By Investment Master Class
Charlie Munger has long reiterated the need to have multiple mental models to aid the investment process. This short essay looks at some of the product attributes that appeal to the Investment Masters.
A company which produces a single product faces a higher risk should that product become obsolete.
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
“If it’s a company with a single product and it’s a product that you have some sense might just have in it the possibility it could be leapfrogged, that is someone is going to come up with a better mouse-trap. That’s risk. Your business dissolves pretty quickly” William Browne
“Another issue would be where there’s a major concentration in one product line. That would be something that I would be hesitant to do again. I had a couple of experiences where I invested in a business with revenues that were overly concentrated in one product line and that product line was ultimately usurped by something else; a better mouse trap. I would be better off avoiding those situations.” Chris Mittleman
Warren Buffett considered the risk of a product being leapfrogged after his recent purchase of a stake in Apple .. "Someone could come along and leapfrog the technology, and add benefits that would be the more competitive threat than price competition. It would be benefit competition”.
It appears Buffett considered significant consumer loyalty outweighed the risk stating "Apple strikes me as having quite a sticky product and enormously useful product that people would use ... the stickiness really is something. I mean, they do build their lives around it, just like you were describing. And the interesting thing is, when they come into ... when they come into get a new one, they're gonna get they overwhelmingly get the same product. I mean, they got their photos on it and, I mean, yeah, I know you can ... you can make some shifts and all that. But they love it.
It's important to consider if the product is unique. If a product has no differentiating features or is a commodity then the only competitive advantage is to be the lowest cost producer.
"Products are not islands. There is an indirect competition, for example, for consumer's dollars. As prices change, some products may lose attractiveness even in well-run, low cost companies" Phil Fisher
“When relatively non-differentiable products are sold on their price, the manufacturers of the products normally need to have low cost structures if they wish to be competitive and earn reasonable profits” Ed Wachenheim
"When a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important" Warren Buffett
Companies selling specialized products which are a small part of a customer's cost structure, but crucial for performance, can be attractive investment opportunities.
“If it’s an industrial business what you want to own is the company that makes the valve that goes into the $100,000 pump which goes into the billion dollar refinery. They’re not going to scrimp on the valve. They want the very best valve they can get. If you’re the valve supplier you’ve got a good business. They’re going to buy your product and you’re going to be able to price your product aggressively because it’s a very low cost component to the end product. So you look for these businesses” William Browne
“The cost of the product should only be quite a small part of the customer's total cost of operations such that moderate price reductions yield only very small savings for the purchaser relative to the risk of taking a chance on an unknown supplier. “ Phil Fisher
“What are the key elements of what you consider a high-quality business? At a basic level, the product or service being sold is critical to customers but is only a small part of their cost structure, and the customer relationship tends to be sticky and recurring." Jeffrey Ubben
“Businesses selling a product or service that’s mission critical, yet is a small fraction of total costs, like you find in some aerospace businesses (or rating agencies in some ways) , are always interesting with long-lived advantages due to switching costs” Allan Mecham
A product with brand strength that is purchased by 'name' can command a price related to usage value rather than the cost of production limiting the potential for competition.
“Buy commodities, sell brands has long been a formula for business success. It has produced enormous and sustained profits for Coca-Cola since 1886 and Wrigley since 1891. On a smaller scale, we have enjoyed good fortune with this approach at See’s Candy since we purchased it 40 years ago.” Warren Buffett
“You really want something where, if they don’t have it in stock, you want to go across the street to get it. Nobody cares what kind of steel goes into a car. Have you ever gone into a car dealership to buy a Cadillac and said “I’d like a Cadillac with steel that came from the South Works of US Steel.” It just doesn’t work that way, so that when General Motors buys they call in all the steel companies and say “here’s the best price we’ve got so far, and you’ve got to decide if you want to beat their price, or have your plant sit idle.” Warren Buffett
When a product is enmeshed in a customer's workflow or the customer benefits from network effects it can lead to high sustainable rates of return and this can provide an attractive investment opportunity.
“Sometimes a product is so embedded in a customer's workflow that the risk of changing outweighs any potential cost savings – for instance in subscription based services like computer systems (Oracle) or payroll processing (ADP, Paychex.) Networks, where the customer benefits from a company's scale, as in the security business (Secom), industrial gases (Praxair, Air Liquide), car auctions (USS) or testing centres (Intertek) are another example. Finally, technological leadership (Intel, Linear Technology) can be another important intangible asset although this is perhaps one of the less durable sources of pricing power, unless combined with others. The very best economics appear when some of the above characteristics combine in a situation in which the cost of the product or service is low relative to its importance. For example, the analog semiconductor chip which activate the car airbag, yet costs little more than a dollar.” Marathon Asset Management
Some companies will sell a product at low margins to deter competition yet collect high returns from servicing/parts revenue into the future. Examples include large equipment manufacturers [eg commercial jet engine manufacturers, earthmoving equipment, mainframe computers etc].
"We really like businesses where you sell a big piece of OEM equipment at a low margin and then collect a 40-year stream of high-margin service revenues that the customer is essentially locked into." Bill Nygren
Once you've established the attractiveness of a product it's important to consider how big the runway for future sales could be.
“Any time you look at an investment, you want to look at what percentage of its market it has and how big it can get” Rory Priday
It's important to remember that markets, industries and consumer tastes can change rapidly and these changes can significantly alter the demand for a company's products. In a recent letter, Steve Romick of FPA Funds noted:
"Innovative technology is driving business transformation faster than ever before. As a result, the expected tenure of a company in the S&P 500 is expected to drop from 25 years to 14 years. We want to avoid those companies whose businesses are existentially challenged."
Jeff Bezos, has talked about the shifting power from companies to consumers ...
“The balance of power is shifting toward consumers and away from companies. The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it.” Jeff Bezos
Phil Fisher recognized these risks more than 50 years ago, in 'Common Stocks and Uncommon Profits' ..
"For a company to be a truly worthwhile investment, it must not only be able to sell its products, but also be able to appraise the changing needs and desires of its customers" Phil Fisher
Don't lose sight of the fact that a company that sells a great product can always be a bad investment if you pay too much. Notwithstanding, having a checklist of mental models related to product attributes such as these, which the Investment Masters focus on, is likely to improve your investment returns. Good luck!