Moats in Commodities: Why Some Price Takers Win Big

Summary

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• Commodity Moats: The podcast explores how certain commodity businesses, typically price takers, can achieve above-average returns due to unique moats such as low production costs, strategic location, long-term contracts, and asset scarcity.
• Return on Capital: A distinction is made between having a moat and achieving high returns on invested capital, emphasizing that a moat doesn't always guarantee high returns, especially in commodity sectors.
• Key Characteristics: Successful commodity businesses often share traits like low production costs, advantageous logistics, and regulatory barriers, which help them withstand market volatility.
• Company Examples: Companies like Southern Copper and Warrior Met Coal are discussed as examples of low-cost producers with strategic advantages, while others like US Lime and Monarch Cement benefit from local market dominance.
• Investment Cycles: The importance of understanding commodity cycles is highlighted, with long-cycle commodities offering different investment dynamics compared to short-cycle ones like eggs and avocados.
• Market Perception: The podcast notes that businesses with consistent but moderate returns, such as those in non-sexy industries, may offer stable investment opportunities due to less competition and capital influx.
• Financial Health: The role of financial stability and strategic capital allocation is emphasized as crucial for sustaining competitive advantages and navigating cyclical downturns in commodity markets.

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Transcript

Welcome, welcome, welcome. How's everybody doing? Hope you are doing well. My name is Andrew with Focus Compounding on Air Live with Jeff Ganon. Jeff, how's it going today? >> It's going very well, Andrew. How's it going with you? >> It's going great. We hope it's going great with everybody else as well. This is the first time you're tuning with us. Thank you so much for joining us. Be sure to check out all of our content that we push out into the investing universe. Best way to do that is to follow me on X at Focuscompound. If you're watching us on YouTube or listening to us on a podcast app, be sure to hit the subscribe button so you'll be notified every time we upload a new podcast. And of course, if you're interested in learning about our money management services, you can reach out to me at Andrewfocuscompounding.com. So in today's podcast, Jeeoff, we're going to continue on and talk about moes in commodity businesses or businesses that are linked to the commodity markets, right? And I guess the main question or the thesis or the whatever you want to call it is, you know, most commodity businesses should be price takers, right? I mean, they're dealing with commodities and that's what, you know, commodities kind of are. uh yet some earn above average returns on equity, returns on invested capital, returns on capital, return, you know, above average returns, whatever metric you want to use. And I guess so the question is why and where does that come from and in some cases that comes from having some sort of moat. So want to go over that here today and we can look at a few different examples. Um there are some you know common themes that you will find in a commodity type business that has a moat. Uh but before jumping into that pulling it up on quickf just wanted to get your general thoughts on that topic in general of uh commodity businesses having a moat and what your thoughts are on that. >> Um well there's kind of two issues. one, most commodity businesses have lower returns on capital um over time and a lot of them have lower returns than you would expect by kind of economic theory and stuff. So they don't just have average type returns for what would justify investment in their industries, but they actually have below average returns for a long time. Um, and so the question is whether that where we talked about moes, the issue with moes is sometimes you can have a moat, but if there's nothing very valuable to protect, then does that really matter a lot? And a lot of the reasons why they might have low returns on capital don't have to do with their interactions with their rivals um, but might have to do with difficulty of pricing and and supply and other things um, with others. So, you know, Porters, five forces type stuff, the things that don't have to do with competitors, but certainly there are some that have relative advantages versus others in their industry. Um, and then, you know, so it's kind of the reverse of what we talk about sometimes where we say that this company has a high return on capital, but that doesn't mean it has a moat. In this case, you might have a moat, but you might not have a high return on capital average over a full cycle. So, those are the two things to keep together because Buffett always says both, right? He says he wants a very valuable castle, but then he wants a moat around it. I think we can definitely find some that have modes. question is whether we can also find them having something valuable um on top of that too. So they can relatively outperform their competitors though. >> Do you want to explain the difference between the two because I I believe people get they kind of think about them as being the same having a moat and having a high return on invested capital or return on capital and that's just not the case. >> Yeah. So having a high return on invested capital has to do with the economics of the business a lot of the times. um whether you're putting in money ahead of someone else or you're getting funded in it. Um so float and the dynamics of how that work. And then also things like um whether you're dealing with a lot of customers or very few customers with not a lot of bargaining power. Uh with a few customers with a lot of bargaining power, many that don't have bargaining power. Same on the supplier side, things like that. So, there's lots of industries where I don't know that there's much of a moat from one company to another, but they tend to be able to make a lot of money because they they um well, one, they might add a lot of value in what they do. And two, um they have a lot of bargaining power to to exploit that value with both their suppliers and with their customers. Um then there's also other things that have to do with the nature of a long-term investment in things. In general, companies that have very high returns are able to invest a lot in their brand. Things that they do specifically and in long-term customer relationships and things that have lower returns over time tend to not be able to invest in those things. So, if your workforce turns over all the time, you can't really invest in training and improving and having these systems for that. If you lose customers all the time, then you can't really invest a lot in working with the same clients and doing things customized for them. But if you tend to retain all those things for a long time, then you know it justifies higher levels of investment and then that's how you get intangibles and things like that. So oneoff type transactional things are less likely to result in in modes over time. >> Mhm. So before the podcast the other day when we were talking through this topic and we came up with just some common characteristics that you see right in these type of uh businesses and we have four bullet points that we uh you know put on paper and low cost of production obviously is something that you want to see. Um location slash logistics and we we're going to go through like what all this means. long-term contracts. Um, and then asset scarcity, regregulatory barriers could be like a source of this. Uh, so low cost of production, right? So, obviously that's that's pretty self-explanatory. Um, personally, if you're ever going to look at like a commodity business or a business that deals where the inputs are commodities or outputs, and you know, um, having like sort of the Costco of that commodity that they're able to produce it, um, at a lower cost than others is is, you know, something that I think is good