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How to Find a Super-Company: From Its Products

Four years ago, when I read the company's financial statements for the first time, I assumed that the performance of property companies will be much better than companies in other sectors. Because a property company selling the houses, offices, apartments etc. that the prices are high, even reaching billions of Rupiah (about US$ 100K) per unit, so that the company’s revenue was definitely big. While for companies such as Indofood, for example, how much the profit from selling Indomie at a price of Rp1,000 per pack? (in the year 2009, the price of Indomie was still around Rp1,000 per pack, or about US$ 0.1). From the appearance of the salesmen, we can see that property agents usually wear suit, aka far more convincing than old woman with pajamas who selling Indomie in grocery stalls.

But after checking the financial statements, I found out that the net profit/return on equity (ROE) of Indofood was far greater than the net income of some leading property companies, such as Bumi Serpong Damai, Lippo Karawaci, and Summarecon. Okay, in the year 2009 the property sector wasn’t yet booming as it is now, but even at this moment, when several property companies began to made its ROE above 20%, but still, their performance in general has never been better than the companies that selling 'low price products' such as Unilever, Mayora, Kalbe Farma, and Indofood CBP. You can see for yourself, the most expensive products that are sold by Unilever is the shampoo with brand TRESemme, at a price of only about Rp16,000 per medium size bottle. While Bumi Serpong Damai? Its ‘cheapest’ products are small houses with a price of Rp250 - 300 million (about US$ 25 – 30K) per unit, in the Kota Wisata Bekasi.

But the point is, how can a product that sold at a very low price can be more profitable than expensive products like properties? And the answer, which I am sure you already know, is located in the turnover! A property company may not be able to sell apartments every day, and its market share is also limited to the location of the apartment itself. While consumer goods company that sells soap, dish soap, and shampoo, they could sell their products everyday, anywhere, and to anyone, depending on the ability of its distribution network. When someone uses the  ‘Lifebuoy’ soap (one of Unilever brands) for example, and he liked it, then in the future he will be back to buy the soap continuously. So although profits from the sale of a bar of soap is small, but what about the accumulated profits from the purchase that repeatedly and continuously by thousands or even millions of customers?

Meanwhile when someone buys a house then feel it comfortable, it does not mean that tomorrow he will buy another house. Not just a house, when someone buys a car and was satisfied with the car, it does not mean he will buy another. The point is, for a company that sells products with a high sale price, then although the profits generated by a single sale may be quite large, but the turnover/sales volume is usually much smaller than the sales volume of fast moving consumer goods.

And based on my experience so far, the performance of the companies that sell low price products almost always better than the companies that sell high price products. In general, the following are the criteria for companies that have good and consistent financial performance (thus the shares are worth for investment), when viewed from the products sold by the company. The following criteria are sorted by priority.

1. Low/Cheap Price of the Products

We have discussed about this above. Low prices also cause the products to be affordable to all segment of people, so its market share is automatically broader than products with higher selling prices.

But is 'cheap product' always means products of daily needs such as soap and shampoo? Fortunately not. When you open a savings account at a bank, then you are only charged an administration fee of US$ 1 per month, so you can say that the banking services are including low cost products. When you watch television at home you may gain a lot of shows, movies etc., and instead of paying, you just have to watch the ads. So the television/media companies are also selling cheap (or even free) products. And when you pay a fee of US$ 10 per month for your telephone and internet (for school children, there is also an interenet package of only US$ 2.5 per month), then the telecommunication companies also includes companies that sell low price products.

Obviously there is an element of subjectivity in describing 'cheap' or 'expensive' here. You probably have no problem to pay US$ 10 per month for the cost of the internet, but for others it could be a large amount of money. That's why when a company sells products at a low price, it does not (yet) mean that the company is offering a good and consistent performance over the long term, unless the product meets the following requirements:

2. The product is needed continuously by a lot of people

Have you ever bought superglue, for example, to repair your flip-flops? I have. The price? It was low, less than a Dollar in the grocery shop. But if you ask how often I buy the glue, then the answer is: In my life, I only bought it once. Maybe if later my sandal is broken again, then I’ll buy another glue, but for today I don’t need it anymore.

So, even though the price of the glue is cheap, but the sales turnover is not as much as soap or instant noodles (which people buy it almost everyday). Everyone would need a bath, but not all people need to fix something with glue. And if people need a bath every day, then someone with broken flip-flops did not have to fix his flops every day.

This point of 'needed continuously by a lot of people' is, in some cases may be more important in determining the consistency of financial performance of the company (that produce the products) in the long run, rather than just a low price of the product. For example, you may know that the investment in the gas station, even though it requires high investment value and also does not offer the break-even point in a short time, but it offers a consistent income as well as low risks. This is because all the people, either directly or indirectly, require gasoline and diesel continuously, no matter how much it costs. You can see, although the price of gasoline is keep rising overtime, but the level of fuel consumption never fell. If the price of gasoline was raised from Rp4,500 to Rp10,000 per liter, for example, then the people will still buy it.

