The 3 Killer Cs - Cyclical, Capital-intensive and Commoditised

"The 3 Killer Cs"

Not one but three 'killer Cs' lurk around the darkest corners of the business world. 

If any one of them grips a business, it makes life hell for the managers and profits elusive for the owners. What are they? 

The first is 'cyclical'. 

• When a business is cyclical, it sees large and unpredictable swings in its revenues, margins, and profits. Everything that matters is all over the place. 

The second is 'capital-intensive'. 

• Businesses afflicted by high capital-intensity require a lot to produce little. They s u  c k investors dry as they need large amounts of capital to make profits. 

The third is 'commoditised'. 

• Companies here can do very little to prove to customers that their product or service is better than their competitor's. 

The presence of even one of these killer Cs is bad news for a business. 

Price Competition

1.  Highly competitive industry (commodity products)

• Industries in which price is the most significant consideration in customers' purchase decisions tend to be highly competitive.
• A slight increase in price may cause customers to switch to substitute products if they are widely available.

2.  Franchise industry (franchise products)

• Price is not as important if companies in an industry are able to effectively differentiate their products in terms of quality and performance.  
• Customers may not focus on price as much if product reliability is more important to them.

Businesses with challenging fundamentals - commodity type businesses

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)

"Mr. Buffett, what types of companies will you purchase in the future?"

Buffett is often asked what types of companies he will purchase in the future.

First, he says, he will avoid commodity businesses and managers in which he has little confidence.

What he will purchase is the type of company that he understands, one that possesses good economics and is run by trustworthy managers. 

"A good business is not always a good purchase,"  Buffett says, "although it is a good place to look for one."

For Buffett, the activities of a common-stock holder and a businessperson are intimately connected.  Both should look at ownership of a business in the same way.  "I am a better investor because I am a businessman," confesses Buffett, "and a better businessman because I am an investor."

Evaluating a Company - 10 Simple Rules

Having identified the company of interest and assembled the financial information, do the following analysis.

1.  Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity-type product?

2.  Do you understand how the company works?  Do you have intimate knowledge of, and experience with using the product or services of the company?

3.  Is the company conservatively financed?

4.  Are the earnings of the company strong and do they show an upward trend?

5.  Does the company allocate capital only to those businesses within its realm of expertise?

6.  Does the company buy back its own shares?  This is a sign that management utilizes capital to increase shareholder value when it is possible.

7.  Does the management spent the retained earnings of the company to increase the per share earnings, and, therefore, shareholders' value? That is, the management generates a good return on retained equities.

8.  Is the company's return on equity (ROE) above average?

9.  Is the company free to adjust prices to inflation?  The ability to adjust its prices to inflation without running the risk of losing sales, indicates pricing power.

10.  Do operations require large capital expenditures to constantly update the company's plant and equipment?   The company with low capital expenditures means that when it makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment.


Once you have identified a company as one of the kinds of businesses you wish to be in, you still have to calculate if the market price for the stock will allow you a return equal to or better than your target return or your other options.  Let the market price determine the buy decision.  

What Warren Buffett says about Commodity Companies

COMMODITY COMPANIES

Warren Buffett does not like to invest in what he calls commodity companies - companies whose product does not differ from that of competitors in any significant way.

A company like this can be vulnerable to the actions of competitors and have limited power to raise prices to retain their profit position in the light of inflation.

WHAT WARREN BUFFETT SAYS ABOUT COMMODITY COMPANIES

Warren Buffett said this in 1982:

‘[Where] 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.’

Characteristics of Commodity and Cyclical companies and their Value Drivers.

Characteristics of commodity and cyclical companies

            While commodity companies can range the spectrum from food grains to precious metals and cyclical firms can be in diverse business, they do share some common factors that can affect both how we view them and the values we assign to them.