because, you know, the nature of commodities, you're going to have these volatile price swings, whether it's from supply demand dynamics or just sentiment, right? things that are going on in the world or the global economy. And if you have a business that's able to withstand that, right, and be set up from like a cost structure standpoint, um, you know, more favorable than others, that's obviously something that's super important. So, um, yeah, something and we'll walk through these. And then another thing is that we we had talked about how cycles matter, right? So um long cycle commodities over long periods of um uh you know you could put like copper and coal and nuts and and you know agriculture type stuff in like long cycle and then there's short cycle right so there's faster swigs um which are harder to gauge or harder to sustain you can think about that like eggs we talk about cmade foods avocado stuff like that >> um but yeah so I mean let's see so you know rule of thumb we had low value to weight um is more like a local mo thing, US lime and high value to weight could be like you know gold or uh diamonds. Uh you have global competition and there may not be a moat there. So think like low value to weight could be a great way to find moes. Um high value to weight could honestly be maybe not a great place to look for molts moes. That's sort of just a general rule of thumb. >> Yeah. Although with something like gold, if the perception is that there's no difference between it, then that would be different than diamonds where there is a perception that there might be a difference. And so you could probably advertise and take advantages of that kind of thing. Um note on this we did mention um soft commodities and things specifically things that people might need and everything. Those will be different because um uh you can definitely have a moat even if your product is the same quality or worse than other people's if it's perceived to be safer or more reliable as to what the source is or something like that because people are going to eat it or have concerns about that and all sorts of things can happen that way. So, you know, there's conspiracy theories around food and things. There's not about diamonds and gold. um people don't really care where it came from and and you know so th those tend to actually a lot of things can be branded and turned into um uh take a commodity and it basically if people eat it then it doesn't have to be that way. Even we mentioned a pet food company not that long ago. Same thing could even happen for animal food as long as it's pets though it's unlikely to happen for animals as livestock. Mhm. So, we could go over to QuickFs, Southern Copper Corporation. Um, lower copper costs than other companies. Um, it can make money when copper is expensive because they can produce it cheaper, longer cycle. Uh, when we were looking at this the uh uh, you know, it's like where where is that source come from? Why is that, right? How are they able to do that? I mean, you see where they operate? Peru, Mexico, Argentina, Ecuador, and Chile, right? >> Yeah. Well, there's so there's a few different things. I mean, that we talked about low cost of production. Low cost of production can have a few reasons. One, in an industry that has a very long lived asset, um, then the low cost of production could be purely historical. So, you just have it because that mine that was developed earlier. In the history of an industry, the things that are developed the earliest are probably going to be some of the lowest cost things. And then those that are developed later will be some of the highest cost. you'll need new technologies and new countries to open up and whatever to even be able to access them. So, in some cases, the first mines or the first uh reserves that are exploited in some places are going to be in the most stable places and be the cheapest and all that kind of stuff just due to history. Now, in a short, you know, if you're fracking for natural gas or something, then that advantage won't last for very long. But if you're producing in some mines like copper and gold and things like that, well, those advantages will last for for an incredibly long period of time. Um, you know, you could have an advantage for half a century. Um, then other things are like, you know, we've I'm sure people have read the book about um Standard Oil and all that kind of stuff. It could also be um that the company itself pursues um cost reductions in some cases by reducing expenses by how it does things. Um that's hard for a lot of companies because that stuff gets swamped by the returns in the commodity itself. So a lot of commodity producers probably don't try very hard to reduce their expenses over time in other things. So you take your standard oil type thing focusing on accounting and how much does it cost to make this barrel and how can we do it so that we can reduce the cost of moving this and that inside the plant and selling to other people and everything. A lot of ones won't make much effort in that way because you're saving fractions of percent in good markets and you'll still lose money in bad markets anyway. Uh but just constant you know attempts to take cost out of the business. So that's another thing and that won't show up until you have better results later. >> Yeah. I mean, I guess if you're setting the company up for to be uh, you know, good or strong in any economic environment, when you do get the eventual um, high prices, a company like that just going to make. Um, but you can look at like Southern Copper Corporation on uh, 10-year total return performance, 433%. Obviously, very strong. Um, I think we could compare that to the S&P 500, and you can see that obviously it's it's it's done a great job. Um for a company like this, where do you think that source comes from though? Right. So local >> historical assets. >> So they've had them for a very long time. >> Copper, it depends on what technique that is being used. They talk about different ones. Open pit a few different things, but um copper mines are incredibly long. Uh yeah, incredibly incredibly long. So um yeah, that would be the main reason. And then but so a lot of big producers that be famous today started out with a really good asset but since they have a high reinvestment rate into other things it goes away over time so the business doesn't stay a good business. Um it's easier to maintain an advantage in something like a commodity at a certain location but then as you expand the business into other things unless you're mainly involved in distribution logistics things you're not going to keep the same advantage because why would you have access to the next location? Sometimes there might be political possibilities of access to the next location and things. Maybe you're attached to one country that's more able to access countries that are risky at first and then you know get involved early on and and those would have very good returns because people would be avo firms would be avoiding entering them because they're afraid about um the situation in terms of the asset being seized or something. Um, you should point out though that something like southern copper probably in a good period for copper will perform poorly relative to higher cost uh copper producers because the highest cost ones will probably be the ones that improve their returns the most and everything. So you would only see an advantage over a full cycle. Um, but you would also have lower credit risk and ability to merge with other companies and not to go bankrupt and all that over time, which is how you kind of have an advantage over a long cycle. But if you knew, for instance, that copper prices were going to go through the roof, the stocks that will do the best are actually the ones that are closest to break even. Um, the stocks that will do the worst are probably the ones that have the biggest gap between break even in the most parts of the cycle. So, your lowest cost producer actually is going to have the most consistent performance over a really long period of time, which is less likely to give you the best performance in a short period of tight