Marge's nutmeg a pinch of salt

"GOING broke saving money" is a popular strategy in the stockmarket.

IN an episode of The Simpsons, Marge visits not Walmart but Monstromart, exclaiming, "Ooh, that's a good price for 12lb of nutmeg" as she places the giant box in her trolley. It's ambitious to think that anyone would need that much nutmeg in a lifetime. And yet because Marge believes the price is cheap she buys it. I call it "going broke saving money". It's a popular strategy in the stockmarket.

While price is important, it doesn't make sense to buy groceries that are unusable or unwanted. You need to know whether you are getting precisely what you want. Unfortunately, a lot of share investors sometimes behave like Marge, choosing investments simply because they're cheap.

To illustrate, let's look at BHP Billiton. The share price has fallen from $39 in February to about $32 today, and many analysts consider that cheap. We don't. It's far more useful to first determine whether we'd be comfortable owning the business regardless of what the sharemarket or the economy does. It is better to buy an extraordinary company at a fair price than a fair company at an extraordinary price.

It helps to determine whether a company provides a service or product that is in some way unique. If a product is difficult to replicate or costly for customers to stop using then this provides the discretion to set the price. Pricing power allows a business to increase revenues without having to increase volumes, but also insulates earnings if industry conditions deteriorate.

Companies that produce generic products or services do not have this luxury and must accept whatever price is being offered in the market. BHP is one such price taker producing commodities such as iron ore and petroleum. In the face of excess supply, BHP has no ability to raise prices.

If the best business is one that can employ large amounts of capital at high rates of return then the worst is one that must, by necessity, do the opposite. Despite the benefit of an additional $30 billion in equity, BHP's profits remain unchanged from six years ago. Moreover, the iron ore price arguably has an unfavourable outlook, given expanding production amid moderating demand from China.

A company may be providing a world-class product, but for it to prosper impressively over the long term it must be able to produce its products or services at a high margin on both sales and equity sustainably. It is therefore important to understand two elements of a business's expenditure: how much capital is required to build and maintain production facilities (capital expenditure) and how much it costs to produce each additional unit (operational expenditure).

BHP requires a high level of expenditure to sell iron ore: it must spend considerable capital on exploration, build the infrastructure, take the iron ore out of the ground, process it and transport it to buyers. BHP does have the ability to produce iron ore at a relatively low cost compared to its peers, due to the high quality of its assets and the scale of its operations, but since significant capital is required to develop a mine it has had to shelve projects because of the deteriorating outlook for commodity prices. This will constrain long-term production.

BHP's share price may ultimately fall to such a level that would justify taking a position in the company. However, just as Marge Simpson doesn't actually need 12lb of nutmeg, I wonder whether you need to own a giant mining company.

Roger Montgomery is the founder of Montgomery Investment Management and the author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com.