A Necessity Good is a type of product or service for which consumer demand increases as their income rises, but it does so at a slower pace than the income growth itself. In economic terms, this means it has a positive but low income elasticity of demand (a value between 0 and 1). Think of the basics of life: food staples like bread and milk, utilities such as electricity and water, and essential healthcare. When you get a raise, you don't suddenly start drinking ten times more milk or leaving the lights on all day. You might buy slightly better quality bread or use a bit more electricity, but your spending on these items won't explode in the same way your spending on a luxury car or a fancy vacation might. This characteristic makes the demand for necessity goods remarkably stable, as people continue to purchase them even when their budgets are tight, making them a cornerstone concept for conservative, long-term investors.
The secret ingredient is how our spending on an item reacts to a change in our wealth. Economists measure this using a concept called income elasticity of demand, which is just a fancy way of asking: “If your income goes up by 10%, by what percentage does your spending on this item go up?”
The line between a necessity and a luxury can be blurry and often changes with societal progress and individual circumstances. For example, a basic internet connection is now widely considered a necessity in developed countries, a stark change from just a few decades ago. For an investor, the key is to identify goods and services that a large portion of the population simply cannot do without, regardless of the economic weather.
For a value investor, companies that sell necessity goods are incredibly attractive because they exhibit powerful defensive qualities. Their business models are built on a foundation of steady, predictable demand.
Businesses focused on necessities are often called defensive stocks. During an economic downturn or a recession, people may cancel their vacation plans and postpone buying a new car, but they will still buy groceries, toothpaste, and medicine. This reliable demand translates into more stable revenues and predictable cash flow for the company, even when the broader economy is struggling. This stability is a key component of a company's economic moat, protecting it from the worst of economic cycles.
Stable revenues lead to predictable profits. For an investor, this predictability is golden because it makes valuing the business much easier and reduces the risk of nasty surprises. Companies with such reliable earnings, like Procter & Gamble or Unilever, are often mature businesses that don't need to reinvest all their profits back into growth. As a result, they frequently become reliable dividend payers, rewarding shareholders with a steady stream of income. This combination of stability and income is a powerful draw for those following the principles of Warren Buffett and Benjamin Graham.
You don't need a Wall Street supercomputer to find these companies; they are often hiding in plain sight. They are the brands you see in your kitchen, your bathroom, and on your utility bills.
While companies selling necessity goods are often wonderful businesses, they are not automatically wonderful investments. First, the flip side of stability is often slower growth. These are not companies that will double in size overnight. Their markets are typically mature, and growth is often slow and steady. Second, competition can be fierce. The rise of private label (store-brand) products from large retailers like Walmart and Costco can put pressure on the margins of even the most established brands. Finally, and most importantly, valuation still matters. You can overpay for even the best company in the world. A fantastic, stable business bought at an inflated price can result in a mediocre investment. The core task of a value investor is to buy a great company at a fair price.