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Economic Moats in Industrial Materials
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A handful of industrial materials firms meet the definition of what Peter Lynch called "great companies in lousy industries" and boast sustainable or growing competitive advantages. 1 Such advantages can counteract the problems identified in this chapter—cyclicality, fierce price competition, slim profit margins, pernicious replacement cycles—because they provide companies with a more stable customer base, more predictable sales and profits, and the ability to rein­vest their capital more efficiently.

Some wide-moat companies in the industrial materials sector include specialty chemical manufacturer 3M, mail meter maker Pitney Bowes, auto parts supplier Gentex, defense contractor General Dynamics (GD), and manufacturing powerhouse United Technologies Corp (UTX), which makes everything from Otis elevators and Carrier air conditioners to jet engines and the Black Hawk helicopter. Gentex and 3M have numerous patents that protect their markets from some competition. General Dynamics and UTX operate in very concentrated industries, and their customers would have a difficult time switching to another product even if there were more choices. Pitney Bowes enjoys both types of advantages: patented technology and high customer switching costs.

Technology and Competitive Advantage

Because industrial materials markets are mature, there's often fierce competition on price and little room for top-line growth. Thus, the only way to improve the bottom line and reward investors is to develop a differentiated product or to find ways to spend less making the same product. By definition, a commodity product cannot be differentiated, so for many industrial materials producers, investments in efficiency are the only way they can improve the bottom line. In the industrial materials sector, about as much technology spending is devoted to improving manufacturing efficiency as it is to developing new products.

Investments in technology can lead to lower-cost production methods. In the steel industry, for instance, the electric arc furnace allows Nucor to recycle scrap steel and produce finished steel products at a much lower cost than the big integrated producers, such as U.S. Steel, whose operations rely on an expensive, capital-intensive blast furnace to make steel. Nucor's technology provides the most important competitive advantage available in a mature commodity industry: the low-cost position. The proof is in the pudding: Between 1999 and 2OOI, Nucor's average gross margin was nearly double that of U.S. Steel (11,8 percent compared with 6.5 percent). Nucor is also working on developing a processing technique that will lower the costs of producing thin- rolled products. If the production technique is commercially feasible on a large scale, it will provide Nucor with yet another cost advantage over its rivals. Those rivals must spend on efficiency improvements just to keep the competitive gap with Nucor from widening, although they have little hope of attaining ks level of efficiency.

While companies funnel a great deal of the money they spend on technology into efficiency improvements, product innovation can still play a crucial role in the industry. For chemical companies, new products represent one of the only available sources of internal sales growth. Chemicals giant DuPont earned its stripes by developing a series of groundbreaking chemical fibers between 1930 and i960, including Nylon, Polyester, and Lycra. Diver­sified powerhouse 3M has excelled at incremental innovation, using slow- growth products such as tapes and adhesives in the production of high-tech applications such as mobile phones.

Some companies have found ways to take a raw commodity and alter it so it adds value for their customers. Such value-added products command a premium to what a basic commodity would fetch. For example, between 1993 and 2OO2, Alcoa spent more than $1.5 billion on R&D to develop new processes that make aluminum stronger, lighter, and better suited to more applications. These producers occupy a valuable niche within the basic materials sector.

Innovation is hardly an easy task, though. A whopping 80 percent of R&D projects result in economic failure. DuPont, for example, has maintained its industry-leading research and development budget, but blockbuster products have been noticeably absent in recent years. Furthermore, its former flagship products have become commoditized as low-cost Asian producers entered the market, stole share, and crimped the profitability of DuPont's textile business.

DuPont's experience highlights the problem with innovation in a slow-growth industry. Companies can pour millions of dollars into new product research, only for competitors to copy their technology "without bearing the same development costs. This reduces the incentive for companies to inno­vate, and they have responded by focusing their R&D spending on process technology and manufacturing efficiency—to improve what they already do—rather than invent new products.

Another problem with innovation presents companies with a tricky balancing act. In the appliance industry, for example, companies must spruce up their products with new and convenient features to Induce customers to buy new appliances before their existing ones wear out. Companies also need to create reliable, long-lasting products to maintain their brand image and customer loyalty. Better, innovative products can lengthen the replacement cycle and reduce product turnover and raise the hurdle rate of innovation. The bet­ter the product, the more difficult it becomes to get customers to replace that product.

Because of intense competition, especially in the basic materials sector, the main beneficiaries of research in industrial materials are the users of the new and cheaper products that result, not necessarily the investors who financed their development.

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