by Donald V. Potter

Familiar commodities get traded every business day, tin, silver, grain. They go up or down in response to market forces. Entire exchanges are devoted to coffee, cotton, and wheat.

Another commodity is the subject of brisk trading these days, although it is not listed as such on any exchange and rarely is quoted by name. This commodity gets traded through the shares of Fortune 500 companies. This new commodity is scale.

Like many commodities, scale once was a scarce resource. Possession of, or proximity to, scale bestowed great advantages upon a competitor. Much of postwar US industrial strategy was based upon accumulation of scale.

However, global market forces created a scale glut in the last 15 years. Japanese, Koreans, Brazilians, Chileans, Indians, and others ardently reaped bumper crops of scale. Scale once was a barrier to entry and much sought after. No more. Scale is now cheap. Scale is cheap because excess liquidity in the worldwide financial markets makes large amounts of capital available to anyone who can employ it well. And this has changed our economic landscape mightily. Buyers can acquire scale when they need it and when the asking price – reflected by the stock of a scale-possessing company – seems low, or else sell their scale when commodity prices are driven higher. Bridgestone acquired instant U.S. scale with Firestone, as did C.F. Thompson when it bought the consumer electronics business of General Electric. Carl Icahn becomes a major airline player with his purchase of TWA. In a similar manner, Tate & Lyle bought Staley Continental, Wells Fargo bought Crocker Bank, and Campeau bought Federated in order to rummage through the scale inventory of the acquired firm, keep those pieces of scale which fit, and toss those that didn’t back into the commodity market for what they hoped would be a premium.

Many winning companies are not those with the largest amount of scale. Minimills, like Nucor and Worthington Steel, regularly beat up on USX. Delta Airlines is more profitable than the much larger United or Texas Air. Salomon Brothers withdrew from the municipal bond underwriting market under the pressure of expanding smaller competitors. Local community banks easily outperform the big money center institutions. Hyundai and Honda are dwarfed by General Motors, yet Asian car makers are increasing their U.S. market shares – despite rising prices.

Scale, per se, no longer guarantees a company an advantage in the competitive free-for-all. Scale, in the form of property, plant, equipment, and even the people needed to run these assets, has been neutralized by the financial markets. It won’t decide the winners anymore. This is not a problem. It becomes a problem, though, when management continues to regard scale as a scarce and expensive advantage and run their businesses accordingly.

This may seem like an odd time to talk of scale as anything other than precious. Spurred by a weak dollar, many U.S. industries are at, or above, peak production levels and are straining capacity. Semiconductors, for example, are in such low supply as to worry original equipment manufacturers (OEMs) like Hewlett-Packard and Sun Microsystems, who are scrambling to source new supplies. In rubber, chemicals, paper, PVC, aluminum, and several other industries, the situation is similar. Yet what these firms are really doing is speculating in “scale futures.” They are betting heavily that the scale supply will continue to be limited in the short term by their unwillingness to expand capacity and, in the long term, by industry consolidation and asset-shedding. This is a high-risk bet that is likely to be a loser. Our study of overcapacity industries suggests that a demand increase is always met with an increase in supply and that mergers, acquisitions, and other consolidation activity has very little effect on reducing capacity in an industry. A company that freezes expansion in favor of high current margins gives away customers to a competitor – almost certainly a losing strategy. Betting on a competitor’s demise is also likely to fail. Overcapacity ends through an increase in demand, rather than through a reduction in supply. An industry “shake-out,” resulting in the withdrawal or disappearance of major competitors, doesn’t reduce capacity, it recycles it. In fact, after most shake-outs, prices decrease, reflecting a continuing imbalance of supply to demand. The airline industry offers several recent examples of this phenomenon.

Winning companies are astute traders in the scale markets. They buy scale when it is cheap (when demand in an industry is terrible and no one else wants more scale). They sell the scale when it no longer suits their needs. They search globally to buy or sell under the most favorable conditions.

More significantly, these companies have put scale in the proper perspective. It is a means to end. The desired end is possession of the customer. Share of the customer’s mind is more important than share of scale. The “right” amount of scale is simply whatever amount allows a company to keep a customer.

Keeping a customer requires that a company’s products be unique in their performance for price. Usually this means having highly reliable products and services that are convenient to buy. Only if two competitors offer comparable levels of reliability and convenience will a customer let price determine his purchase. Companies that stress reliability and convenience tend to do well, despite market fluctuations – companies such as Hewlett-Packard, IBM, Goodyear, and Paccar. These companies do not voraciously accumulate scale in hopes of driving down unit prices and eliminating competitors. Nor do they shy away from increasing scale if their customers need it. Instead, they treat scale as just another factor in making their products fit their customers’ needs.

Will the Big Board ever change its name to the New York Scale Exchange? Not likely. But the stock markets will continue to reward those companies that emphasize the reliability and convenience of their products and which zealously defend their share of the customer’s mind – while buying and selling scale with the elan of a savvy commodity trader.

(Note: This Perspective was written in the context of the economy in 1988. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

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Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis.