Editor’s note: This article was first published in October 2013; its tables cover 2008 to 2012, and its comments on Berkshire Hathaway’s portfolio and on Consol Energy’s performance against the S&P 500 reflect that time.
Warren Buffett is not only cautious about investing in technology companies. He is not very fond of companies that rely too heavily on commodities as their main source of revenue either. Of course, this has not stopped him from investing in the past, through Berkshire Hathaway, in companies such as Exxon Mobil and ConocoPhillips.
Buffett himself admitted that his bet on ConocoPhillips was one of his biggest investment mistakes, as he ended up losing $1 billion.
The mistake came about because Mr Buffett increased his stake in the company in 2008, just before the price of oil collapsed along with the rest of the stock market. In fact, any company that depends heavily on the prices of certain commodities will always carry extra volatility compared with others.
That lesson made Warren Buffett prefer to stay away from commodity companies, since nobody can predict accurately what the price of these products will be over time. What is more, for Buffett, companies that depend on commodity prices have no way of guaranteeing results for their shareholders, even if the CEO does a spectacular job. To some extent, they are at the mercy of chance.
Let’s look at some concrete examples of what Warren Buffett means, using figures put together by our friends at Fool.com. We will compare a commodity company (whose behaviour can more or less be generalised) with Buffett’s favourite, the great Coca-Cola.
Consol Energy
| 2008 | 2009 | 2010 | 2011 | 2012 | |
|---|---|---|---|---|---|
| Revenue | $4,270 | $4,360 | $5,010 | $5,960 | $5,020 |
| Gross profit | $954 | $1,130 | $1,120 | $1,550 | $792 |
| Gross margin | 22% | 26% | 22% | 26% | 16% |
| Net income | $443 | $540 | $347 | $633 | $389 |
| Net margin | 10% | 12% | 7% | 11% | 8% |
Source: Fool.com. Figures in millions of dollars.
Consol Energy produces coal and gas. Over the last five years, its prices have been under pressure and its gross and net margins have suffered. Because of this price volatility, the company lacks clarity about its financial outlook. In fact, during one of the strongest bull markets in the United States, the company’s return has been well below that of the S&P 500.
Coca-Cola
| 2008 | 2009 | 2010 | 2011 | 2012 | |
|---|---|---|---|---|---|
| Revenue | $32 | $31 | $35 | $47 | $48 |
| Gross profit | $21 | $20 | $22 | $29 | $29 |
| Gross margin | 66% | 65% | 63% | 62% | 60% |
| Net income | $6 | $7 | $12 | $9 | $9 |
| Net margin | 19% | 23% | 34% | 19% | 19% |
Source: Fool.com. Figures in billions of dollars.
Coca-Cola’s ability to set the prices of the products it sells shows how it has managed to keep its profit and profit margin steady. Together with rising revenue and control over its manufacturing costs, without too many shocks from its raw materials, this makes it a favourite of the big investors.
If we look at the companies in Warren Buffett’s portfolio, we can get an idea of the kinds of companies he likes and dislikes. Clearly, Buffett prefers above all financial stocks and companies that lead their market, ideally with the potential for a monopoly.
In summary:
Warren Buffett prefers not to invest in commodities for two reasons:
- In the long run, the price of the products is unknown, so the company’s results could suffer.
- Companies that depend heavily on commodities have no pricing power, so if costs rise, profit margins can fall quickly.
See also: Warren Buffett’s 16 best investing tips
Featured image: Sd400-4204, CC0 1.0, via Wikimedia Commons.
