The Oracle of Omaha has been quoted many times stating that he does not like to invest in companies that rely on commodities as a main source of income. Having said that, this has not stopped him from directing Berkshire Hathaway Inc. (NYSE:BRK.B)'s cash to companies such as Exxon Mobil Corporation (NYSE:XOM) and ConocoPhillips (NYSE:COP) in the past. Of course, Buffett's Conoco bet led to a $1 billion loss, leading the sage himself to openly admitted that the Conoco investment in particular was a mistake.
So why does Buffett like to stay away from commodity companies? Well, the answer becomes pretty clear we we take a quick look at the erratic earnings of companies that rely on commodities as their main source of income.
Buffett's first rule of investing is "never lose money." Rule two is "never forget rule 1." In effect, these rules imply that you shouldn't gamble with money. Unfortunately, investing in the commodity markets is gambling to an extent, as no one is able to accurately forecast the price of commodities over time. What's more, without the ability to accurately or reliably predict commodity prices, companies that operate in this space have no way of maintaining a wide profit margin and are at the mercy of the market. Right now, the best example of this is the gold mining industry.
Consider CONSOL Energy Inc. (NYSE:CNX), the largest U.S.-based company in the basic resources sector.
Consol produces coal and gas, both of which have seen their prices come under pressure during the past five years. As a result, Consol's net income has fallen 12% during the five-year period and both its net and gross margins have been erratic to say the least. Because of this, the company lacks any clarity regarding its financial outlook.
In comparison, consider the financials for Buffett's core holding The Coca-Cola Company (NYSE:KO) over the past five years.
Coke's ability to set the prices on the products it sells means that it has been able to keep its gross profit and profit margin steady. In addition, a steady gross margin has resulted in the company's net and gross incomes grinding steadily higher along with revenues -- something that Consol has not been able to achieve.
Buffett's mistake Warren Buffett famously doubled his stake in ConocoPhillips back in 2008, right before the price of oil plummeted (along with the stock market). Volatile commodity prices hurt all commodity companies, no matter how big or influential they are. Chevron Corporation (NYSE:CVX), one of the largest international oil and gas companies in the world, was hit hard by the oil price collapse, and the company's revenue is only just now getting back to levels seen before the crash.