Commoditisation

A commodity is a product that is completely undifferentiated. If a product becomes less differentiated, so that buyers care less about who they buy from, this change is called commoditisation.

The key effect of commoditisation is that it reduces the pricing power of the producer: if products become more alike from a buyer's point of view they will tend to buy the cheapest.

Commoditisation is a key reason why many growth markets disappoint investors. Sales volumes grow as expected but, as the market matures, prices come under pressure and margins shrink. This is a key issue to consider when picking growth stocks.

In order to avoid commoditisation companies need to be able to differentiate their products with something unique, that is not easily copied by competitors, and which is valued by customers. This may take the form of a strong brand, a technology lead, good design, good retail locations, or anything else that will convince customers not buy the cheapest product. The alternative to avoiding commoditisation is, of course, to compete on price.

The personal computer market and certain other types of computer hardware provide a perfect example of this. When this was a fast growing industry each computer manufacturer would sell a computers together with a built in operating system, both of which were unique. Different manufacturers' products looked different, ran different software and had very different capabilities. At this point the market attracted many growth investors at it was obvious that demand for the new technology was exploding.

As the market matured two vital changes happened. The product became standardised, and therefore largely commoditised. In addition personal computer manufacturers largely ceased being significant producers of software — which is highly differentiated and commands huge margins.

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