supply. >> Another company, Warrior Mech, ticker HCC. Um, this is a company that's bringing on probably like one of the last uh coal mines in America in Alabama and they're a lowcost producer. And I think that the new mine's going to like raise your capacity by like 75%. It's a really big deal. Um, but also, you know, what's interesting about this company as I understand it is that they're pretty close to um the mobile port as well. So from like a distance perspective, you know, like obviously if you have a coal mine in the middle of the country and you're trying to get it to somewhere else, that could really affect your cost because transportation is like a huge cost component for these companies. Um, so being close and having your minds close to that uh is is a huge competitive advantage from like a cost perspective. >> Yeah, that's like the biggest advantage that way. I mean I remember doing um uh research on things years ago uh for school thing not not for investing things unlike tobacco and uh other farming things in the south and the importance of rivers there to be able to do that explained a lot about the performance of one plantation versus another and everything being able to just move it better. The other thing that you have the other thing you have to do is um think about over time what tends to happen with like we're talking about ports and other things that could have to process things and and all that is that you tend to have a sort of um a focal point that becomes like a nexus of all this other stuff that supports it. So you tend to have fewer and more um more profitable type locations for exporting and importing certain things and for being supported in different ways from it so that the advantages that come are bigger at the transportation aspect to it which would not be so much for other parts of it. So, even when we talk about uh like I mentioned fracking and stuff, the a big difference would just be if you knew that you were going to get infrastructure to take that product out of the fields there and bring it to someplace where it gets a good price and knowing that ahead of time and everything, right? Because that's going to be your biggest advantages is is those sorts of things where the cost differences are going to be the biggest for you. So, same thing here, right? If if it becomes something where a port is being used for moving a lot of coal from something, then again, you could invest in it. other companies will grow up around it. There'll be all sorts of things to do that. Whereas being the first one to try a completely different method of getting things out is trickier, but you could develop the advantage that way. You know, that's usually what happens is like someone says, "Oh, there's this incredibly cheap deposit somewhere. That would be great if you could do it." But you said, "Well, there's no infrastructure for it, so it's going to take all this money. You're going to have to work with the government. How are you going to do all this? It'll take years to develop it, you know, and if it works, then you then you have a long-term advantage. a lot of times the project doesn't work and that's the reason why people aren't doing it right to be the first one to do that. So those are there's like kind of I don't know if you want to call them economies of scale but they're advantages of relationships between firms and things in a certain area usually. So there's fewer places that move things than you would expect and there are bigger advantages to those places that move it. So getting hooked into that network early on is kind of an advantage. Mhm. We've talked about US lime a a lot on this podcast. >> Yeah. >> Um we could look at other I mean we talk about like low value 28 consolidation in the industry stuff like that. Um what about like an eagle materials or a monarch cement or vulcan materials? >> So aggregates lime cement are all better businesses and um over the long run than um globally traded commodities. Um it wasn't always the case necessarily. Um there was a period that wasn't that great from maybe the 30s to the '7s in the United States, but um it wasn't necessarily terrible. I mean, some of that was there was plenty of inflation and things and so that can cause some issues, but um those industries tend to be more local. The issue is that because of the, you know, the low value versus the weight. Um, and also because of how you move it. But the the issue with some of these is that um why we talk more about US lime than some of the others is US Lime is more of a lime business that you can see cleanly what the economics of that are. It's not that I doubt that other companies have that inside of them. It's just that they're also invested in a lot of other lower return things as well. Um, so it the the tricky thing though is of course like over an entire cycle the returns for some of these companies isn't that amazing especially if they acquire other things. You can see it most purely in US Lime and how good their results are. It's harder to see in things like Eagle and some of these other ones that we just mentioned because when you take into account the acquiring of other things, the price that they pay tends to go to benefit the acquired company and then there's enough years that aren't very high return um where it's an issue. I I don't know. I mean like in this case over the very very long term it might be okay because you might assume that there's not going to normally be a period as bad as the um housing bust, you know, over 25 years. So, if you look at that 25-y year return on invested capital, as long as they apply some leverage to that, a company like Eagle Materials could create value for for shareholders. >> What about a U Martin Marietta? >> Yeah, same thing. Same thing for Eagle and Martin Marietta. Yeah, there's like two or three other ones too that are the same. It's just a question of what their mix of things are. So, that you know >> that's the same. It's like looking at a big oil company or something. They have a mix of good and bad things inside of them. Monarch Cement talked about this company a lot, looked at it pretty closely. 2019, we very familiar with the company. Um, and performance for this stock is has been pretty good over the past 5 years. We're looking at 418% total return versus uh close to 100% for the S&P. So, stocks have done really well. >> Yeah. I mean, look, the the issue is that one, there's environmental, there's regul there's regulatory and just local things that people don't want something so much. There's not a lot of people that are going to push to add things. Um, then the places that have them don't want to encourage other people to come in there. So, it's the same thing we talk about with a landfill or a junkyard or whatever. They're the even we mentioned with strip clubs and things. someone who already has them kind of encourages the local area not to let more in and there isn't a big push by individuals to say let's get them in here. Um so there's not a lot of political pressure to to increase supply over time. And then you also have things like you know we're talking about um AI and stuff. There's only only so much investment to go around in a in an economy. And so there are some places which are going to tend to earn the best returns where there's underinvestment relative to what their projected future returns on the projects are and there's other parts of the economy that have overinvestment relative to it. Right? There's so in other words the math is the most important part of it but there's an overlay on that math of what's sexy to get into now and what is not sexy. And the not sexy stuff is likely to have higher returns in the intermediate period because they don't put enough capital into it when their capital's so high. If you were getting these returns in some growth area, new capital would enter and press down the returns. It's a little less likely if you're in an industry where people aren't going to suddenly up the capex a lot. >> What about a Talon Energy Corp T? >> Well, we don't have a lot of data on it because it being spun out and that whole kind of history of it. I mean it um