Commodity Businesses, Holding Margins, and Incentives

Over the past few months I’ve been carefully reading Warren Buffett’s past annual letters to Berkshire Hathaway shareholders. Buffett has great insights on successfully managing a commodity business (1) by holding margins and avoiding unprofitable business and (2) by creating the right incentives. Below are some of the most enlightening passages broken down by year, with my comments in italics.

2004 Annual Letter

“Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies (‘owned’ by policyholders rather than stockholders) with profit goals that are limited. Moreover, most insureds don’t care from whom they buy. Customers by the millions say ‘I need some Gillette blades’ or ‘I’ll have a Coke’ but we wait in vain for ‘I’d like National Indemnity policy, please.’ Consequently, price competition in insurance is usually fierce. Think airline seats.”

This is one of the best definitions I’ve read of a commodity business: a standard/uniform product across the industry, lots of suppliers of this standard product, and customers who “don’t care from whom they buy.” The less these conditions apply, the more pricing power a company has.

“So, you may ask, how do Berkshire’s insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage? We’ve attacked that problem in several ways. Let’s look first at NICO’s (National Indemnity’s) strategy.

When we purchased the company — a specialist in commercial auto and general liability insurance — it did not appear to have any attributes that would overcome the industry’s chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. . . .

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. . . . Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers — but they left us. . . .

Finally, there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing, telling themselves that poorly-priced business must be tolerated in order to keep the organization intact and the distribution system happy. If this course isn’t followed, these employees argue, the company will not participate in the recovery that they invariably feel is just around the corner.

To combat employees’ natural tendency to save their own skins, we have always promised NICO’s workforce that no one will be fired for declining volume, however severe the contraction. . . . NICO is not labor-intensive, and, as the table suggests, can live with excess overhead. It can’t live, however, with underpriced business and the breakdown in underwriting discipline that accompanies it. An insurance organization that doesn’t care deeply about underwriting at a profit this year is unlikely to care next year either.

Naturally, a business that follows a no-layoff policy must be especially careful to avoid overstaffing when times are good.”

So here you see how Berkshire has used incentives — a no-layoff policy — to avoid unprofitable business and maintain underwriting margins even if it means declining sales. Through these incentives, and through its willingness to suffer long periods of declining sales, Berkshire and NICO have created a unique business model and business strategy that competitors are unwilling or unable to copy. This is consistent with Michael Porter’s belief (1) that companies should compete to be unique and (2) that they shouldn’t try to grow sales at the expense of a unique, profitable strategy.

“Another way to prosper in a commodity-type business is to be the low-cost operator. Among auto insurers operating on a broad scale, GEICO holds that cherished title. For NICO, as we have seen, an ebb-and-flow business model makes sense. But a company holding a low-cost advantage must pursue an unrelenting foot-to-the-floor strategy. And that’s just what we do at GEICO. . . .”

So if you’re in a commodity business and are not the low cost operator (NICO’s situation), you can stay profitable (1) through incentives that maintain healthy profit margins and (2) through tight cost control (especially with new hires). If you’re in a commodity business and are the low cost operator (like GEICO), it’s essential to always look for new ways to drive costs even lower.

“Reinsurance — insurance sold to other insurers who wish to lay off part of the risks they have assumed — should not be a commodity product. At bottom, any insurance policy is simply a promise, and as everyone knows, promises very enormously in their quality.”

This is another great snippet about how Buffett distinguishes a commodity business with no pricing power from a non-commodity business with lots of pricing power. When the quality of the product or service matters to the customer, and this quality varies across the industry, then the product or service isn’t a commodity and the seller has pricing power.

Property-casualty insurance sold to the individual insured is a commodity because policies are standard and customers aren’t concerned about the insurer’s ability to pay a claim. Reinsurance isn’t a commodity because property-casualty insurers can only lay off claims exposure — through reinsurance — if the reinsurer is financially sound and the reinsurance promise is “high quality.”

2003 Annual Letter

“Our [insurance] results have been exceptional for one reason: We have truly exceptional managers. Insurers sell a non-proprietary piece of paper containing a non-proprietary promise. Anyone can copy anyone else’s product. No installed base, key patents, critical real estate or natural resource position protects an insurer’s competitive position. Typically, brands do not mean much either. The critical variables, therefore, are managerial brains, discipline and integrity.”

Another excellent, succinct definition of a commodity business: a product that’s easy to copy, with no installed base and no patent protection.

2002 Annual Letter

“On another front, Gen Re’s underwriting attitude has been dramatically altered: The entire organization now understands that we wish to write only properly-priced business, whatever the effect on volume. Joe and Tad judge themselves only by Gen Re’s underwriting profitability. Size simply doesn’t count. . . .

At GEICO, everything went so well in 2002 that we should pinch ourselves. Growth was substantial, profits were outstanding, policyholder retention was up and sales productivity jumped significantly. . . .

Randy Watson at Justin [Shoes] also contributed to this improvement, increasing margins significantly while trimming invested capital. Shoes are a tough business, but we have terrific managers and believe that in the future we will earn reasonable returns on the capital we employ in this operation. . . .

Bob Shaw and Julian Saul are terrific operators. Carpet prices increased only 1% last year, but Shaw’s productivity gains and excellent expense control delivered significantly improved margins. We cherish cost-consciousness at Berkshire. . . .”

These quotes all emphasize the importance of avoiding unprofitable business, retaining and keeping customers happy, and increasing productivity while tightly controlling costs.

2000 Annual Letter

“Despite State Farm’s strengths, however, GEICO has much the better business model, one that embodies significantly lower operating costs. And, when a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important. This enduring competitive advantage of GEICO . . . is the reason that over time it will inevitably increase its market share significantly while simultaneously achieving excellent profits. Our growth will be slow, however, if State Farm elects to continue bearing the underwriting losses that it is now suffering.”

This quote is interesting because it notes how sales growth can suffer due to unprofitable competitors. Buffett seems quite alright with this — he prioritizes profits and a reasonable return on invested capital over sales growth.

Many companies seem to reverse this, prioritizing sales growth over reasonable profits. Some of these companies — Uber, Tesla, etc. — are losing popularity as investors realize they’re subsidizing unprofitable, unproven business models through multiple rounds of equity fundraising. Investor tolerance for these losses runs contrary to Clay Christensen’s advice: in deciding whether to pursue a new business model, Christensen recommends companies be impatient for profits and patient for sales growth.