Checklist Series, Part 7: Low Cost Rules
A lot of what we have covered so far in the checklist series involves understanding how a company can create a superior product or customer experience which can sustain higher prices and higher margins. But sometimes, customers don’t care where or who they buy from.
If you’re selling a commodity, you can’t charge extra just because it shows up on a pallet with your fancy logo on it. Your only job is to deliver it on time and cheaper than anyone else. There’s still a way for companies that sell commodities to build up competitive advantages.
This is where the low cost advantage kicks in. And despite the widespread belief that commodity businesses tend to suck due to a lack of pricing power and vulnerability to commodity price swings, a company with a cost advantage can use it to strangle the competition when times get tough.
The things you can’t control
You can’t control the price of a commodity, and that’s a big problem. All the cost savings in the world won’t save you if marginal revenue per unit drops below your marginal cost. It’s bad news. But it’s worse news for the higher cost producers.
If you’re bleeding less than your competition, you will be more likely to live to fight another day… and perhaps even emerge from the downturn stronger than ever, with less competition fighting for market share. This takes wily management and a strong balance sheet - two must-haves when investing in the commodity space.
The things you can control
The elements that drive sustainable competitive advantage on the expense side of the income statement are built up over time by forward thinking managers, and so they can be quite durable through the cycles.
Potential sources of these cost advantages include:
Process advantages;
Location (proximity to the commodity source and/or key customers);
Scale advantages;
Ownership of unique assets, licenses, or patents.
etc…
These can take many forms. Your “unique assets” could include geological deposits or wireless spectrum.
Process advantages could be due to a technological edge, or a manufacturing “secret sauce” refined over decades.
Any key asset or proprietary process that allows you to maintain a lower unit cost than your competition falls under this definition.
Durability
And this brings us back to evaluating the durability of this competitive advantage. Particularly in this world of rapid technological change, we must be ever vigilant of how the competitive advantages we take for granted today may be wiped out tomorrow. This is the most difficult part of the exercise, but also why I’m willing to price an “old economy” company higher than a “new economy” as long as I have more faith in the lasting strength of the competitive advantage.
The fast new growers can flame out just as quickly as they appeared on the scene.
The importance of patience
A cost advantage can be one of the most ephemeral of competitive advantages, so I wouldn’t invest in a company on this basis alone. But if you catch a low-cost producer on a commodity down cycle, you can make a lot of money on the way up. Often this requires patience, because one can’t really time commodity prices with any accuracy.
Many years ago, post-Fukushima disaster, as nuclear plants were shuttered around the world, uranium became dirt cheap. It was, in my opinion, a virtual certainty that the price of the commodity would rise. But investing in uranium companies was a risky proposition, involving a virtually endless cycle of mine flooding, wars, and tax disputes. It was dead money for the better part of a decade, but ultimately, patient accumulators did pretty well.
If your company’s profits rely on unpredictable commodity prices, you’re going to need patience, and a lot of it.
It’s not my favourite type of investment, but it’s a pretty good portfolio diversifier, and if done intelligently, it works.