1. The Economic/Commodity price cycle: Cyclical companies are at the mercy of the economic cycle. While it is true that good management and the right strategic and business choices can make some cyclical firms less exposed to movements in the economy, the odds are high that all cyclical companies will see revenues decrease in the face of a significant economic downturn. Unlike firms in many other businesses, commodity companies are, for the most part, price takers. In other words, even the largest oil companies have to sell their output at the prevailing market price. Not surprisingly, the revenues of commodity companies will be heavily impacted by the commodity price. In fact, as commodity companies mature and output levels off, almost all of the variance in revenues can be traced to where we are in the commodity price cycle. When commodity prices are on the upswing, all companies that produce that commodity benefit, whereas during a downturn, even the best companies in the business will see the effects on operations.
2. Volatile earnings and cash flows: The volatility in revenues at cyclical and commodity companies will be magnified at the operating income level because these companies tend to have high operating leverage (high fixed costs). Thus, commodity companies may have to keep mines (mining), reserves (oil) and fields (agricultural) operating even during low points in price cycles, because the costs of shutting down and reopening operations can be prohibitive.
3. Volatility in earnings flows into volatility in equity values and debt ratios: While this does not have to apply for all cyclical and commodity companies, the large infrastructure investments that are needed to get these firms started has led many of them to be significant users of debt financing. Thus, the volatility in operating income that we referenced earlier, manifests itself in even greater swing in net income.
4. Even the healthiest firms can be put at risk if macro move is very negative: Building on the theme that cyclical and commodity companies are exposed to cyclical risk over which they have little control and that this risk can be magnified as we move down the income statement, resulting in high volatility in net income, even for the healthiest and most mature firms in the sector, it is easy to see why we have to be more concerned about distress and survival with cyclical and commodity firms than with most others. An extended economic downturn or a lengthy phase of low commodity prices can put most of these companies at risk.
5. Finite resources: With commodity companies, there is one final shared characteristic. There is a finite quantity of natural resources on the planet; if oil prices increase, we can explore for more oil but we cannot create oil. When valuing commodity companies, this will not only play a role in what our forecasts of future commodity prices will be but may also operate as a constraint on our normal practice of assuming perpetual growth (in our terminal value computations).

In summary, then, when valuing commodity and cyclical companies, we have to grapple with the consequences of economic and commodity price cycles and how shifts in these cycles will affect revenues and earnings. We also have to come up with ways of dealing with the possibility of distress, induced not by bad management decisions or firm specific choices, but by macro economic forces.

Commodity and Cyclical companies: Value Drivers

Normalized Earnings

If we accept the proposition that normalized earnings and cash flows have a subjective component to them, we can begin to lay out procedures for estimating them for individual companies. With cyclical companies, there are usually three standard techniques that are employed for normalizing earnings and cash flows:

1.     Absolute average over time: The most common approach used to normalize numbers is to average them over time, though over what period remains in dispute. At least in theory, the averaging should occur over a period long enough to cover an entire cycle. In chapter 8, we noted that economic cycles, even in mature economies like the United States, can range from short periods (2-3 years) to very long ones (more than 10 years). The advantage of the approach is its simplicity. The disadvantage is that the use of absolute numbers over time can lead to normalized values being misestimated for any firm that changed its size over the normalization period.  In other words, using the average earnings over the last 5 years as the normalized earnings for a firm that doubled its revenues over that period will understate the true earnings.

2.     Relative average over time: A simple solution to the scaling problem is to compute averages for a scaled version of the variable over time. In effect, we can average profit margins over time, instead of net profits, and apply the average profit margin to revenues in the most recent period to estimate normalized earnings. We can employ the same tactics with capital expenditures and working capital, by looking at ratios of revenue or book capital over time, rather than the absolute values.

3.     Sector averages: In the first two approaches to normalization, we are dependent upon the company having a long history. For cyclical firms with limited history or a history of operating changes, it may make more sense to look at sector averages to normalize. Thus, we will compute operating margins for all steel companies across the cycle and use the average margin to estimate operating income for an individual steel company. The biggest advantage of the approach is that sector margins tend to be less volatile than individual company margins, but this approach will also fail to incorporate the characteristics (operating efficiencies or inefficiencies) that may lead a firm to be different from the rest of the sector.

Normalized commodity prices

            What is a normalized price for oil? Or gold? There are two ways of answering this question.

1.     One is to look at history. Commodities have a long trading history and we can use the historical price data to come up with an average, which we can then adjust for inflation. Implicitly, we are assuming that the average inflation-adjusted price over a long period of history is the best estimate of the normalized price.

2.     The other approach is more complicated. Since the price of a commodity is a function of demand and supply for that commodity, we can assess (or at least try to assess the determinants of that demand and supply) and try to come up with an intrinsic value for the commodity.

Once we have normalized the price of the commodity, we can then assess what the revenues, earnings and cashflows would have been for the company being valued at that normalized price. With revenues and earnings, this may just require multiplying the number of units sold at the normalized price and making reasonable assumptions about costs. With reinvestment and cost of financing, it will require some subjective judgments on how much (if any) the reinvestment and cost of funding numbers would have changed at the normalized price.

