s total assets less the company’s total liabilities.  Warren Buffett looks for a business that can provide higher than average returns on shareholders’ equity (anything above 12% is great).

5. Does the company have to spend a high percentage of retained earnings on plant and equipment? –Buffett prefers to invest in companies that don’t require significant injections of cash in order to sustain operations.  A company that can produce a quality product without replacing all its plant and equipment annually is ideal.

6. Are retained earnings reinvested in the business or used to repurchase company shares? – Both are good indicators that the company is a good investment – as long as the return on the investment into the company is higher than the alternative option.

7. Can the company freely adjust prices for inflation? – Consumer monopolies are free to adjust their prices to account for inflation without experiencing a decline in demand.  Commodity businesses don’t really have that luxury and can often see increasing costs while experiencing decreasing prices.

8. Will the value of the company’s stock increase because of the retained earnings? – Buffett believes that if you purchase a company with a consumer monopoly at a good price, the retained earnings should increase the overall value of the business and the market will then increase the value of the company’s stock.

These eight questions can help guide us to understanding how Warren Buffet evaluates a company before investing in it.

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