Tuesday, December 20, 2011

Warren Buffett on Profitability: For Commodity Businesses, "Nothing Fails Like Success"

From Buffett's 1982 Berkshire Hathaway (BRKashareholder letter:

"Businesses in industries with both substantial over-capacity and a 'commodity' product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. These may be escaped, true, if prices or costs are administered in some manner and thereby insulated at least partially from normal market forces. This administration can be carried out (a) legally through government intervention (until recently, this category included pricing for truckers and deposit costs for financial institutions), (b) illegally through collusion, or (c) "extra- legally" through OPEC-style foreign cartelization (with tag-along benefits for domestic non-cartel operators).

If, however, costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.

Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a 'two-ounce candy bar') but doesn't work with sugar (how often do you hear, 'I'll have a cup of coffee with cream and C & H sugar, please').

In many industries, differentiation simply can't be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent.  For the great majority of companies selling 'commodity' products, a depressing equation of  business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.

Of course, over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success.

What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal. (It seems as if the most recent supply-tight period in our textile business - it occurred some years back - lasted the better part of a morning.)

In some industries, however, capacity-tight conditions can last a long time. Sometimes actual growth in demand will outrun forecasted growth for an extended period. In other cases, adding capacity requires very long lead times because complicated manufacturing facilities must be planned and built."

Capacity-tight conditions can persist for a very long time.

After several years of experiencing what seems like a favorable profitability environment, an investor can be lulled into thinking the recent experience represents what is normal.
(When something goes on for many years, it's not hard to make the mistake of projecting things indefinitely forward.)

So watch a commodity business put up five or seven years (maybe more) of outsized profitability and it's easy to incorrectly interpret the performance as ongoing. Yet, in all likelihood, over a long enough cycle, that profitability will eventually shrink or even become persistent losses (possibly for a very long time) as the capacity/demand imbalances are corrected.

When an executive at a commodity business decides to invest in new capacity, assumptions need to be made in order to judge the likely pricing environment many years down the road. Get it wrong (either due to weaker demand than expected or too much unexpected new capacity) and the returns end up sub-par or much worse.

No business is easy but getting that judgment consistently right seems difficult at best.

When the added capacity (often with a substantial time lag...enough for the macro world to have changed a whole lot) does come on line, what seemed like persistent profitability can shift and dramatically so.

The problem is that for most commodity businesses the fixed investments are enormous. Also, commodity prices fluctuate in ways that a differentiated product or service generally does not.
(Compare Coca-Cola's beverage or Pepsi's snack prices over a few business cycles to suppliers of copper, oil, sugar, etc.)

All commodity business equity investments need to be looked at carefully in this light.

Is the recent period (even if a very long cycle) of profitability a precursor to something much different once new capacity comes online or demand takes a hit?

Does the business have a sustainable cost advantage and a conservative balance sheet that lets it outlast competitors during the supply-ample years?

None of this is really an issue for businesses that can differentiate their offerings and wrap a trusted brand around it.

Products and services that can be differentiated, in contrast to commodity-like businesses, are more likely to experience a temporary but manageable hit to profitability -- all else equal -- during times of meaningful economic stress.


Long position in BRKb

* The commodity price spikes that occurred in recent years were certainly a headache for consumer goods businesses, but the hit to profitability for most of them was actually rather modest. Naturally, this requires that reasonable degree of leverage is employed.
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