Producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage.
As long as excess productive capacity exits, prices tend to reflect direct operating costs rather than capital employed. (Buffett)
This means that the prices of finished goods are lower than the full production cost, which should include amortization.
The capital employed not only does not earn a return, but also does not reinstate itself.
After Berkshire Hathaway's textile business closed in 1985, Buffett commented that over the years, there had always been the possibility of making a large capital investment in the textile business that would have resulted in a reduction of variable costs.
Those investment opportunities, if viewed throught the prism of standard return on investment tests, would have brought greater economic gains than if similar investments had been made in other Berkshire businesses (candy and newspapers).
However, the potential benefits from investing in the textile industry were imaginary.
Berkshire's competitors were implementing the same types of capital expenditures, and once a certain proportion of the industry participants had made these investments, the reduced cost base in the industry would have resulted in a reduction in prices.
Considered individually, each company's investments appears to be justified, but viewed collectively, these decisions affected every company and did not benefit the individual players ("just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes").
After each cycle of capital investment, all the companies had more money tied up in the bsiness, but their returns did not improve.
As Buffett's parade revelers rising on tiptoes demonstrate, the managerial decisions of individual participants in uniform industries are intertwined.
Poor judgment by a single manager may lead to future losses for all involved.
"In a business selling a commodity-type product, it is impossible to be a lot smarter than your dumbest competitor." (Buffett)
If your competitors set prices at a level that is lower than your production costs, then you also must set prices at that level and suffer the losses if you are to remain in business.
"The trick is to have no competitors. That means having something that distinguishes itself." (Buffett)
While the degree to which it is possible to introduce product differentiation within an industry may change because of technology developments or the evolution of consumer preferences, in many industries differentiation among products may be simply impossible to implement.
A few producers in such industries may consistently do well if they have a wide sustainable cost advantage, but such exceptions are rare or, in many industries, nonexistent.
For the great majority of companies selling "commodity-type" products, persistent overcapacaity without regulated prices (or costs) results in poor profitability.
Overcapacity may eventually self-correct as capacity shrinks or demand expands, but such corrections are often long delyaed, and "when they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates ovecapacity and a new profitless environment." (Buffett)
As long as excess productive capacity exits, prices tend to reflect direct operating costs rather than capital employed. (Buffett)
This means that the prices of finished goods are lower than the full production cost, which should include amortization.
The capital employed not only does not earn a return, but also does not reinstate itself.
After Berkshire Hathaway's textile business closed in 1985, Buffett commented that over the years, there had always been the possibility of making a large capital investment in the textile business that would have resulted in a reduction of variable costs.
Those investment opportunities, if viewed throught the prism of standard return on investment tests, would have brought greater economic gains than if similar investments had been made in other Berkshire businesses (candy and newspapers).
However, the potential benefits from investing in the textile industry were imaginary.
Berkshire's competitors were implementing the same types of capital expenditures, and once a certain proportion of the industry participants had made these investments, the reduced cost base in the industry would have resulted in a reduction in prices.
Considered individually, each company's investments appears to be justified, but viewed collectively, these decisions affected every company and did not benefit the individual players ("just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes").
After each cycle of capital investment, all the companies had more money tied up in the bsiness, but their returns did not improve.
As Buffett's parade revelers rising on tiptoes demonstrate, the managerial decisions of individual participants in uniform industries are intertwined.
Poor judgment by a single manager may lead to future losses for all involved.
"In a business selling a commodity-type product, it is impossible to be a lot smarter than your dumbest competitor." (Buffett)
If your competitors set prices at a level that is lower than your production costs, then you also must set prices at that level and suffer the losses if you are to remain in business.
"The trick is to have no competitors. That means having something that distinguishes itself." (Buffett)
While the degree to which it is possible to introduce product differentiation within an industry may change because of technology developments or the evolution of consumer preferences, in many industries differentiation among products may be simply impossible to implement.
A few producers in such industries may consistently do well if they have a wide sustainable cost advantage, but such exceptions are rare or, in many industries, nonexistent.
For the great majority of companies selling "commodity-type" products, persistent overcapacaity without regulated prices (or costs) results in poor profitability.
Overcapacity may eventually self-correct as capacity shrinks or demand expands, but such corrections are often long delyaed, and "when they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates ovecapacity and a new profitless environment." (Buffett)
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