Why are commodity less valuable long-term investments?

Table of Contents

Buffett’s view

Buffett detailed his views on commodities and commoditized businesses in his 1982 letter to shareholders:

To understand the change, we need to look at some major factors that affect levels of corporate profitability generally. 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.

Relevant contents in my book

On page 150 of 3-1 of my book “The Rules of Super Growth Stocks Investing“, I mentioned that long-term investors should avoid commodities that are susceptible to economic fluctuations.

In Section 3-2 of the book The Rules of 10 Baggers“, on page 125, it is discussed that semiconductors are modern commodities, and product profits are easily affected by the boom.

Properties of commodities

The characteristics of commodities are good or bad. The industry has an obvious industrial cycle. Most of the company’s profits come from the prosperity of the cycle. When the economy is at the bottom, it is necessary to tighten its belt. Enterprises that cannot survive the bottom of the economy will go bankrupt or seek opportunities for mergers and acquisitions.

Typical examples of commodities

Agricultural products

It has the longest history and is also the most typical commodity. The main agricultural product is also a commodity that is almost necessary for commodity exchanges around the world. In fact, the original purpose of setting up the commodity exchange is to be able to trade forward agricultural products and reduce the risks of relevant farmers.

Oil

In the past hundred years, since human beings have entered an industrial society from an agricultural society, energy consumption has been increasing day by day. Among them, oil and natural gas are the largest. The most typical impact is that the source of funds for the sovereign funds of many countries is the surplus of natural resources and bulk goods exports.

Precious metal

Gold is the best representative of them. The most famous investors in Japan and the United States a century ago were Chuan Yinzang and Bernard. Baruch was able to accumulate a lot of wealth, mainly because he invested in stocks related to precious metal mines, because these mining industries were the main industrial pillars a hundred years ago, and they accounted for a large weight in the main stock market.

Modern commodity

Since the invention of semiconductors in the 1970s, industrialization has entered the era of silicon-based technology. As the application fields continue to expand, semiconductors are almost ubiquitous, and the use of semiconductors shows no signs of slowing down. But two things worth noting are:

The evolution of the semiconductor and technology industry is too fast, resulting in the mature technology and mass production of the semiconductor field, which will be eliminated by the market immediately. The result is lack of interest and price competition, which greatly reduces the profits of manufacturers.
Like traditional bulk commodities (such as agricultural products), the semiconductor industry has an obvious business cycle. When there is an excess supply, the price will collapse.

For now, panels and memory in the semiconductor industry are the most typical modern commodities.

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