Understanding Cost Leadership and Investor Returns
In the last two parts of this series, we explored how to identify companies with strong cost leadership that have exceptional returns to investors. In Part 1, we talked about why cost leadership is a crucial area for the stock picker, and in Part 2, how effectively managing operational costs is crucial for businesses to become cost leaders.
Defining Low-Cost Producers and Their Strategies
What defines a low-cost producer? A low-cost producer is a business that uses economies of scale to sell goods or services at a lower cost. Price-sensitive consumers are more likely to shop at stores with the lowest prices, especially if the product or service is relatively uniform. These companies survive first and thrive later by maintaining a cost of operation that progressively becomes more and more efficient resulting in a wide operating margin relative to their competitors.
The Power of Low-Cost Leadership: Success Stories
A low-cost producer is capable of making a substitute good or providing a substitute service for a lower cost than other companies. They can price their goods on par with or just below the market, undercutting their competition. By doing so, companies can gradually ramp up their market share and eventually profits. When GEICO ramped up its presence in the American insurance industry, its approach of selling direct marketing offered it a significant cost advantage over competitors that sold through agents, a method of distribution that was so embedded in these insurers’ business that they couldn’t abandon it.
This does not mean that these companies are in danger of running out of gas; on the contrary, the free cash flows for such companies tend to be robust and give them an adequate cushion to withstand any market disruption. Cost leaders’ businesses actually are enhanced by a crisis. The worse the environment gets for the economy in general, the better it gets for these cost-advantaged businesses because customers flock for cheap yet quality products.
In the airline industry, there is a concept of “Low-Cost Carriers” to LCCs. SpiceJet and Indigo were the first low-cost carriers to enter the airline market of India in 2005 and 2006. They weren’t like Jet Airways or other full-service airlines. Jet Airways, being a full-service airline, had a business class that included in-flight meals and more baggage space. LCCs had aggressive pricing. They had no business class, and meals were not provided (or actually charged separately for them). They also had a smaller luggage allowance, allowing them to charge extra for any oversize bags. LCCs could fill more seats on a route, resulting in substantially higher utilisation than Jet Airways. LCCs had a 12 percent market share in the year 2000. In 2012, it reached 59 percent and over 76 percent in 2019.
Cost Leadership Across Industries: Case Studies
This low-cost leadership approach is true for almost all industry sectors. If we consider the industry composition of Nifty 100 and the industry sectors represented in it, we will find that every industry is subject to the law of ‘economies of scale’ and hence low-cost producers rule the roost in most cases. Whether it is Jio in Telecom, HDFC Bank in Banking, or Bajaj Finance in Lending, the leaders are often holding the lowest cost offering powered by large-scale and efficiently run operating engines. There will be exceptions to this rule but with genuine reasons.
Consider the market economics of high-demand consumer staples. They frequently have easily available replacements from a variety of market competitors. Household items, cleaning products, rice, wheat, edible oils, food, and beverages—anything that customers can’t live without—are all examples of consumer staples manufactured by low-cost companies. Luxury goods, Jewellery, high-end autos, and some types of apparel are examples of specialty items that do not have low-cost manufacturers.
Barriers to Entry for Low-Cost Producers
A new entrant will find it very difficult to become a low-cost producer. The barriers are very high, which is another reason why incumbents who have achieved scale are difficult to dislodge. Jio having achieved pole position will be difficult to beat as things stand in the Indian telecom industry.
To be competitive in such a market, the upstart will need to raise a huge amount of capital or have enough cash on hand to generate economies of scale large enough to attain a significant pricing advantage over its competitors. This is why many businesses are unable to manufacture at a low cost. Companies must also invest in technology that reduces production costs while increasing productivity. On top of this, businesses must guarantee that demand is met without hurting their brand reputation.
Low-Cost Leadership in Retailing: Amazon and Walmart
Retailing as an industry illustrates the importance of low-cost leadership. Amazon gained a cost advantage by avoiding the expense of physical stores themselves and reinvesting its cash flow in other businesses. Jeff Bezos, its CEO, was ruthlessly efficient in controlling costs. Amazon even went so far as to save $20,000 a year by removing the light bulbs from vending machines in its offices. Bezos was obsessed with saving money and time for customers. All these cost savings and re-investments helped lay the groundwork for mind-blowing growth later on. Writing to Amazon’s shareholders in 2005, Bezos explained that “relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term.
Another example of a low-cost producer with great economies of scale is Walmart. In all, they run 11,443 retail stores in 24 countries under several labels. It has implemented a number of methods that make it hard for its competitors to stay up. By obtaining and purchasing things on its own, it is able to reduce the cost of the goods it offers. Walmart can also exercise a lot of control over its suppliers due to its large footprint. The corporation is able to distribute through a very low-cost network and has made significant investments in technology to keep up with its client base. Other examples are Costco and Amazon. In India, the counterpart of Walmart is possibly D-Mart.
Conclusion: The Impact of Cost Leadership on Market Supremacy
To summarize, the competitive edge in business is often claimed by low-cost producers who masterfully leverage economies of scale to deliver goods and services at lower prices than their competitors. Their strategic efficiency in operations and commitment to cost reduction allow them to generate a significant operating margin, affording them a cushion against market turbulence. Furthermore, these companies, through their business acumen and strategy, erect high barriers to entry that deter new competitors, thereby cementing their dominant position. Examples like Amazon, Indigo, and Walmart underscore the power of this low-cost leadership model in achieving market supremacy. They’ve redefined their industries by prioritising cost efficiency, thereby setting a high standard for competition. Investing in these companies often yields significant returns, as their cost leadership typically results in sustained market dominance, robust free cash flows, and strong shareholder value creation over the long term.
