We Cannot Turn Our Backs on Our DNA

No matter how hard we try, our DNA cannot be ignored. It is what sets our course and determines who and what we are. Denying that is to deny our very existence. This is true about our biological selves as well as our businesses. The DNA in the diamond industry is to buy rough, manufacture and sell polished. The price of polished is determined by consumers who walk into stores, that is a given. The fair cost per carat of rough is determined by the following equation: The total price of its polished output divided by its total rough weight in carats, less polishing costs and margins. I’ve said it many timesin the past and I’m stating it here again. Why? Because that is our DNA and my manifesto.

The agenda

There is no need to describe the current market situation, with its rough premiums and first hand buyers who would rather sell the goods than polish them. We know this all too well. We know that the established traders stick by our DNA, which is what made them successful. Sadly, many have chosen a path that is contrary to our DNA and we are wandering off the path of success and into the wilderness.

Banks in New York City, Antwerp and Tel Aviv, even a few in Mumbai, found that many in the industry did not apply the price-cost formula above, did not understand what was going on, suffered damages and simply opted to leave the diamond sector behind in favor of other industries. 

Manufacturers in India are very hard working. They learned the trade, developed the skills and took market share from the established centers. That process included employing the basic DNA of our trade: translating the price of polished into the cost of rough they could afford. However, there seem to be some underlying issues.

Remember what I said about the three drivers: The factory driver, the rough buying driver and the financing driver. Basically, these forces drive activities that do not drive profit in the profit equation of rough cost based on polished prices . They are possibly joined by another driver, the political agenda for employing people.

The main drivers at play

Rough buying drivers – One driver is the ability to generate profit when trading in rough diamonds. The main diamond miners directly supply to a limited number of manufacturers, pre-qualified companies that are chosen for their good business practices (among others). Most of the others depend on secondhand supply. Rough diamond trade between firsthand buyers and the secondary market can, at times be lucrative, generating large premiums for the sellers.

This means that these firsthand buyers/manufacturers prefer to sell the goods for a premium rather than manufacture (because they understand and try to stick by the DNA formula). By preferring the premium from selling the rough they generate funds that allow them to sustain large manufacturing plants that really should be closed. The secondary market is, in effect, subsidizing the large factories, supporting the over-sized manufacturing facilities and contributing to the vicious cycle.

This driver is so powerful that most firsthand buyers often purchase goods from the miners with the intention of selling them to the secondary market. At times, a seller will do the deal for the interest on the credit term. This credit usually carries an interest of 1% per month, a very profitable return on the money.

The downside is that manufacturers find themselves acting as a bank, which is not their core business. 

The financial driver – Many companies have deep credit lines and are highly leveraged. The need to service debts is important. The problem is that companies are often far more leveraged than is healthy, and the magnitude of it is such that it impacts the entire pipeline. Many business failures in the diamond industry over the past couple of years were exacerbated by this phenomenon.

The banks are export oriented, often willing to disregard the DNA equation, wither because of legal requirements, opportunism, or the fact that the banks simply do not want to face market realities. Sadly, this might blow up in their faces when they will need to write off toxic debts.

The factory driver – At times, the push comes from the need to keep the many employees busy with the belief that the good times will return. Wishing to enable workers to generate extra income, say before an extended vacation, some manufacturers extend work hours and therefore need to buy rough diamonds so there is enough work to be done.

Or maybe manufacturers don’t understand that they have excess manufacturing capacity and they continue to hold on to the large plant in hopes that the “good days” will return. They have been waiting for years.

Many factory owners have been operating within the diamond industry for many years and that is what they and their families, including the younger generation, know how to do – polish diamonds. There is a concern and resistance against closing the factory and going into another business. That is a psychological driver.

Other drivers related to factories include a need to show the banks that the company is working, functioning.  This is achieved through continued manufacturing. This is especially true if they are firsthand buyers. They need to keep the factories to protect their supply agreements. Whatever driver motivates any individual manufacturer, in the meantime they are not adhering to our DNA.

The case of the falling price of melles

Look at the following graph. It exemplifies the problem of following an illogical business decision making process, such as with the drivers above. The graph shows the decline in melles price over a period of nearly four years, from December 2012 to the present. The manufacturing of these goods is so widespread it resulted in excess-supply – a direct result of the over-capacity  in manufacturing I’ve discussed several times in the past. This excess capacity led to an abundance of goods that, in turn, led to the continuous price decline.

This unhealthy price decline is a disservice to the industry as well as business and is a direct result of conducting business outside of our basic DNA.

The high quality/top color diamonds weighing 3 carats and more are not selling. Even 2-carat goods are in low demand. The entire industry is focused on polishing 0.75-5 carat rough, which raises the concern that an excess supply will reoccur, and once more push down prices of their polished output – just as we are seeing with the melles.

The price of not being true to our DNA

I run a successful and profitable business and you may ask why I should be worried about the mistakes (as I see it) that others are making. The answer is simple: it impacts all of us. It hurts other businesses, it hurts the diamond trading centers and it therefore hurts the livelihood of many in the industry. It creates a distortion in the market.

One offshoot of this distortion is that export oriented banks in India are willing to ignore the DNA equation. Of course, there will always be a certain distortion in the market between the cost of rough and the price of diamonds. This is a result of the time lag between buying rough and selling polished and is therefore not only a natural outcome, it is always taken into account. 

What worries me is the results of the distortion that have been emerging in the market. The established players prefer to sell their rough diamonds to others instead of manufacture. This, while even the central bank of India understands the distortion of not acting based on the formula and warns against it.                                                                                                     

The situation is such that even second hand buyers are passing the goods on to third hand parties. How well known are these companies? What do they know about adding value, polishing efficiently, etc.? There are a number of polishing facilities for sale because of the market distortions. There is a rise in inventory that who knows how it was priced. After all, they paid a very high premium for the rough. Will they succeed in recouping their costs in a market of oversupply and declining prices?

Another offshoot of this new situation is that the established, professional companies in India, which internalized the large disparity between the cost of rough and the price of polished, are afraid to provide credit to buyers. These professional companies naturally prefer to polish at a premium and make a profit, but in the current situation, they are forced to sell to those held captive by the drivers.

At the end of the day, no matter how you feel or view the market, we all agree that, in order to succeed in the long run, we need sound foundations to act upon. They include business expertise, an understanding of the goods and the desire to increase one’s own capital and leave something for the next generation. For that, we need to think long term and act long term. And that means adhering to our DNA.

The views expressed here are solely those of the author in his private capacity. No one should act upon any opinion or information in this website without consulting a professional qualified adviser.