Achieving low-cost producer status entails realizing economic economies of scale, wherein a company produces more units at a lower cost than its competitors.

Low cost lollapalooza

Various factors contribute to driving down costs per unit, including geographic location, production efficiency, distribution networks, vertical integration, marketing and advertising, expertise, and capital structure. Companies often employ strategies such as owning platforms, engaging in vertical integration, and leveraging marketing expertise to spread advertising costs over a large number of product units. Examples of successful companies benefiting from low-cost manufacturing and economies of scale include Amazon, Alibaba, and eBay, demonstrating the enduring nature of this competitive advantage.

The holy grail of moats

With the exception of high-tech industries (where a new innovation can change the entire structure of the industry), this is one of the surest competitive advantages to last for a long time.

Companies attain the status of low-cost producers through the achievement of economic economies of scale, wherein they produce a greater quantity of units at a lower cost than their competitors. Various manifestations of economies of scale contribute to reducing the price per unit, including Location, Production and Distribution.

Location, Production, Distribution, …

1. Location:

Geographical advantages come into play when a company can easily connect with customers or reduce operational costs. This advantage is challenging to replace and provides a significant edge.

2. Production:

The standard example involves producing the maximum number of units at the lowest possible cost. Large factories seek to distribute their fixed costs over a vast quantity of products.

3. Distribution:

Establishing a network of distributors, either in terms of total volume or concentrated within a specific geographical area, exemplifies economies of scale. Historical examples include the East India Company dominating major sea routes, and contemporary instances include Amazon, Alibaba, and eBay.

In Summary:

Finding the low-cost producer is always a good investing strategy. But it can be hard for growth-stocks and new industries because they are typically funded with venture capitalists and other types of private investors, which allows them to break-even or lose money for a long time in hopes of gaining a dominant market share.

The easiest way to apply the idea of low-cost producer in investing is in commodity stocks (precious metals, coal, oil, uranium, etc.)

For example, the low-cost producers of oil worldwide are Sinopec and Petrobras. And they were both great investments a few years ago (high dividends, low downside). But now the geopolitical risk has increased for both and the dividends are reduced, so the risk/return isn’t necessarily as appetizing.

[This investment in Petrobras A yielded 100% total return over roughly 1 year, when combining stock appreciation and dividends of around 30%.]

I made it because Petrobras is a low-cost producer of oil, looked cheap on a historic basis, paid a large dividend, and therefore believed it might therefore be re-rated upwards in terms of its valuation multiple. That happened.

/Ludvig Sunstrom

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