By-Product

A by-product is a secondary item or substance that is produced incidentally during the manufacturing of a main product. Think of it as a valuable leftover. Unlike waste, which has no commercial value and often costs money to dispose of, a by-product can be sold to generate additional revenue. For example, when a lumber mill saws logs into planks of wood (the main product), it creates a mountain of sawdust. Instead of throwing it away, the mill can sell the sawdust (the by-product) to be pressed into particleboard or used as animal bedding. The key characteristic is that the company isn't in business to make the by-product; its creation is an unavoidable consequence of making something else. However, this “accidental” revenue stream can have a surprisingly positive impact on a company's financial health, often boosting its profit margin with very little extra effort or cost.

For the value investor, by-products are a delightful concept, akin to finding a twenty-dollar bill in an old coat pocket. They represent what the legendary investor Warren Buffett might call “lagniappe”—a small, unexpected bonus. The market often overlooks or undervalues these secondary revenue streams, focusing solely on the main product line. This oversight creates an opportunity for the diligent investor to find companies whose profitability is secretly enhanced by these forgotten treasures. A strong by-product business can be a sign of a well-managed and efficient operation. A company that takes the time to monetize its leftovers is likely disciplined and focused on maximizing value from every part of its business. This revenue often comes with exceptionally high margins, as the raw material costs are already accounted for in the production of the primary product. This “free” profit flows directly to the bottom line, improving the company's overall profitability without requiring significant new capital expenditure.

The real magic of by-products for an investor lies in their potential to be a “hidden asset.” When analysts build financial models to determine a company's valuation, they might assign little to no value to by-product sales, especially if they are small or volatile. They are often lumped into an “Other Revenue” category and forgotten. An investor who does their homework and uncovers a stable and growing by-product business might realize the company is worth more than the market thinks. This means the stock could be trading at a discount to its true intrinsic value. By identifying and properly valuing these income streams, you can gain an edge and potentially unearth a bargain that others have missed.

Finding these hidden gems requires a bit of detective work. Here’s where to look:

• Read the Annual Report: Comb through the company's annual report (like the 10-K filing in the U.S.). The “Business” description or “Management's Discussion and Analysis (MD&A)” sections might mention revenue from secondary products.
• Understand the Business: Think critically about the company's core manufacturing process. What “waste” does it create? Could that waste have value? For example, a coffee roaster produces coffee chaff (the dried skin of the bean). A quick search reveals it can be used in gardening or as a biofuel. Does the company monetize this?
• Look at Industry Norms: Certain industries are famous for their by-products. Companies in mining, energy refining, food processing, and chemical manufacturing are prime hunting grounds. The value of these by-products can sometimes fluctuate with commodity prices, creating interesting dynamics.

• Oil and Gas Refining: The main goal is to produce gasoline and diesel. However, the refining process also yields valuable by-products like jet fuel, asphalt for paving roads, lubricating oils, and petrochemicals used to make plastics.
• Meat Processing: When processing cattle for beef, nearly every part of the animal is used. Hides are turned into leather, fats are rendered into tallow for soaps and animal feed, and bones are ground into bone meal. These are all crucial by-products.
• Corn Milling: While the primary products might be high-fructose corn syrup or ethanol, the process also creates by-products like corn gluten meal (a high-protein animal feed) and corn oil.

A by-product is far more than an industrial leftover. For a smart investor, it’s a clue. It points to operational efficiency, a source of high-margin revenue, and a potential “hidden asset” that the wider market has ignored. Paying attention to a company's by-products is a classic due diligence step that can help you uncover the true earning power of a business and find exceptional value where no one else is looking.