so it's the quickf little murky from the past but yeah independent power producers how does it describe it on quick FS I think there's just kind of a um >> exactly as that independent power producer infrastructure company >> produces and sells electricity capacity and services into wholesale power markets in the United States >> yeah um it says it's headquartered in Houston but I think some of the markets they're in are not in uh in um Texas, which is a separate system from the rest of the country. Um so for people from other countries and things, if you don't cross state lines for certain things, then that would affect how your uh laws apply to you and stuff. In the United States, regulation does, whereas if you did cross state lines, it wouldn't. So some places rarely have something else set up. And Texas has this Urgot thing that's different from the rest of the power system, the rest of the country. Um so I mean, I just mentioned AI. I mean the whole thing is basically that I think all the independent power producer stuff is is surging. I mean so so this one is a good example. This would be a mix of high cost and low cost. Um it's interesting how they describe it actually. Did the company even write that for itself? That's a really weird way to describe it. It says it operates nuclear, fossil, oil, natural gas, and coal. fossil is uh so that's a weird very strange way of describing itself but um nuclear is what it was originally um kind of pitching itself as but I don't even know if it that matters as much now um so some of those are things where the variable cost of it is high right so if you produce a lot if you produce a lot more at a natural gas plant that's not going to have the same effect as if you produce a lot more at uh if you have a a price improvement and uh can use up all of your um needs that nuclear or coal because nuclear and coal are kind of base things that would be producing all the time and then they would either get a good price for it or not if you're an independent power producer. Um so theoretically if you own coal or nuclear and you are not under contracts or regulated in such a way that you can just sell at the market price then you would do very well based on what's been happening lately in electricity prices which is that they've been going up and are expected to go up a lot um due to AI stuff. So in other words that it it's expected to be in shorter supply and those are kind of lowcost ways of producing it nuclear and coal generally but a lot of nuclear and coal plants don't have freedom to sell however they want in the United States. Um they're already set up to kind of make money every year but get just a decent return either through regulation or through things they've done themselves. If you're just selling then you're going to have a volatile ride but you'll make a lot of money in the years where supply is tight. Mhm. Let's look at your old friend BWXT, uh, BWX Technologies. So, they do stuff with Uranium, but it's not like a pure play, right? It's it's more of what you describe as like a pure engineering type of company. >> Yeah. So, >> equities, everything's been just exceptional. >> Um, yeah, BWX Technologies is and gets lumped in with nuclear things. They did consider doing nuclear. They had developed a modular nuclear um reactor business which uh but they terminated it I don't know um probably seven eight years ago or something. It wasn't predicted to generate revenue until 2026 2027 or something and so they thought on a DCF basis it didn't make sense. Now, as it turned out, venture capital and stuff and government things went into that area and there will be modular nuclear power things for um developed and some companies are going to sell them probably around that time frame. I don't know if they'll make money or not on it or if they would have invested if they had put the money in themselves, but that would have put them in the power business, but they would have done it like they probably would have gone a royalty on it, not produced it themselves. And it would have been um kind of assembly line type production. And then you have something that you can use for let's say 5 to 15 years. You never refuel it and then um it's returned stuff. So it basically would replace other forms of um power in remote places if you need it and an army needs it or an oil field needs it or a mining thing needs it someplace not hooked up to the grid. Um so that they they consider that but aren't in that. The rest of the things they do are mostly for government things. So they make nuclear reactors for subs and carriers for the US. Um they did inherit a civilian business too. Um and they're in some other stuff. They make things for nuclear weapons. Um and they have some related things. So they do some defense things that are related because it's on the same subs and things even though it's not nuclear. Um this the sub is nuclear, but I mean they're not not everything has to do with nuclear weapons. Um, so nuclear power ships, nuclear weapons, and then also, you know, historically they were involved in down blending and things like that because the US had very large nuclear stockpiles and didn't know what to do with them. So a lot of the source of uranium in the United States over time has been from the formerly large nuclear weapons program, which is smaller now, although a lot of that's been exhausted. So I don't know that like nuclear weapons numbers will drop in the US and Russia going forward, but they have been dropping for the last 30 years. Let's go uh avocados. How do you pronounce it? Kavo. >> They got the Kavo. They got the AO. Avocado. But Kavo Growers Inc. ticker CVGW. Uh >> smaller company, $486 million market cap, $426 million enterprise value. Um yeah. What are your thoughts on like agricultural type companies and where the if there is a potential move there? I mean, you know what's funny is I was listening to a podcast and it was a farmer that was talking about they're trying to diversify the family's holdings because they're soybeans and corn, but they're trying to do like meat packaging stuff. And he's like, he's like, "Yeah, you know, the difference between the two of the businesses is for my meat, you know, it's all we grow the cows oursel. It's organic. I could basically charge, you know, within reason what I want or what I think it's worth." Uh, he's like, "Whereas the corn, for example, it's just the commodity price. I have no control over it, right? It doesn't matter how how good of corn it is or whatever. Um, and I was like, yeah, I mean, you you just described uh being in the commodity business, but it's true, right? So, what are your thoughts on avocados and, you know, or companies like that? We don't have to pull up a corn company, but we can look at nuts. Uh, talk a little bit about tobacco. We'll we'll loop that in with that. Uh, but yeah, what are your thoughts on if there is a potential moat? I mean looking here right on the returns on equity and everything you would say no way. >> No it looks like Fresh Delonte or Dole or one of those kinds of businesses it looks like the long historical fruit fruit and vegetables generally look the same. Uh it has gross margins that you can see there are 5 to 10% and then based on that you have operating margins which are in this case sometimes zero but what they're hoping for is 2 to 5% or something. Um and then you just have really low returns. It's surprising sometimes how low the returns have been in this. So like if you look here, you know, and their numbers are lower in recent years than it was in previous years. But of course, we don't know that means volume's lower. But it is fascinating because you have something that's priced at, you know, um uh that it keeps pursuing this even though it's it's had, you know, poor returns for such a long time. But like I said, Fresh Monty's FTP, you could check that, too. I think it will look a lot like this even over a 25-y year period. too. I don't know other ones that have been public that long. Okay. So, they did have a period in the early 2000s where they made a lot of money, but in general, it's not just that it's bad. It's it's below