In this case, the subjectivity on whether the price of gasoline is considered expensive or cheap, it's not important anymore. Because if you consider that the price of gasoline is expensive, you'll still buy it anyway, as your car/motorcycle might not filled with water.

3. Could be mass produced at low costs

When the price of a product/service is affordable to all people, and it takes a lot of people continuously, then the product only needs one more condition to be able to generate large sales turnover for the company in question, namely: Can be produced in mass quantities. I mean, how could your company sells one million bars of soap per year if the production capacity is less than that?

But fortunately for companies that produce the goods such as natural resources, pharmaceuticals, cigarettes, cement, etc., the production volume is usually large. If the products are services, such as banking, insurance, media, the quantity of production could be even larger. To provide banking services in a district, for example, then a banking corporation could simply open a branch office there, so the marketing team could offer savings and loan services to the surrounding communities.

But when a product can be mass produced, so that the sales turnover became large, then it does not mean that the company in question would make huge profits, unless the company could suppress the production costs so its net profit margin become huge.

Therefore, the final condition of an ideal product is can be produced at low costs. If you look at the Indonesia Stock Exchange, there are several sectors which have low production costs (could be seen from their net profit margin that is large). They are the consumer goods, banking, financing, insurance, cement, animal feed, coal mines, oil palm plantations, and automotive and components.

While other sectors have lower profit margins on average, including property and construction sectors. For some sectors such as basic industry and manufactures, the margins are relatively small because they have to import their raw materials at a price that is quite expensive, because the domestic industry has not been able to supply.

On the other hand for some specific sectors, their large margins can be lower at any time when their revenue drops because of the falling price of the products. For example, the coal sector, where the price of coal in the last two years continued to fall to a level where the cost of production was almost bigger than the value of coal itself. That’s why Warren Buffett does not like commodity stocks, because its profit margin is not stable in the long term.

Okay, I think that's all. Thus when you want to buy a stock for long term investment, then try to learn the type of products of the company. Is it cheap? Is it affordable to all segments of customers? Is it takes a lot of people continuously? And can be mass produced at low costs? You may check the company that their products/services meet the above criteria, usually their fundamentals are excellent.

Then about the example of companies with ‘perfect products’, you must be already know. But here I will give one example of a company that is not listing here, but in the Nasdaq Stock Market in the United States, namely Google, Inc. Well, check this out:

  1. The price of products/services: Not only cheap, it’s even free! More than 90% of Google's products can be obtained/used by people all over the world for free. And even for the pay products, the price is never too high, but only in the range of US$ 5 - 25 per item (on average).
  2. It takes a lot of people constantly: When someone starts using the internet, he will surely uses the services provided by Google continuously, ranging from search engines, email, Youtube, Google Map, Google Earth, etc.. Even the website you are now reading is using one of Google's services, namely Blogger. And yes, I use it every day without rest at all.
  3. Can be mass produced at low costs: If Indofood may be dizzy when the price of wheat rise, then Google did not have to worry about the cost of 'raw material' in the making of their services, because their various kinds of services can be obtained/used by all people throughout the world. Google's biggest costs are only for the research and development of the products. But once the product is finished and functioning, then the company would gain the income almost without the cost of production at all.

Because their products are perfectly meet the three criteria above, then it would not be a surprise if Google become one of the most 'magic companies' in United States and even in the world, because on the other side the company is managed by brilliant owners. In 2009, its stock price was US$ 400 per share. But now? Already more than US$ 1,000! If you like to invest in overseas, then Google is one blue chip stock that you may consider.

Unfortunately, when a company’s products meet the above criteria, then the share price is usually too expensive, because the company generally has excellent fundamentals. Google itself, at the share price of US$ 1,011, its PER reached 27.5 times. And of course, it is hard to say that Google is a value stock.

A collection 'cheap products' produced by 'expensive company'. You do not need to guess, what company it is.

That's why I’m not too hard when implement the above three criteria in selecting stocks, but gave some tolerance. For example, for a phone credit retailer company like Erajaya Swasembada and TiPhone Mobile Indonesia, as we’ve discussed in last week's article, the price of the products is cheap and it takes a lot of people continuously. On the other hand the cost of production is very expensive because the companies buy the phone credit/vouchers from other companies, not produce it themselves.

But because the share prices are make sense, then the shares are still worth to invest. Even in the case when the valuation of a stock is really undervalue, we do not longer need to pay attention to whether the products of the company meet the three criteria above or not, as long as the profitability and other indicators are good. On the other hand if you find a stock with low numbers of PER, PBV, and dividend yield, while the products sold by the company meet the three criteria above and the company itself have fairly good fundamentals, then what are you waiting for?

Original article written at October 21, 2013

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