Monday, April 18, 2011

Invest in a product, provide a service

Hey guys,

This week I would like to discuss some more important distinctions that are found when selecting companies to invest in.  I have already discussed competitive advantage at some length and I encourage you to go read that article if you haven't yet.

Today I would like to discuss something that will make you and save you a lot of money.  Presuming you are on the same quest I am on, you want to 1. Get richer and richer 2. Learn more about money and 3. Become a better businessman.  I endeavor to cover all of these in this article, so read on, this is going to be a good one!

I want to talk about the distinction between a goods producing company and a service providing company.  We know that these are the two distinctions of a business today.  All businesses either produce a product or provide a service, or some combination of the two.  Be aware of which one your favorite companies are providing, because I will tell you now that it makes a huge difference in the quality of the investment you are acquiring.

Let me first start by talking about service companies, and why I suggest starting one over buying one.

In the most basic sense, when you apply for a job and work for someone else, you are providing them a service.  The service you are providing them is your labor, and they pay you for it.  The success of your company, that is, selling yourself as an employee to a potential employer, is the result of two things:  Firstly, your reputation and branding (What is on your CV and what your references say about you, how you come across in the interview), and secondly, the price you charge (how much salary you demand.)  This remains true for more complicated service industries as well.  Let us look at the next layer:  Suppose you decide to start up a tutoring business as the only tutor.  Like the employee in the first example, you are providing your own labor, but the conditions have changed slightly:  Instead of having one client (your boss) that consumes all of your labor, your labor is divided among many clients (those being tutored by you).  The tutoring business is, for this reason, is a preferable structure.  Having a diversity of clients means your risk of catastrophic loss is less, as it is better to lose one student than lose your only client as an employee ("You're fired!").  These sorts of one employee businesses are an excellent way to generate income by cheerfully giving your talent to the world.

From here, the service business grows in scope.  This blog, for example, is a service business.  The idea behind it is to provide a bit of interesting insight to as many clients as possible.  Most of the internet is structured this way, attempting to having a small connection with as many people as possible.  Thus internet business finds itself a cozy bedfellow with another industry that follows the inverse structure: the advertising industry provides the attention of many to the benefit of a few clients.  Because of this, the fusion of internet and advertising has occurred effortlessly.  You could easily look at Google as an ad company, not a search engine provider, as most of their revenues are derived from their AdSense program.

Services get larger and larger in scope.  Microsoft is a service company.  They do not provide a product, as such, but instead provide lines of code that result in the Windows operating system.  The big four accounting firms are all service businesses.

And many service businesses have, in fact, made pretty good investments.

And yet, I am here to say that investing in a service business is far riskier than investing in a product producing business.

As a value investor, you will leave certain opportunities to others.  It is okay that we would never have invested in Microsoft or Google, even if it would have made us a fortune.  For every Microsoft, there are many VA Linuxes.  For every Google, there is an Alta Vista.  The biggest mistake that rookie investors make is that they look for that "next big thing."  This is a hazardous land to play in as an investor, and is not actually investing at all: it is speculation.

A goods producing company relies on a brand/reputation and a competitive price as well.  Let us presume that the quality of the product is "covered" by the brand/reputation category (a large presumption, I know, but for our sake we will imagine that if a product is bad, its reputation will also be bad.)  In this case, there is another factor that I would like to talk about, which I touched on briefly in my competitive advantage article, which is economies of scale.  To explore this more in depth, let's buy a soda syrup factory.

Suppose this factory requires 8 employees to run, all of which require $100 per day.  The factory needs electricity, cooling systems, and utilities:  And all this costs another $1,000 per day.  There are other associated costs with the factory that (conveniently) add another $200 of charges per day.  Our total costs, even if we don't produce anything, is $2,000 per day.

Every bag of syrup we produce costs us 5 cents, and we sell it to bottling companies for 20 cents, which gets us a profit of 15 cents per bag.

Now, let us imagine the difference between our factory (A regional brand that sells 15,000 bags of syrup a day) vs. Coca Cola which sells 100,000,000 bags.)

We cannot compete with Coca Cola on price.  Their brand/reputation is clearly better than ours.  And now, look:  When we sell 15,000 bags at 15 cents profit, we make $2,250.  Once we take away the fixed costs of $2,000, we are left with a meager $250 per day.  Coca Cola can make $15,000,000 per day, given the scenario above.  When we extract the $2,000 from this, it has very little impact at all. Coca Cola could, if they wanted to put us out of business, lower the cost of selling the bags of syrup to 10 cents.  If they chose to do so, we would only make $750 per day if we adjusted price to keep up, in which case we would have a negative profit after our fixed expenses were removed and we would have to close shop.  We are in a very dangerous position, and Coca Cola is in a very strong position.

As value investors, we look for the companies that provide us not only steady returns, but those with the returns least likely to be put in jeopardy.  There is an ancient Chinese game called "Go", and I encourage all of you to learn how to play it.  The object of Go is to claim territory by strategically deploying yourself on the board.  The amazing thing about Go is that each move is so simple that it causes you to train an ability that often goes untrained: your foresight.  Once you become good at Go, you can see the paths of possibility that result from moves that are played.  This is a tremendously helpful skill in security analysis, as we are often required to imagine scenarios and what their results would be on our investments.  Coca Cola lowering their price to defeat us is an offensive maneuver, and one we cannot counter.  Because here today we have explored this path, we can decide not to purchase the factory in the first place, even if it appears profitable from their income statements.  We have seen that we would be playing a futile game, and can instead focus our efforts elsewhere.

Remember, business is not just a collection of financial statements.  The financial statements are the score at the end of the day, and business is the game.

When contemplating companies to start, then, consider starting the company in an industry where much of the success relies on the quality of the service.  And then, provide the best damn service you can!  Jobs that are good to create for yourself include graphics designer, tutor, masseuse, a tradesman (locksmith, electrician, etc.), and so on.  The good news is that no matter what your educational background or interest, there is some service that you can provide based on it!  Yet, these businesses are not scalable.  If you hire another masseuse, you will only profit from what they make less the salary you pay them.  If you want to crank out an additional 200 surfboards in your surfboard factory, you make far fewer concessions.  So, once you generate sufficient income from the service you are providing, consider investing some of that money in an existing goods producing company with excellent competitive advantage.

Long story short:  Make money with your service and invest in a product.

I hope you enjoy having read this article!  I feel as if I have outlined some useful tips for early success for an aspiring businessman.  I am speaking from experience here, having tried to break into producing a product and I found the endeavor to be a horrible mess!  I do not wish this fate upon you, dear reader, and while new products come out all the time, ask yourself how many are being made by a start-up in his garage and how many are being mass-produced by a multinational corporation?

There is no reason to play a game where the odds are already against you.  So start a service, but on the flip side of that, invest in that goods producing company that would pound you into the ground if you tried to compete with them.  If you do plan to invest in a service business, ensure that they are sufficiently protected by reputation to do so:  Insurance companies, for example, may be service based, but they are not necessarily a bad investment because insurance is so directly related to trust and reputation have lots of regulations that keep new competitors out, along with high capital requirements.

Feel free to comment about your experiences with product producing and service providing companies!

See you next week.


  1. Product producing shouldn't be looked down upon so much, I think you could do it if you excluded sleep from your life and dedicated your life to it. Just like they did.

    But investing in a product is 100% sound advice.

  2. What if your service is your product.