            Using a normalized commodity price to value a commodity company does expose us to the critique that the valuations we obtain will reflect our commodity price views as much as they do our views on the company. For instance, assume that the current oil price is $45 and that we use a normalized oil price of $100 to value an oil company. We are likely to find the company to be undervalued, simply because of our view about the normalized oil price. If we want to remove our views of commodity prices from valuations of commodity companies, the safest way to do this is to use market-based prices for the commodity in our forecasts. Since most commodities have forward and futures markets, we can use the prices for these markets to estimate cash flows in the next few years. For an oil company, then, we will use today's oil prices to estimate cash flows for the current year and the expected oil prices (from the forward and futures markets) to estimate expected cash flows in future periods. The advantage of this approach is that it comes with a built-in mechanism for hedging against commodity price risk. An investor who believes that a company is under valued but is shaky on what will happen to commodity prices in the future can buy stock in the company and sell oil price futures to protect herself against adverse price movements.

Little Book of Valuation

Aswath Damodaran

Buffett (1978): Commodity type businesses must earn inadequate returns except under conditions of tight supply or real shortage

In this write up, let us see what Warren Buffett has to say to his shareholders in the 1978 letter:

"The textile industry illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. (Comment: Note Glove companies!)  As long as excess productive capacity exists, prices tend to reflect direct operating costs rather than capital employed. Such a supply-excess condition appears likely to prevail most of the time in the textile industry, and our expectations are for profits of relatively modest amounts in relation to capital. We hope we don't get into too many more businesses with such tough economic characteristics."

The above paragraph once again highlights the fact that no matter how good the management, if the economic characteristic of the business is tough, then the business will continue to earn inadequate returns on capital. This can be further gauged from the fact that despite all the capital allocation skills at his disposal, the master was not able to turnaround the ailing textile business that he had acquired in the early years of his investing career. He further adds that such businesses have little product differentiation and in cases where the supply exceeds production, producers are content recovering their operating costs rather than capital employed.

While the comment is reserved for the textile industry, we believe it can be extended to all commodities like cement, steel and sugar. Infact, the current downturn the sugar industry is facing has a lot to do with supply far exceeding demand and this in turn is having a great impact on returns on capital employed by these businesses. The only hope for them is a scenario where demand will exceed supply.

"We get excited enough to commit a big percentage of insurance company net worth to equities only when we find 

• (1) businesses we can understand, 
• (2) with favorable long-term prospects, 
• (3) operated by honest and competent people, and 
• (4) priced very attractively. 

We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only US$ 10.7 m at cost and US$ 11.7 m at market. There were equities of identifiably excellent companies available - but very few at interesting prices."

Those of you, who are regular readers of content on our website, the above paragraph must have rang a bell or two. Indeed, time and again, in countless articles, we have been highlighting the importance of investing in good quality businesses run by honest and ethical management. That the master himself has been looking at similar qualities does go a long way in further reinforcing our beliefs. Buffett then goes on to make a very important comment on valuations and says that no matter how good the businesses are, there is a price to pay for it and he in his investing career has let many investing opportunities pass by because the valuations were just not right enough.

Comparison can be drawn to the tech mania in India in the late nineties when good companies with excellent management like Infosys and Wipro were available at astronomical valuations. While these companies had excellent growth prospects, investors had become far too optimistic and had bid them too high. Thus, investors who would have bought into these stocks at those levels would have had to wait for five long years just to break even! Hence, no matter how good the stock is, please ensure that you do not pay too high a price for it.

http://www.equitymaster.com/detail.asp?date=6/28/2007&story=2

Identifying the Commodity Type Businesses

Commodity type businesses have the following characteristics:

• Low profit margins on sales coupled with low inventory turnover
• Low returns on shareholders' equity
• Absence of any brand loyalty
• Presence of multiple producers
• Existence of substantial excess production capacity in the industry
• Erratic profits
• Profitability that is almost entirely dependent upon management's abilities to efficiently utilise tangible assets.

The Economic Engine Buffett Wants to Own

Warren Buffett has separated the world of business into two different categories:

1. the healthy consumer monopoly type business and
2. the sick commodity type business.

A consumer monopoly is a type of business that sells a brand name product or has a unique position that allows it to act like a monopoly.

A commodity type business is the kind that manufactures a generic product or service that a lot of companies produce and sell.

Warren Buffett believes that if you can't identify these two different types of businesses, you will be unable to exploit the pricing mistakes of a short-sighted stock market.