“Every investment trend has three characters first an innovator, then the imitator, and then comes an idiot”
~Warren Buffet
I believe that if you are exploiting the pessimistic short-sightedness of the stock market, knowing what not to buy is equally important as knowing what to buy. Don’t invest in price competitive commodity type “sick “businesses. They lack the ability to sustain economic shocks and can’t recover from the situations that got them into trouble. In simple words, they can’t make you superrich.
These type of companies can best be described as mediocre and inherently plagued by problems. They pose problems in front of their management one after another. When problems do arise they become life threatening. However, you should always hunt for businesses with durable competitive advantage that will ensure that stock prices will recover and continue to increase in value. In order to build enormous wealth you should give a pass to price competitive business regardless of how tempting the buying opportunity looks. No matter how many times investors kiss these frogs, they walk away with nothing more than a bad taste in mouth.
Identification of a Price Competitive Business
The price competitive business is easy to identify because it usually sells a product or service whose price is the single most motivating factor in consumers’ decision to buy it.
Automobile manufacturers
Airlines
Gas and oil companies
Steel producers
Paper manufacturers
The lumber industry
Internet service providers
Memory chip manufacturers
People buy gasoline on the basis of price, not on brand value. Even though oil companies would like us to believe that one brand is better than other, we know that it doesn’t really matter because price is the dictating factor. The same goes for goods such as cement, airlines, automobile, lumber, refrigerator, air conditioner, television sets and memory chip for your computer.
Automobile manufacturers are selling a price competitive product, for each segment of the auto market, every company competes to give maximum possible features at the lowest possible price. Similar goes with airlines, they operate in a very price competitive industry. The airline with the lowest-priced seats attracts the most customers.
Internet service providers (ISPs) – the companies that connect individuals to the internet- face such a low cost of entry to this business that a flood of companies compete for the same customers. The data which costs INR 300 per GB a decade ago now costs only INR 700 per month with unlimited data. Who wants to be in a business where the competition is giving the service away for free!
In a price competitive business the low cost provider wins. This is because the low cost provider has great freedom to set prices.
Let’s look at an example:
Company A makes improvements in its manufacturing process that lowers its cost of production while it increasing its profit margins. Company A then lowers the price of its product in an attempt to take greater market share from Company B & C.
Company B & C start to lose business and now in the same fashion they lower their product prices in order to eat-up Company A’s market share thus any increase in Company A’s profit margin. And the cycle repeats itself.
An increase in consumers demand should help the company to raise the prices but if in a price competitive sector where there are many sellers it’s difficult to even increase inventory turnover.
Price competitive businesses occasionally do well.
In a boom economy, in which consumers’ desire to spend their hearts out, producers like auto manufacturers respond by increasing the supply to meet demands. The balance sheets get healthy and bloated which help them expend operations. The shareholders seeing the company prosper will spread their hands out for their cut and company offers dividend pay-out. Once the boom is over the company will be stuck with excess production capacity, a fat dividend being paid out every three months. Suddenly, the healthy bloated balance sheet start to bleed during a mild recession.
