A quick fundamental analysis on commoditization

I’m going to go over a quick fundamental analysis I did a while ago. This covers commodity products, but hopefully the example is broad enough to get you thinking about the right/wrong way to think about simple investment analysis. I’ll use Nokia as an example.

Mobile-phone sales continued at a torrid pace in the first quarter as consumers worldwide latched on to camera phones and cheap deals, according to a new report.

–From Sales of cell phones totally off the hook: 180.6 million units sold worldwide during first quarter, an SF Chronicle story

Wow!! Sounds really hot!! Maybe I can make some money!! Well, maybe. But I was thinking the same thing 4 years ago and I’m glad I didn’t do anything in this area.

Quick background

• I previously wrote All about stocks and bonds, in which I went through a very simple in-my-head analysis of Gap. The main point was that, even though something sounds good when you talk about it with your friends, that doesn’t make it a good investment. To summarize this article, one very good way to pick a long-term stock is to (1) think of the companies you know, love, and use, (2) do a quick fundamental analysis to get rid of the bad ones, and then (3) do a rigorous analysis of the financials to see which makes an attractive stock choice.
• I also wrote how it is really dumb to buy a stock solely because they have a new product in an article called Dumb: “The iPod is selling a lot so I’ll buy Apple stock. Bottom line: If you know this, so does everyone else, and the market has priced the upcoming product into the stock price.

Why a promising market doesn’t mean good ROI
Ok, so in the continuing tradition of embarrassing myself, I’m going to take you through another stupid mistake I made in my thinking a few years ago. In the early part of 2000, I realized cell phones were really hot. Everyone had them, there was talk about the “mobile platform providing synergistic efficiencies” and other crap like that.

I paid attention to these fancy buzzwords.

And when I did my quick fundamental analysis, it came out something like this:

Cell phones are increasing. More people are buying cell phones. Nokia is the #1 provider of cell phones. They are only getting bigger. I bet there is a lot of upside in their stock.

I told you it was a simplistic analysis.

Now I want to show you what would have happened had I followed that train of thought and invested in Nokia back then.

“But Ramit,” you might say, “the entire market went down during that 5-year period! What about the rest of the market?”

So even though the market did indeed go down, Nokia underperformed the S&P 500′s decline.

Ok, there are a few lessons that I took out of this:

1. Again, doing a simple fundamental analysis isn’t enough. Even though Nokia did indeed manufacture a whole bunch of cell phones (more than anybody else), that wasn’t sufficient to increase their stock. This brings me to…

2. Commoditization. When a company’s product becomes a commodity, that is BAD. It means that the product is substitutable and doesn’t have any special competitive advantage. Salt, for example, is a commodity product; you don’t care which brand you buy. By contrast, Apple can charge a whole bunch more for an iPod–even for identical technical specs–because it has a special allure.

Companies hate being in commodity markets. And in 2000, when I had these ideas, I never thought cell phones would become so ubiquitous that they’d end up being commodities. A lot of people will disagree with me, saying that they love their Samsung or whatever, but for the majority of consumers, cell phones are commodities. It took a product like the Motorola Razr–priced at over $500 when it was released!–to transcend the commodity status.

So while the market did indeed increase like I thought, I was stupid by predicting that because Nokia was the biggest player, its stock price would continue to go up.

3. A caveat: Nokia’s stock price didn’t only go down because of the commoditization of its cellular products. There’s a LOT more to the story (look it up) but, if you’re starting out on a quick analysis of some stocks, this mistaken thinking–”The company is big and the market is increasing!”–is a tool you’ll want to be aware of.