QUALIPORT
Invest In Commodity Dogfights!

By Maynard Paton (TMFMayn)
April 23, 2001

Carburton Street, London -- Traditional wisdom suggests the best companies to own for the long haul should have some sort of intangible "franchise" asset, for example, patents, brands, reputations and so on. However, the likes of Wal-Mart (NYSE: WMT) have worked wonders for its shareholders over the long-term. The US firm has just used competitive pricing and efficiency to produce ever-increasing profits.

But if you're considering a company whose main weapon is price, when's the best time to invest? In my opinion, it's during an intense industry dogfight. Such a slump typically leads to irrational share price pessimism, when investors suddenly view the price-based operators as all about to cut each other's throats.

Although it may be tough going at times, the strongest and leanest players in "commodity" industries usually see through the downturns. The weaker players, more often than not, go to the wall. After the bloodbaths recede, those still standing will have even greater potential to gain market share. The investing-in-a-downturn trick is simply (!) to ensure you're involved with the dominant company at the right price!

Sporting recovery

Last week's results from JJB Sports (LSE: JJB) reminded me of how dominant companies in very competitive environments can succeed through heavy bouts of sector turbulence. Indeed, the history of JJB is a classic example of this phenomenon.

During the mid 1990s, JJB built up a chain of sports clothing and equipment outlets. The winning retail strategy was simply of selling its goods at "value for money" prices. Encouraged by many years of double-digit like-for-like sales growth, JJB's profits raced ahead. At their February 1998 peak, the shares hit 820p and traded on a prospective price to earnings (P/E) ratio of 32.

Overcapacity in the marketplace, plus the declining appeal of replica football shirts, quickly took their toll on all sports retailers during 1998. Like-for-like sales growth promptly slowed and JJB shares quickly lost their go-go rating.

During the malaise, JJB bought its biggest rival, Sport Division. At a stroke, JJB became by far the dominant company in its sector.  The subsequent integration didn't go smoothly however. Logistical and stocking problems caused JJB's shares to plunge to 180p (and a forward P/E of 7) in late 1998.

Easy to say now, but those dark days of late 1998 were the time to buy into JJB. If market leader JJB was struggling, you could be sure that its smaller rivals were having an even harder time. Two years on, the company has resolved its operational problems and JJB shares are now 751p.  Impressive growth figures of late have been aided by JJB's weakened rivals unable to match the market leader's substantial economies of scale.

Three commodity dogfights

The JJB opportunity is history. So where are today's "commodity dogfights" that could lead dominant companies becoming even stronger a few years down the line? Here are three areas worth watching. Unfortunately, Mr Market has yet to cast a gloomy spell over the share prices concerned.

Clothes retail

Sticking to the retail theme, and there is a distinct smell of desperation in the discount clothing sector. Just about every operator in this area of the High Street has issued a profit warning since Christmas. Good news, perhaps, for fans of Matalan (LSE: MTN), which is the pre-eminent participant in this particular retail sub-sector.

However, one problem considering Matalan as an emergent long-term winner is that the company doesn't really dominate the entire clothing retail scene. It only has a market share of around 3% at present. Compare that to JJB, which had around 20% of the sports retail market during its woes. The other problem with Matalan is the valuation. At 518p, the shares stand on a toppy P/E of 36.

US computers

Former Qualiport company Dell Computer Corporation (Nasdaq: DELL) ought to be a long-term beneficiary of the current economic slowdown in the US. Notably, the computer manufacturer recently took the number one spot for both the US and global PC industries. Recent results from Dell, contrasting starkly to the losses posted from industry counterparts Gateway (NYSE: GTW) and Compaq (NYSE: CPQ), appear to underpin the company's competitive pricing strengths.

Unfortunately, even with no immediate profit growth, the stock market has already awarded Dell the long-term honours. At $30 a share, Dell's stock stand at 36 times this year's earnings. No irrational pessimism here.

Telecoms

And how about considering one or two potential beneficiaries from the current shake-up in telecom sector? Controversial perhaps, but British Telecom (LSE: BT.A) could be a long-term winner with its fixed line telephone business. Sure, there are regulatory issues involved, but I'd rather have my money running on the cash-strapped company with an 80% market share than on the cash-strapped companies who are just starting out in this field.

But perhaps a better telecom bet would be Cable & Wireless (LSE: CW.). Just like BT, it too has seen its revenues decline, as penny-pinching customers increasingly view the industry's services as a commodity-type purchase. Such customer pressure, though, will inevitably leave only the strongest operators to reap the longer-term rewards. C&W is in a better position than most of its international counterparts. It presently sits on a £7b cash hoard.

Again, valuation is a stumbling block with the telecom giants. Both companies are forecast to report declining profits this year and next, yet both perch upon P/E ratios above 30.

Summary

Those are just three examples of current shakeouts in commodity-esque industries. Having a reasonable knowledge of all four companies mentioned, I feel none of them are to become Qualiport companies anytime soon. However, I never say never... But if you know of any other leading companies whose industry is in a middle of a competitive shake out, please relay your thoughts to the Qualiport discussion board.

And just to reiterate, investing in industries undergoing abnormally severe competitive pressures requires two rules:

* Ensure you're involved with the industry's most dominant company, the one most likely to win through when the bloodshed recedes, and;

* Ensure a significant margin of safety, just in case the carnage and uncertainty continues far beyond your original expectations.

More Discounters Show Good Value | Dell Peeks Towards Quarter's End | BT Increases Customer Numbers | Duelling Fools: Cable & Wireless