Why Buffett Won't Invest in Commodity Companies

The Oracle of Omaha has been quoted many times stating that he does not like to invest in companies that rely on commodities as a main source of income. Having said that, this has not stopped him from directing Berkshire's cash to companies such as ExxonMobil and ConocoPhillips in the past. Of course, Buffett's Conoco bet led to a $1 billion loss, leading the sage himself to openly admitted that the Conoco investment in particular was a mistake. 

So why does Buffett like to stay away from commodity companies? Well, the answer becomes pretty clear we we take a quick look at the erratic earnings of companies that rely on commodities as their main source of income.

Buffett's first rule of investing is "never lose money." Rule two is "never forget rule 1." In effect, these rules imply that you shouldn't gamble with money. Unfortunately, investing in the commodity markets is gambling to an extent, as no one is able to accurately forecast the price of commodities over time. What's more, without the ability to accurately or reliably predict commodity prices, companies that operate in this space have no way of maintaining a wide profit margin and are at the mercy of the market. Right now, the best example of this is the gold mining industry.

Consider CONSOL Energy (NYSE: CNX  ) , the largest U.S.-based company in the basic resources sector.

 

2008

2009

2010

2011

2012

Revenue

$4,270

$4,360

$5,010

$5,960

$5,020

Gross income

$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: MarketWatch.com. Figures in $US billions.

Consol produces coal and gas, both of which have seen their prices come under pressure during the past five years. As a result, Consol's net income has fallen 12% during the five-year period and both its net and gross margins have been erratic to say the least. Because of this, the company lacks any clarity regarding its financial outlook.

Source: InfoMine.com. The collapsing price of thermal coal has been outside of Consol's control.

In comparison, consider the financials for Buffett's core holding Coca-Cola (NYSE: KO  ) over the past five years.

 

2008

2009

2010

2011

2012

Revenue

$32

$31

$35

$47

$48

Gross income

$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: MarketWatch.com. Figures in $US billions.

Coke's ability to set the prices on the products it sells means that it has been able to keep its gross profit and profit margin steady. In addition, a steady gross margin has resulted in the company's net and gross incomes grinding steadily higher along with revenues -- something that Consol has not been able to achieve. 

Buffett's mistake
Warren Buffett famously doubled his stake in ConocoPhillips back in 2008, right before the price of oil plummeted (along with the stock market). Volatile commodity prices hurt all commodity companies, no matter how big or influential they are. Chevron (NYSE: CVX  ) , one of the largest international oil and gas companies in the world, was hit hard by the oil price collapse, and the company's revenue is only just now getting back to levels seen before the crash.

 

2008

2009

2010

2011

2012

Revenue

$255

$159

$190

$237

$231

Gross income

$52

$46

$59

$73

$52

Gross margin

20%

29%

31%

31%

23%

Net income

$24

$11

$19

$27

$26

Net margin

9%

7%

10%

11%

11%

Source: MarketWatch.com. Figures in $US billions.

Despite the company's size, Chevron's revenue collapsed 38% between 2008 and 2009. Furthermore, the company's fiscal 2012 net income was only 10% higher than that of 2008 and 4% lower than fiscal 2011. The company's gross income has been highly varied over the period, as has the company's net income. 

Source: Google finance. Chevrons stock price compared to Dow Jones-UBS WTI Crude Oil Subindex.

If we compare Chevron to one of Buffett's other key holdings, Wells Fargo (NYSE: WFC  ) , we can see a trend similar to the Coke vs. Consol comparison shown above.

 

2008

2009

2010

2011

2012

Operating Income

$6

$20

$22

$26

$29

Net Income

$3

$12

$12

$16

$19

Source: MarketWatch.com. Figures in $US billions.

Wells expanded rapidly through acquisitions during 2008, but since then the company has grown steadily. Operating and net incomes have marched steadily higher, and the company has clarity on where its going. It also has control over the prices that it can charge its customers to maintain a stable and wide profit margin.

All in all, there are three key points to keep in mind here:

1. Over the long term, the price of a commodity is unknown.

2. Commodities will run out, and if the company does not evolve then it will have nothing to sell.

3. Commodity companies have no pricing power, so if costs rise the company's margins rapidly fall.

These three key points make commodity investing look highly speculative. That's why Buffett avoids commodities: They are just too speculative for him. 

A stock Buffett wishes he could buy
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