average returns. I mean, you you could make money every year in this business. They only lost money in a couple years and yet be below the return on treasuries. Um, and that's on like a cruel basis. >> But, >> yeah, that's like on a cruel basis, too. So that's the fascinating thing about commodity things is it's not just like you're getting so so returns as predicted. You're actually getting poor returns for long periods of time. FTP uh fiveyear returns 74% versus S&P at 97. Let's go longer though. Yeah, nothing basically 9% total return. >> That's the big thing for the industry. Uh I mean the big thing for commodities generally is you're going to keep seeing this pattern where uh you can have not particularly good returns for the business in a period and yet you can perform well or better than the market for like say a 5year period but over a 20-year period it can be bad. Um and that's constantly what you see. >> Um you know some of these things are undervalued versus some of their assets if they broke them up. Um obviously Fresh Del Monty's um results are much much more stable um than what we're just looking at with Calabo. Um but they're incredibly low. I mean there were best return on equity year was 13% as it say there but most would be seven four five. Um yeah they had returns in the early early 2000s that were better. Um, but you have returns going from 0 to 10% or something. Um, and yeah, they stay in the business. So, but like I said, the gross margins of the operating are pretty similar. Theirs is a little better because they have more scale probably. So, there there's less of a gap every year between those two. We can look at John B. Sanilippo and Sun Inc. Fisher Nuts is is their product if you're familiar with that, if you like nuts. um their return on uh equity has improved, return on invested capital has improved. >> They have a good long-term record as a stock. Yeah, >> they were net net about 25 years ago. I remember the company well um it's quite cheap and it had a history of being cheap until the point where it kind of stopped as you can see in the early 2000s it stopped having any years where it lost money and since then has just had returns improve. So I don't know last 20 years basically is when it started doing well before then it was even cheaper than things like uh those two. >> Where does their source of mo come from if they have one? >> So they basically are um processors. So if you go to the business description um it's similar to what you see with like a milling business for grain or something. So they it says process and distributes tree nuts and peanuts in the United States. Um, so it's you're not talking about something that is um producing it that way, but something that's making money off of the difference on the two. And you can see in the gross margins are quite a bit higher. Um, and then then the ones we were just comparing, even in a bad year, you're getting 15 to 20% type things. And then the operating margins, um, you know, obviously look very good in recent years. It's interesting that the stock over a really long period of time hasn't wildly outperformed the market or something, but it's pretty cheap whereas the market's pretty expensive. So, it's results as a business have far outperformed the market. >> I was going to say why why do you think that is? So, the results have been pretty good as a business, right? Look at the 10-year keer and free cash flow or you can use your return on equity. I mean, whatever. >> EPS, revenue, assets, everything has gone up faster. It's gone in the right order. Free cash flow is growing even faster than EPS. EPS has grown even faster than revenue. Revenue has grown even faster than assets. That's a that means your marginal return on capital is improving every single year basically. Yeah. because you're probably >> Yeah. Go ahead. >> You look at the the you know total return and >> yeah it's been it hasn't been good compared to the market at all. >> Well over the shorter periods that you're looking at because the stock got overpriced. Um but over the longer periods of time it did outperform. I mean so from let's see so if you bought it at any time in the early 2000s like we just talked about you would have been better than the market for most of the last 10 years or more. But then you're below the market in the very recent period, right? Um how are you doing now? Yeah. So if you go back, you can see that you um but you see how poorly the company did in the 1990s, right? They're they're we don't have the business results from back then, but the um I remember the company then and it was only in where you can see here in the mid 2000s uh that decade. So about 20 years ago where it started consistently making more making money every year and also making more money the return on capital if we can see on quick FS you can see the return on capital numbers graphed and it's almost every year that it got better for the last 15 years or something um yeah um you know so you just have a you have um a price that isn't And I mean, I know this sounds hard to believe that two times book or something is not a lot of money for a uh company that's just processing nuts, but relative to the S&P and everything right now, the the market pays over two times book for somewhat poor businesses at this point. Um, so honestly, with a 17% return on equity, which is driven by I mean, the simplest way is just look at return on assets. They've had a double digit return on assets each of the last five years or something. That's a very good business if it's doing that. The only businesses where that would be a problem is if you can't apply any leverage to it, if you can't apply anything like that. So, um, now very slow growth in like revenue, right? So, over the last 10 years, revenue has only gone 3%. Considering inflation, everything that means there's basically no revenue growth over time. Um, but that's not I mean that's not as weird as it sounds. In some businesses, productivity gains in specific facilities and functions that you perform sometimes will lead to you having better results and even doing higher volume while not having higher prices, you know, in terms it just depends on what's happening with the commodity. So they've certainly you know tended to make like if you're processing and things I for a lot of businesses I'd say gross profit is the more important number and there's not a lot of years where the gross profit is lower in one year than the year before and even on a real basis the gross profit growth is you know it's okay. So, um, you know, the revenue number, yeah, but I don't know how important that is because most of the 80% of that, you know, is probably planned to pass through you, right? It's like Costco or something. They're not really looking to keep that gap. They're looking to provide a small amount of value um for a lot of volume that passes through their plants and everything. So, that's that's kind of what the business is trying to do. Um, obviously the stock could be down in recent years because of the poor earnings per share. We've seen like, you know, the last three years is 30% growth, 1% growth down. Um, that's possible combined with my memory is it had a somewhat high price only three or four years ago. So, um, compared to what it used to be. So, but EB to Ebida of 7, price to sales of 0.7, those are kind of low prices for it in the modern era. Although, like I said, it wasn't net 20 years ago. >> Mhm. Universal Corporation, ticker UV, middleman tobacco company. Um, large company that's probably one of the biggest uh in its industry, right? and has always earned and what it does and has always earned a below average return on capital. >> So I guess a good example, you could have these large companies that obviously we kind of talked about before um may not make a ton of money, but yeah. >> Well, they're very similar to um John Slipper. So JBSS and and um UVV are very similar. You can see the difference is that um Universal has poor asset turns. So it has almost the same margins the two stocks every year where you have similar sorts of gross margins around 20% or so and then you have operating