While the goal of any business is to generate profit, some of them do it more consistently than others. In Canada, the average investor has been led to believe that a broadly diversified “buy and hold” approach to investing is a good long term strategy for portfolio growth. However, as many have learned the hard way over the last twenty years, what’s good advice for our US neighbours is not necessarily good for us. As Canadians, we’re stuck with a lot of companies that don’t necessarily make for the best long term holdings. Here’s why:
In 1998 business authors Pine and Gilmour wrote a landmark book that changed the way investors understand prices and products. Their study of economic history through agrarian, industrial, and service economies provides a lens through which investors can better understand which companies can generate higher profitability than others. Illustrated in their chart below, businesses can be grouped into one of four broad categories: commodities, goods, services, and experiences.
Commodity businesses extract raw materials from the natural world. Goods businesses process the raw materials for consumption. Service businesses increase the accessibility and convenience of goods. And finally, experience businesses engage their customers in personalizing the product, essentially creating a custom service. As a product progresses through these stages, two very important things happen. First, the product moves from being undifferentiated to customized. Second, at each stage the business adds a layer of value for the customer, increasing what the customer is willing to pay for the product. Therefore, the more differentiated the product, the higher the profit margin.
We can take coffee beans as an example. As a commodity, coffee beans off the tree are not worth too much to you and me. The beans are totally undifferentiated and present little economic value to consumers. However as a good, buying a bag of fresh roasted coffee is something we’re willing to pay for at the supermarket. The beans are now somewhat differentiated, but prices generally don’t vary too much between brands. As a service, the convenience of drinking an already brewed cup of coffee demands a higher price. Here, differentiation starts to create a wider spectrum of retail prices. And finally, customizing that coffee by writing your name on the cup transforms the service into a personal experience, which earns a higher premium price.
As Canadian investors, this framework explains much of the long term lacklustre performance of our market. Undifferentiated commodity producers in the energy, minerals, and utilities sectors represent about 33% of our investible market. Slightly differentiated goods producers like financials, telecoms, industrials and consumer staples make up another 47% of our market. That leaves only about 20% of our market in service and experience businesses. Thus, investing in a broadly diversified Canadian market implies that about 80% of a portfolio is going into businesses that provide little long term economic value-add to consumers, have limited capacity to set prices through an economic cycle, and thus suffer from low profit margins. The average Canadian investor would have only 20% of their portfolio in businesses able to generate long term economic value through product differentiation and thicker profit margins.
We can take a look at share prices over the last twenty years to highlight our point. We are using the US market as an example since there is more long term data to make comparisons. Since 1996:
Commodity copper producer Freeport-McMoran has earned a total return of 30%.
Goods provider AT&T earned about 278%.
Service business IBM earned about 748%.
Experience business Starbucks earned about 4,853%.
The broad market (S&P 500) earned about 372%
The differences in returns are spectacularly clear – investing in companies that create economic value through differentiation earn far higher profits over time.
It is no wonder our current government wants to differentiate away from a resource based economy. Expanding growth into other sectors creates not only a more diversified economy, but an economy that is able to compete on long term profit margins, not just compete on the upside of a business cycle. As Canadian investors seeking higher than average long term returns, this is very welcome news.