What are Commodities in Stock Trading?
The English language is a very complex tool that can confuse many of those who are learning it as a second language. Nuances such as the difference between “minute” as in time, and “minute” as in small will easily confuse even native English speakers. The fact that there are multiple definitions for the same word as well as different pronunciations can lead many people astray, and one particular word in stock trading that has no very important meanings is the term “commodity.”
What is a commodity?
When we hear the term “commodity” many of us think of gold prices, corn prices, pork belly prices, coffee prices, oil prices, and other physical properties that are used as raw materials. Commodities in economics have a much broader meaning that applies to any good or service available that satisfies a want or need, and using this definition to analyze companies will help you develop a great understanding of the competitive advantage of branding – You don’t care who made the plastic wrap that goes around your new pack of gum, or who created the thread that lines the clothes you’re wearing right now. Despite their seeming triviality these companies are a crucial part of the whole of the product making process and without them you wouldn’t have many of these unbranded goods.
Price is the biggest driver in deciding who to purchase a commodity from and therefore creates a highly competitive atmosphere between firms that can only be won by the most efficient and economically savvy player.
How do you identify a commodity firm?
Some characteristics of commodity firms are those that produce goods that you could care less where you’re getting them from as long as the end result is what you expected. Do you care if the plastic that was used to create the media device you’re currently on was produced by Plastic Makers of America , Inc., or American Makers of Plastic, Inc.?
Thin Profit Margins
Go to the public records of the company you’re currently considering and see what its current profit margin is (A great way to figure this percentage out is by taking the average Operating Income, or the average Net Income and dividing it by the average Revenue over some amount of time). Most commodity goods are heavily competed for and rarely generate a good profit margin percentage over, or even close to 10%. Despite it being the largest retailer in the world with $421 billion in revenue, Wal-Mart has a very small 6% profit margin.
They Sell a Commodity Good
The most obvious sign is when the company in question sells something you know for sure is a commodity, such as corn or aluminum. The largest steel producing company in the world is ArcelorMittal and, you guessed it, they produce steel with a low profit margin of 5%.
A Low P/E
Despite the two examples above, Wal-Mart and ArcelorMittal, many commodity good companies have very low price to earnings ratios. Financial analysts will say that this is most likely due to the nature of commodity companies and their operating in highly competitive markets.
Be careful while you navigate the stock picking landscape because you are more likely than not to run into a commodity firm, and they have to be priced at a discount in order for it to be worth the investment due to the level of risk you are purchasing. A low P/E, the production of a commodity, and low profit margins are sure signs that you have come up to a commodity good business and you can skip over them.
Photo credit digitalmoneyworld.