margins around 8% or something. The difference is that your returns are very very low because it's holding the tobacco itself. If you look at the balance sheet you can see this it's a good business kind of good business that's just like this is Stella Jones but what happens is you have really high levels of inventory. So they've been holding um up to what a billion dollars worth of tobacco just a few years ago at times and yet their all of their liabilities together including long-term debt was only about a billion dollars. So their inventories are financed in part by long-term debt and all the rest in short-term debt and then in accounts payable and and all of that kind of stuff. the tiny numbers of things in accounts payable versus um your uh accounts receivable you can see and you can also see inventories versus everything else have that problem. So that's why we've talked about sometimes you add up PP&E with accounts receivable and inventory. This looks a lot like uh textile mill like when Buffett took over Bergkshire in that a lot of the investment is in accounts receivable and inventory which probably means your customers have a lot of um power over you and then you're financing all yourselves. So they're basically spending a ton of capital invested in in tobacco sitting around and stuff. Um, and so that's leading to poor returns. Even though on a margin basis, tons of companies do well with a margin of say 8% gross margin of 20% or something. It's just that the turns are so low. Um, and that's a built-in part of the business that they have. So, it gives you an idea because of the power that others have over them. It's unlikely that another company in the same industry could really do better than that. It's just a question of like are your um the are the companies that uh do you have a lot of power over those that you buy from and those that you sell to and if you're a middleman without a lot of power then you're not in a good situation that way. If on the other hand you're you know um I don't know their mar their well their gross margins will be a lot higher but you know if you were a MRO type business like a Granger or something you have a lot of power over that and you don't have to hold all this stuff. Um, so you know, the results are actually pretty stable. You can see uh they make money every year that they only came close to losing money twice in the last 25 years. Um, they mostly generate some cash, but they have a very low return. And so even applying leverage, which they apply some leverage all the time, they're only able to get like 8% or lower return. return on assets is less than half of what we're just looking at um every year than a company that they have the same margins as. So to give you an idea, we're looking at return on assets here of four or 5%. We were just looking at a company JBSS that's 10 to 12% and yet the margins gross and operating are the same or better here. It's just because of the very very slow turns because they have to finance all that stuff themselves. So it's not good to sit on a lot of stuff that you're paying for with C with a shareholder money which is what their entire business is based on. But like I said moat they might have a moat. I don't know that you can do better than them with the same exact kind of like not same exact but with a very similar business model. If you said I want to be in the same business by market share I think they're quite big um like really big. There was a competitor that I'm not I haven't followed, but I don't remember outside of those two that anyone would be this size. So, yeah. >> H interesting. Let's talk about uh chicken manufacturer Tyson Foods, large company, 20 billion market cap. uh return on equity 10-year median returns 16% but it has been wobbly since 2010. So what do they change after 2010 where their business the return on invested capital got a lot better? >> That's a good question. I don't know. Um their bad returns were in the early 2000s period actually basically like the boom and then after the financial crisis their results were better consistently after that um until very recently. Um, and it's you barely even notice things like COVID and stuff in that record even though that had a big impact. Um, >> you have any thoughts on Tyson? A little different than Buffett's uh take a commodity, turn it into a product, right? Like compare this to like a a Coca-Cola for example. >> Yeah, but like um it's not good. I wouldn't invest in it, but um it is overly cheap. uh this and also some other companies in the same sort of industry compared to some of the things we were just looking at in that there's almost nothing that's a halfway decent business that's valued around one times book and at those levels of EV to sales and everything as this. Um it's true that on like a IBIDA basis it looks like it's eight times or something but it's IBIDA has really ever been this low. So, um, and then like we talked about, it does have advantages over other kinds of, um, uh, o over, um, suppliers in some ways. It's a little complicated because they contract out. They're kind of captive to them. Like, for instance, it doesn't actually usually raise chickens and things itself. It produces lots of other things besides chicken. You can see in the business description, um, but other products and beef and pork basically, but um, it it doesn't it can avoid having to have those things directly on its balance sheet. So like a hatchery or something, it could be controlled by them, but it's not literally their hatchery, but it's cited near where they're going to process the um chicken, for instance. So it's kind of the opposite of UVV. Um and then you just it's more reminiscent of like uh we've talked about airlines before. Airlines are really bad business in terms of the high degree of competition. But the dynamics in terms of the turns and the margins that you have do mean that the business itself is capable of having high returns. Whereas it's hard to see how Universal would ever justify investment in that business model. Something like Tyson does justify investment in the business model except for the fact that there tends to be eventually too much competition, right? um which leads to some bad years which causes the problems when that happens. Um but in general, you know, bad years is probably when as a stock you would want to buy it. So you'd want to buy it in a bad year where it's going to improve because that's when people will give it the least amount of um multiple. I don't know what the multiple look like. We could check, but often in a business when it goes 10, 15 years with pretty consistent returns on capital, even if it's a commodity business, it starts to get a higher multiple in the market than it should really. Um so price to earnings was always low but then you see price to book varied quite a bit in price to sales. I don't think price to earnings is important for a company like this. If you understand the business model it would make more sense to value it on things like sales and book. So or like cycllically adjusted Schiller type things. You know basically you want to look at sales and then what would it look like in a year where it has more average returns than that. Um, it's more variable actually than the stock we're just looking at, but its returns over time will be better. >> You say going forward? >> Uh, yes. I believe the return on capital of Tyson Foods will be higher than the return on capital of Universal. I think it's pretty easy to tell that's going to be the case. And some of the ones we were looking at were priced even lower than that, I guess. But like it's a better business than say Fresh Delonte or Kavo or Universal or something like that. um meat processing and things is a better industry. >> Call main foods. >> Yep. >> Eggs. Shortest of Yep. Yep. Shortest of the shortest cycle there is. Right. So, >> Yep. >> Um >> long cycle assets, you get longer periods of out or underperformance. Shorter >> cycle assets like this, faster swings, right? Harder to sustain. So, >> yeah. And you generally don't have much of a change in the price. I know people write entire articles about how much