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Collection: Mohnish Pabrai - #35 'How To Evaluate Commodity Business?'



That's a very good question.

In fact, I did not understand that much about commodity-based businesses till late 2008. And it dawned on me at that time when I'm looking at numbers of these businesses that commodity-based businesses can have incredible moats.

In order for them to have incredible moats, they need to be low-cost producer. So most commodities, you know, they talked about which quartile of cost they are in. So you know, the bottom – So let's take not the company with the ticker symbol ZINC but let's take the commodities 'zinc' for example.

So if you look at the commodities zinc, the lowest cost producers on in the world who have the lowest cost mines, the bottom 35% of production may have a cost of – let's say, $0.40-$0.50 a pound.

The next quartile which is the 25% to 50% producers may have a cost of production of – let's say, $0.60-$0.70 a pound. Then the third quartile, you might get to $0.70-$0.80 a pound. And the fourth quartile, you might get to maybe close to $0.90 a pound, $0.85-$0.90 a pound.

And so if you are trading – if zinc is trading like it's trading right now about $0.85 a pound. And of course, there are zinc producers who have a cost of $1.00 a pound. There are zinc producers who have a cost of $1.25 a pound, $1.50 a pound, you know, it just goes on.

You can have parts of Earth where you can produce zinc, but it's very expensive. And of course, all those guys who have cost about $0.80-$0.90 a pound. Unless their marginal cost for producing zinc are very low, they pretty much have to shut down production at present prices. They are not able to produce because they will lose money on every pound they produce. So those mines are [Inaudible], if you will.

And so if zinc demand increases, you know, the price might go up to $1.00 or $1.05 or $1.10 a pound and more production may come on line. The person who has the greatest spot in that business is that mine that's producing at $0.40 or $0.50 a pound.

So that mine is going to make money day in and day out. They're going to make money no matter pretty much what's the state of world economy is, because you know, even if production dropped, even if China goes into a tailspin, all kind of things happened. It's still unlikely you get less than $0.50 a pound.

And so if you owned a commodity business where you are the low-cost producer and you have some pretty significant volume you can bring on at that low cost, that is a fantastic business. That is a business that has as much of a moat as Coca-Cola has or GEICO has for example, it is an enduring durable competitive advantage.

And so when I looked at commodity businesses, one of first thing I looked for is what quartile are they in? In their production?

And if they are generally speaking and of course, you also has to look at the [Inaudible] continuum of where commodity prices are. So like for example in 2008, when we are making these commodity investments, most of the investments we made were in businesses that were first quartile producers.

And in fact, prices had come down to the point where they were barely making money. But it was clear to me that at some point the economy would start functioning again. The world would go from a standard, you know, completely stalled economy situation to a working economy globally. And as soon as you got to working economy globally, those prices would raise. And then these low cost producers go from making way little money to making lots of money.

And of course, when they got to making very little money, their stock prices absolutely collapsed. I mean they collapsed to the point like in – there was a company Teck Comico in Canada, blue-chip miner, they are like the IBM of mining. Their stock price went from $50 to $4 in about 4 months because of the – they have some specific dynamics with leverage that was causing stress for them.

But also commodity prices had come down a lot but they had some of the lowest-cost mine in the world. And so they had incredible assets and in fact, we invested at those $4-$5 prices. And eventually the business was went up to $40-$50 and not that long a period.

And so yes, I think that you know when we were talking about expanding circle of competence. I did not understand commodities very well before 2008, I got a lot much better understanding and I do feel that I got some, let's say, tools in my arsenal now which helped me understand commodity businesses.

Which I didn't in 2003 or 2005 so that is somewhat helpful in the future and such. And the same with you know, when I studied like Autos like GM and such. I understood some dynamics about the auto business that I never understood before, with again give me some – hopefully, it will give me some advantage over time.


[YAPSS Takeaway]

1. The durable competitive advantage of a commodity-based business is being the lowest cost producer.

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