Monday, October 6, 2008

The New Buffetology: Chp 5: The Types of Business Warren Fears and Avoids

Warren does not want to invest in price competitive commodity-like businesses because they lack the economic wherewithal to ensure they will survive. With these types of businesses, intense price competition leads to lower profit margins and less wealth for company owners. While its true that low-cost producers win in a price competitive business, often the success is short lived.

Typically, a low cost producer makes significant capital expenditures to obtain their low-cost status. It's also common for the low cost producer to lower prices in order to capture more market share. Competitors experiencing declining market shares will often respond by making similar capital expenditures to reduce their production costs enabling them to lower their prices. The cycle will then repeat over again, creating another temporary low cost producer.

Price competitive businesses tend to do well when the economy is booming and consumer demand exceeds the available supply, thus allowing manufacturers to raise prices and earn good profits. However, during the good times, these companies will tend to expand capacity, make concessions with their unions and appease shareholders by e.g. increasing dividend payouts. In the subsequent industry downturn, the excess capacity, the increased dividend payouts and increased labour compensation will rapidly deteriorate the financial health of these companies.

In summary, excess competition leads to poor business economics and production overcapacity which in turn leads to lower profits and poor long term appreciation for shareholders. Warren stays away from price-competitive commodity-like companies even though they can do well during boom times, because they lack a durable competitive advantage and thus do not hold the best long term potential for shareholder appreciation.

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