Two Kinds of Business
November 7th 2006 16:14
Here is how I understand anything about business. All I write here I learned from reading books about Warren Buffett. The two kinds of business are: commodities business and business with a durable competitive advantage.
First the commodities: classic commodities are iron ore and wheat, flower but also cars, computers and bank loans.
All these goods are purchased on the basis of price meaning that the lowest cost provider wins over the competition. Producers often have to invest in more cost efficient plants and methods of production in order to offer a lower price.
Not strangely, they need to sell in great quantities.
An example of a commodities business is Ford Motor Co. US which in the last decade injected billions back into its plants and whose share price barely changed in the same time.
Businesses with a durable competitive advantage are like Coca-Cola or American Express or Geico Insurance. They have individualized products - Coke, travel financial services and car insurance, respectively.
These products are like necessities and can always be priced higher.
Businesses of this kind have lots of surplus money and can use retained earnings to buy other companies like them, therefore increasing the wealth of their shareholders.
Sometimes, a commodities business creates a local monopoly and acquires a durable competitive advantage.
This is the case of Nebraska Furniture Mart.
This business sells furniture in great quantities which allows them to obtain very low prices from the manufacturer. It also owns a very large floor space used for display. Nebraska Furniture Mart is very well known in the location and has a reputation for honesty.
Any other business trying to enter this market would need to pay high lease costs, also marketing costs to make them known and would need a large customer base from the beginning in order to offer low prices.
In practice this is impossible.
Another example of a business creating a local monopoly is Buffalo News.
This small town newspaper purchased the other only competitor and then priced its advertising services at will. It grew so prosperous that it went on to buying other newspapers with similar characteristics. It should be noticed that this kind of business does not need Plant and Equipment expenses on a regular basis.
With this kind of understanding it’s easier to make investment decisions.
First the commodities: classic commodities are iron ore and wheat, flower but also cars, computers and bank loans.
All these goods are purchased on the basis of price meaning that the lowest cost provider wins over the competition. Producers often have to invest in more cost efficient plants and methods of production in order to offer a lower price.
An example of a commodities business is Ford Motor Co. US which in the last decade injected billions back into its plants and whose share price barely changed in the same time.
Businesses with a durable competitive advantage are like Coca-Cola or American Express or Geico Insurance. They have individualized products - Coke, travel financial services and car insurance, respectively.
These products are like necessities and can always be priced higher.
Businesses of this kind have lots of surplus money and can use retained earnings to buy other companies like them, therefore increasing the wealth of their shareholders.
Sometimes, a commodities business creates a local monopoly and acquires a durable competitive advantage.
This is the case of Nebraska Furniture Mart.
This business sells furniture in great quantities which allows them to obtain very low prices from the manufacturer. It also owns a very large floor space used for display. Nebraska Furniture Mart is very well known in the location and has a reputation for honesty.
Any other business trying to enter this market would need to pay high lease costs, also marketing costs to make them known and would need a large customer base from the beginning in order to offer low prices.
In practice this is impossible.
Another example of a business creating a local monopoly is Buffalo News.
This small town newspaper purchased the other only competitor and then priced its advertising services at will. It grew so prosperous that it went on to buying other newspapers with similar characteristics. It should be noticed that this kind of business does not need Plant and Equipment expenses on a regular basis.
With this kind of understanding it’s easier to make investment decisions.
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