the price of eggs have changed just like they do about orange juice. But honestly, in the case of both eggs and orange juice, you're being protected from a significant amount of the price swings. Actually, companies like this, grocerers, etc. are absorbing huge amounts of the swing for you and you're not seeing it to the same extent as you would in like say gas prices, you know, um gasoline prices where you're not being protected from those swings and they're just passing it through. here. They're not willing to triple the price of eggs or something when their costs triple. And so you have, you know, uh slower increases and decreases from that than what happens here, which leads to very wide returns in the years that are good here because basically um it doesn't mean that the the price collapses right away. Um but then you're followed pretty shortly by really poor returns afterwards. Um it's an interesting business. It's pretty good business. It rarely loses money and then it has a few years where it makes a ton of money with great returns on invested capital. So when Buffett talks about he prefer a lumpy, you know, 15% to a stable 10% or something, it's rare that companies that have lumpy returns actually do better. Um, some of Bergkshire's own insurance companies do. Uh, but it's super rare. And yet, this company has much higher returns on capital than other kinds of businesses. and um is often available at cheaper type prices, but you have to be careful about that because um people tend to look at like the earnings and everything, which isn't necessarily that good a way of looking at it. So the long-term average here, for instance, is like a 10% pre-tax type, you know, EVA type number, and like an 8% free cash flow number. So at price to sales of one, let's say EB to sales of one, price to sales of 1.3 is what we're seeing here on QuickFs. Um, that could be a pretty normal price, right? That could be like, okay, for a company that earns a 13% return on equity and all that, that looks good to me. Um, the issue is that it says the EV, the EBA is 2 and a half. It says price to free cash flow is like four, P is less than five. So, it shows up as being incredibly cheap, but that's because it's earning very high returns right now. It will show up in a year where it earns almost nothing as being really expensive. So you just don't you want to look only at price to book and EV to sales. It looks pretty reasonably priced on both of those. So if the long-term average return on equity is like 13% and price to book is only 2.2. If the long-term margins are 7 to 10% and EV is only one one point and and price of sales is 1 1.5 things like that compared to the market that's actually really good. So it doesn't it's not necessarily even overpriced even though it's in this incredible period of outperformance. One thing to note though is that if you have incredibly high performance in a industry like this, you could start to have people being hesitant to own the stock because they know that it's going to have bad performance and they don't want to own it during the bad performance even if it makes sense to own it for the longer term which is a thing with you know what's the share turnover in this for instance >> a ton. Yeah, 465%. >> Beta is low though because beta is a measure of both volatility and correlation. volatility of the stock's high, correlation is low. So if you want a ton of company specific risk that's not correlated to the market, you should own um CalMain. So it, you know, it would make a lot of sense in people's uh high risk, low correlation type uh uh thing. There's not a lot of stocks like that and almost none of them have good returns on capital. So actually it's kind of an interesting diversifier. I can't think of something that diversifies more and has good returns. Yeah. Would you ever say that the a company like this has a moat? >> Oh yeah, I think it has a huge moat probably. Yeah. >> So what what is that source? >> Scale. Um uh it it it's also an incredibly I don't think people want to get in this business. So >> if you can find a business that people don't want to get >> scary job. Well, but I I think well, who's going to want to put more capital into this kind of business basically is what I mean. You know, who's going to want to start up something and compete with this and say we have good for for a lot of reasons. One is that um growth attracts people generally. So, they'll go into industries that are growing whether or not there's any case for how we're going to make a lot of money eventually. And then the other thing that attracts people is sustained high returns on capital. Um, you can get fooled into thinking there's going to be sustained high returns on capital for a while. If you look here, returns were were consistently pretty good for like 10 years, right? So they looked okay to good for the 2006 to 2016 type era. Um, and so people could overdo it then, but I don't see the narrative where it's hard to explain to people that there's a lot of money to be made in eggs the way that you could explain that in all sorts of other things. So, it I just think it's uh it's more likely to be sustained than we might think um because you're like unlikely to have as much new entry into it and everything. But um you know it it's and it has the other thing honestly that's attractive about it too. Could get into this with commodities and the dangers of them and stuff over time. The most dangerous commodities to businesses to invest in are things that have long lives, assets with long lives and a long cycle. That's much more possible that you could not make money in the long run owning a stock like that than it's something that's short cycle. Short cycle is much much more uh interesting if the company has um a strong capital situation. So if you have a really short cycle and you have the best creditworthiness over time, um that's something that's really exciting versus an industry in which there's a much longer cycle because a longer cycle is not going to protect you that much even if you have the best uh even if you have a lot of advantages. So, um, it's entirely possible that this company over time will, although less, look, I don't want to be too positive on it because they'll probably have terrible results in the near term, right? It's going to have some terrible years really soon. But, um, I wouldn't be surprised that this can actually have returns on invested capital that as high or higher than say something like um, Exxon or something. So take a leading oil company over time because the problem with a leading oil company over time and maybe ESG and stuff will change with this but the problem that they have is their the lives of their assets are really long they're invest it's much more possible they could misallocate capital for the really long term and it's possible that um people could get really over excited about it and because the cycle is really long too there might not be as much advantage in having really strong situation in terms of your um uh your your capital and um financial condition because everyone is so big uh now and has more adequate access to that kind of thing. Whereas if I think the advantages of being one of the biggest companies and in something that's smaller and shorter cycle is is likely to be better. So, I wouldn't be surprised if in the long run something like Cal may outperform something like Exxon if you could get them both at the same price. But I know everyone likes something like Exxon better and it's a smoother ride, too. So, but but I mean I don't know that the riskiness is really all that different. People perceive the riskiness to be hugely different because the volatility is hugely different. But I mean, if you're a leader in eggs and you lose money this year, why are we going to have too many eggs next year? And if we have too many again next year, why are we gonna have too many the year after that? I mean, I get this question a lot like insurance. >> Yeah, I get this question insurance things because it's always been a question of like, well, yeah, but how do you know they won't lose money that year? You know, Progressive