by Mawer Investment Management, via The Art of Boring Blog
Often, one of the simplest ways for a company to be successful is to be big: have scale in marketing/brand, R&D, manufacturing, and/or distribution. But in highly commoditized industries, can a smaller entrant compete?
The short answer is, yes. We believe smaller players can be competitive, profitable, and create value in commoditized and competitive markets—the crux is having an effective strategy.
But before we get into that, we should define what we mean by “effective strategy.”
In Michael Porter’s article “What is Strategy?” he argues:
Cost is generated by performing activities, and cost advantage arises from performing particular activities more efficiently than competitors. Similarly, differentiation arises from both the choice of activities and how they are performed. Activities, then, are the basic units of competitive advantage. Overall advantage or disadvantage results from all of a company’s activities, not only a few.
Porter goes on to say, to be competitive, each “activity” a company takes must complement another. They must “fit.” And, ideally, these combined efforts should produce a unique offering in the marketplace.
It’s much harder for competitors to replicate a carefully knitted system of actions than individual ones, such as simply lowering costs, using a certain technology, or offering a specific service.
Porter cites the textbook example of Southwest Airlines, noteworthy for achieving good returns above its cost of capital in a highly commoditized business over a long time frame. While the combination of specific and unique “activities” that made up Southwest's strategy of being a low-cost and convenient airline has since been emulated, it took years for competitors to catch up.
What helped was that both convenience and low cost were complementary efforts. To be convenient, Southwest Airlines offered short-haul, point-to-point service between mid-size cities for customers that wanted to fly those specific routes. To keep the ticket prices low, meals were not offered, nor interline baggage transfers. To increase profits, Southwest Airlines was fast at gate turnarounds, which meant planes could be flying more frequently (maximizing productivity). The airline also chose smaller, non-main hub airports, and used the same fleet of airplanes, which was easier to maintain (again lowering cost), and increased convenience for its customers.
Every activity Southwest did was aligned with its overall strategy—they “fit.” Altogether, they created a sustainable competitive advantage in line with what Southwest was trying to achieve and that would also attract and retain its customer base, thereby increasing profits.
Southwest’s business strategy, of course, is just one of many. It’s also important for investors to keep in mind that business models in highly commoditized industries can eventually be copied (as the appearance of many low-cost carriers have shown).
So, in answer to our initial question: can smaller entrants compete in established commoditized industries? Yes. Two of our portfolio holdings that demonstrate it is possible to be competitive and create value as a small player without apparent purchasing power or unique access to low cost inputs are Tehmag and Croda.
Tehmag, a small cap equity company in our emerging markets and global small cap portfolios, distributes premium bakery ingredients in Taiwan and China. It manages to operate profitably in a highly commoditized industry with typically low margins.
For comparison, Sysco, the largest food distributor in the U.S., earns a gross margin of 17-19%, an EBIT margin of 3-5%, and a net margin of 2-3%. Tehmag earns 35-37% gross margin, 13-17% EBIT margin, and 9-11% net margin over the last 5 years. How? First, premiumization. Tehmag chooses to carry premium, differentiated ingredients, such as specialized flour imported from Japan—at three times the cost of regular flour— which gives its bread and pastries a different taste and texture. It also distributes the most expensive milk in the wholesale market to avoid competition from the mass dairy market.
Tehmag also provides value-add services in addition to simply picking up the ingredients and shipping them to its customers’ doors. Tehmag has 70 in-house pastry chefs that are always designing new menu items using the raw ingredients it sells to customers. For example, one type of popular bread it developed allows customers to sell a loaf of bread for 400 TWD (Taiwan New Dollar), equivalent to $16 CAD per loaf. They call it the “crying toast,” which is a direct translation, because it tastes so good it makes you cry! For context, regular bread sells at roughly 50-100 TWD per loaf ($2-4CAD). So not only is Tehmag selling premium ingredients to its customers, it also helps its customers upsell their end products. This in turn incentivizes customers to buy more premium products from Tehmag.
In addition, because Tehmag only sells high-quality and more expensive products, they have accumulated a lot of customers to make volumes meaningful. This makes it difficult for other players to come in and gain sufficient scale to make the same economic model work (i.e., higher barriers to entry).
Croda, a specialty chemical ingredient company based out of the UK and a holding in our international equity and global equity portfolios, also operates in a competitive and considerably commoditized industry. Croda’s overall strategy is to create high value-add ingredients that make a fundamental difference in their customer’s product. Think: the anti-aging element in an anti-aging face cream, or drug delivery excipients that extend the shelf life of health products.
While most chemical ingredient companies gain scale to lower prices, Croda chooses specialized ingredients that give it pricing power. And, whereas competitors tend to design plants that can produce large batches to lower costs, Croda’s plants are designed to produce small batches, making it easier for the company to adapt and uniquely change their products into other ingredients as needed.
To further align its activities with its strategy of providing tailored and quality ingredients, Croda has an R&D team that works closely with its sales team to fully understand its customers’ product needs. That is a differentiating factor: many competitors’ R&D teams are more focused on operational—rather than product— improvements, or there is no R&D team at all.
Moreover, Croda will intentionally stop selling the commoditized products of the companies it acquires. Instead, it uses the acquired company’s specialized products portfolio and combines that with the company’s existing distribution channel to cross-sell and increase overall revenue from the specialized products.
Both Tehmag and Croda’s strategies have arguably been successful because their various and complementary activities (e.g., premiumization, unique product offering, R&D, acquisition integration, etc.) align—or fit—with one another. While any of these activities taken independently would likely contribute positively to the company’s bottom line, it is the concept of alignment between all the activities that reinforces their competitive advantages. In other words, the overall effect is not easy to copy. As Michael Porter says, “fit locks out imitators by creating a chain that is as strong as its strongest link.”
And, despite being smaller, the efficiencies and synergies both companies gained through their strategies has made it difficult for others to replicate. While we do invest in companies that have scale as their central competitive advantage, a company doesn’t have to be the biggest to achieve return higher than cost of capital—as Tehmag and Croda demonstrate. We also invest in ones that may be smaller, but have good, sustainable, and hard to replicate strategies.
This post was originally published at Mawer Investment Management
