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Why cheap can be a trap door

Nowadays, the whole world seems spaced out to find the next bargain. TV shows are conditioning our minds to always hunt for the best offer. Furthermore, we are constantly bombarded by ads telling us when the next "banging", "mindblowing", flash sale will come out. The marketing departments must work overtime to come up with all these well-designed webpages, catchy TV ads, and click-baiting social media campaigns. This whole circus is so well-established that I can hardly find opposing voices to this phenomenon. Well, I want to give it a try coming up with an opposing view on why cheap ain't so good. But let me be clear; I don't judge anyone for having to buy cheap because, for already many, this is the only way to come by. However, others participate in this circus, blissfully unaware of the mechanics behind it. Let's demystify!

The mechanics behind cheap


Principle 1: For something to be sold cheaply, it needs to be produced cheaply! So far, so easy. But this is not the whole picture. There are a few ways how a company can achieve to sell cheaply. I can particularly relate to this because I work in one of the fiercest industries when it comes to pricing: The automotive industry. The automotive industry is a battleground where many car markers fight over the ever-tighter customer wallets. None of the well-established car-makers has a competitive advantage anymore. If you scan through the financial statements of the automakers, you will see that the vast majority have high debt burdens, and low margins and have grown its capacity at a faster rate than its earnings. Sometimes the odd car company has to revert back to accounting gimmickry to keep the illusion going: Prominent example from the UK: Aston Martin was applying a practice called channel stuffing: Alistair Osborne from The Times has written about it in an article called: Car of your dreams has a nightmare. You can also read up on this, amongst other examples of accounting gimmickry, in a book by UK fund manager Tim Steer called: The Signs Were There

Where does it all start?

You see, in general, producing sth is an expensive affair start to start with. You need to build a factory, buy machines, have a beancounter like me, arrange insurances, etc... All these things are "fixed costs". They are there no matter how much you produce, they effectively don't change whether you sell 1 or 10.000 cars. HOWEVER, the thing that changes is your bottom line. A simple example: You own your own car company: You have bought all the stuff mentioned before for 1,500,000GBP. You plan to sell 100 cars for 20.000GBP each, which gives you sales of 2,000,000GBP. In addition, each car uses up what we beancounters call variable costs, these are costs that change with the level of production; examples are wages (think of hours worked), or materials (steel, oils, cutting tools, etc...). If you produced 0 cars you have 0 variable costs. So let us assume that each car costs 10.000GBP in variable costs. So now we can summarize our calculation:

My example highlights the fact that you essentially have two choices:

  1. You either increase the number of cars you sell, making the most out of your fixed costs, such as the brand-new factory

  2. Or you increase the sales price!

Either way is fine to get into profit territory! This leads me to:


Principle Nr 2: Increase the production to the point where you start covering your costs

In Finance lingo this is called economies of scale. You see, in our base case assumption (of the illustration above) at the left we made a loss. But in the middle scenario in which we achieved to double our sales, we turned a profit. This is the "Good Boy, have a treat" kind of scenario, the whole automotive industry, and many, many, many other companies work on this principle. Hence the clothing companies bombard us with discounts and flash sales. Because up to a certain discount each sold pair of trousers contributes to covering some of their costs and thereby turning a profit (hopefully).


Principle Nr 3: Don't touch the price when the competition is fierce

What is less desired, hence the frowny face is to increase prices, no, no, no this is bad stuff, absolutely not tolerated! In the automotive supplier industry, long-term contracts such as 10 years include price step-downs: Meaning, the buyers assume that you will be able to find ways to produce cheaper each year here hence the force you to sell your goods to them cheaper each year. Price increases feature less and less on the executive menu of things to do in order to improve business.

Let's move on: What else can we do? Well, if we want to sell cheaply, we have to attack costs. Beancounters like to attack the fixed costs first because they are easier to cut (at least in my experience). You can shop for cheaper insurance, cut some of the admin costs, cut overhead labor; does the company really need a receptionist? But what if all the small fry does not turn the odds anymore, and suddenly a new contract comes up that requires a factory expansion?


Principle Nr. 4: Can someone else do it?

Also called outsourcing in business lingo. It is not unusual anymore for companies to outsource the entire production of sth to a business partner. In the clothing industry, these business partners are in countries where obviously everything is cheap: Building a factory, buying materials, paying wages, etc...). The entire production is organized by the business partner, which is normally a no-name firm from India, Vietnam, Bangladesh, etc... The selling and marketing is done by the actual clothing brand itself. This in principle, is a perfectly fine idea when certain standards are followed but when a factory collapses or burns down with all its workers still in it, buying a pair of knickers for 1GBP has a bit of an aftertaste. Here is a good article on the subject.