has this advantage or whatever. And I say, I I do not know, they could very possibly lose money. The question is, as long as their balance sheet looks okay, and Progressive pushes a balance sheet far, so they're not as great an example. But if you have a good enough balance sheet and you know that you have an advantage versus the industry that your combined ratio is going to be five 10 points whatever lower than them eventually they should stop writing dumb business. They might not stop immediately but they will stop. I don't know that you can stop dumb things from being done for the long term and being an overhang forever in oil. So I would be more concerned about that risk in oil than eggs. A lot more concerned. So, but you know, who knows? It also depends on the management, all those sorts of things. But if you're asking like if I want to inherit a stake in a leading egg company or leading oil company, I take eggs. But >> Mhm. So, it sounds like your favorite type of moat in these sort of companies and has some sort of scale advantage. >> Yeah, scale advantage is good. Um, something where financial condition also helps is really good. That's how many companies got their advantage in the first place. um how you build up an advantage in the early years of something that's very commodity like you get lucky, you hit something whatever, but you don't overextend yourself. You're able to take out competitors um and to then, you know, get that scale because you have an advantage like just a slight advantage in expense or something that doesn't help you in a boom. But in a bust when some people need capital and everything can't get it and they're operating at a loss or close to it and you're not. Um you can put things together that make sense for you. Um in a boom, nothing stopping anyone from being very sloppy about their operations and uh everyone's able to expand, but you're looking at the points where it's hardest for people to expand and you might have an opportunity to gain scale then. Um and that's why when you get really really big things and when the life is really really long and also when it's based on turns and not margins. So if if it is that you have too much assets versus having margins that are pretty good. Those are some of the riskiest. So take a business that is not a um commodity business necessarily but one that has scary aspects to it that way is cruise lines. It is not difficult to put a cruise ship into service that will generate cash um while it's in service. It is very easy to miscalculate and put it into service where it will not earn an adequate return versus your initial outlay to make it. And so you should never contract have the shipyard build it. You should never have taken possession of it. You shouldn't run it for 20 to 30 years, but you're going to. And then at what point do we know you'll stop doing that and the industry will get better for you, right? That's not a commodity. there other you can get other advantages in that industry but it's very hard if you're in that industry to stop over supply of these assets for a long time and it's hard in oil and gas things to stop over supply once it starts happening um you know because if you have over supply for things that on a variable basis are somewhat cash generative then they'll keep running it right um so that's the part that's that's worrying as as opposed to things that have a very short cycle. And then the other one that I would avoid is anything where the problem is generally turns. Now that can get better if you have one facility or something. So if you have so I don't know what what JBSS looked like uh 20 years ago. I don't remember it well enough to know 20 25 years ago. If it had like one facility or something that said if we can get our volume up a little bit more, you know, this will be successful. or you see this like you know some companies will open up a new plan or something and it'll take a few years for it to to work. If you get to that level then okay it starts to make sense and it the problem was turns but um in general I'd be really careful about anything in terms of a poor working capital cycle. So that's why I would avoid things like universal is not for any other reason. Even something like Stella Jones, which has much better returns, is dependent on their ability to get um to use debt all the time. And so a change in management or strategy there would be a problem. The good news about that though is that's such a moat because it's much easier to operate with a moat if you're saying well because because here's what you don't want to do and this is why short cycle is also really good. The easiest way to have a moat, whether we're talking about Stella Jones, Costco, whatever, is something companies don't like to talk about as a moat. But the easiest way is to say, I want to make a 16% return on equity every year forever. Because you'll create value for shareholders, and no one wants to get into a business that if you do really well over time, you can aspire to be making 16% a year. They want to get into a business that's making 20 30% right now, and who knows what'll happen in the future. but they don't want to uh they're not going to be attracted to a somewhat above average return that will be um continued forever. So Stella Jones is it's calculated here on QuickFs and I think it's pretty close to being the truth is the return on invested capital is 10%. Now return on assets it shows is almost 9% which is the issue. it has a high return on assets which is often a it's complicated but it's tends to be a better sign um that different management different approaches whatever can kind of fix some things if your return on equity isn't great versus your return on assets. Um it's not perfect but having very low return on assets tends to be a harder problem to fix. Um so they have a high return on assets actually even for really good businesses having return on assets of almost 10% you know 9 10% a year is really good. Um their worst year that we see is like seven that does actually with a little leverage you still get a decent return. Um so it just shouldn't attract a lot of people because one you have to split the business with them you know um so you're unlikely to be as good and this is why we see with like gross margin they're right there at the same levels we were talking about before of 20%'s a good year but they're able to turn that into an operating margin of 10 to 15%. What attracts in my experience what attracts new entrance is one sexiness right but then if we put that you know one which is hard to define what that means but that narrative one that doesn't have to do with the numbers aside it's rapid revenue growth especially volume growth um and high gross margins um so if you have lower gross margins and higher operating margins and if you have faster turns that that's usually not doesn't attract them as much. They really like to see very high gross margins even though when they talk about other things um it's high gross margins and high revenue growth that are kind of the things that tend to attract. Um so if you can build a business on more reasonable gross margins um and consistency in how you make money every year then you're okay. Um, the Stella Jones business wouldn't be very good if it wasn't for the extreme consistency. Um, which you can see there. Yeah. But that's because they basically have the same customers year after year who have the same replacement needs for most their business. For like 80% of it, it's a replacement supply. >> Got it. Cool. Well, I want to thank every so much for tuning in with the both of us on the Focus Company podcast. So, if this is the first time you're joining us, be sure to hit the subscribe button wherever you are listening or watching us here today. Uh, and of course, if you want to get uh access to QuickFs and you decide you want to sign up, uh, you could either go to the about section and click that link or just let them know about Focus Compounding when you check out to help support everything that we do on the podcast. I want to thank everybody so much for all the support and we will see you in the next podcast. Take care.