Principle 5: clean up your backyard:

This is called business process improvement. The idea behind is simple: Increase efficiency (I stop with the fancy words in a minute), which means more production with fewer inputs (such as labor hours, materials, and other resources). This is usually the creative side of the business where the real magic happens. Engineers and businesspeople sit together to come up with more innovative ways to do things. However, it can turn sour from here as well because sometimes the creative juices don't really want flow. Therefore companies task their purchasing departments to find cheaper alternatives or force cheaper prices onto their suppliers, which is a common practice nowadays in the automotive industry. And again, we are trapped in this hamster wheel of cheapness! Another measure of increased popularity nowadays is flash lay-offs. Some companies are laying off people in a rush just before the financial year-end to appear leaner to their investors. Once the financial reports with lower head-count numbers are produced, people are rehired. This re-shuffling is a costly affair that when planned badly, cuts deep into the innovative meat of a company.


When expensive is the real bargain

Many times sth what appears cheap is actually expensive and vice versa. I want to provide three examples that illustrate this point:


Example 1: Investing in property

Like the TV series, when it comes to property, it is all about location, location, location! When you purchase property in a desirable location, you will typically have to pay a hefty price. But on the upside, you can demand an equally high rent, which covers your financing costs and leaves enough for a profit and cash reserves to cover future repair jobs. The other plus side of great locations is that you won't have to worry about demand shortages and, therefore an empty property. Higher demand will also allow you to charge a higher rent up to a certain point, provided the property is in good condition.

But when it comes to investing, people sometimes think differently. Trying to strike a bargain, and with the future dollars already rolling in their eyes, they are purchasing a property in a less desirable area, thinking it might appreciate in the years to come. It really is the case that you might purchase a property for 30-40% less in some areas of England compared, for example, to the South, such as Sussex. However, the crux with a property in a less desirable area is that you are not guaranteed a renter and might have to accept that the property stays empty. However, hourly rates for builders, tradesmen, and contractors are not vastly different across England, so you will still have to pay the same for the repairs in, let's say the Midlands than you would in the South. Not only that, with a property in a less sought-after area you also face a higher risk of a total loss of capital because investment in the area is not coming in, a change in demographics for the worse, or anything else that would lead to an appreciation is not materializing... Buying cheap or cheaper has to be based on solid assumptions and research because the downside risk is substantial if it doesn't work as planned.


Example 2: Investing in stocks

Almost the same applies to stocks. TV pundits sometimes cite a stock's PE ratio (Price to Earnings) and claim that it is either too cheap or too expensive. This is frustrating, because it is merely a matter of opinion and, at best, a snapshot in time. Things that have value are normally priced on the higher end and for a very good reason because we all expect a certain quality to come with it. Therefore Rule Nr.1: refrain from buying a stock merely because its PE ratio is cheap or someone says it is cheap. More often than not, a stock that appears cheap has got a problem otherwise, people would not have sold the stock, thereby driving its price down. It could be either that, or the company has got poor earnings, too much debt, or any other fundamental issue. Again you have to do substantial research before you buy a stock at a low price. Most of the time you are better served to buy a stock at a high price because other people will have done all the research and deemed it worth putting in money thereby driving the stock up. The media is full of accounts of financial pundits claiming Apple is too expensive or Amazon is overvalued since 5 years ago. Please don't listen to them do your own assessment!


Example 3: Buying quality items

To finish, I wanted to bring up a personal story. A few years ago my mother bought me a suit as a Christmas present. It was not a tailor-made suit however, it was from a small Italian manufacturer, and I had it adjusted so it would fit me better. I still remember the small shop where we bought it. It was a small outfit run by two owners. One of them showed me a picture of him visiting the Italian supplier. I can tell you the suit was pricy, but the material and quality of work were beyond outstanding, so much so that after 7 years, I still own the suit. A while ago, I asked a friend how often he buys a suit. He replied every year a new one. His money on the suits has already surpassed the price my mother paid for the suit I got as a Christmas present 7 years ago. Not always, but more often than not, quality does endure, and it is worth paying a bit more for it. The only thing to remember is rule Nr. 3: Think long term, think of quality. Try to resist the temptation of a quick bargain.

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