Demand Risk

• The Bottom Line: Demand risk is the fundamental danger that customers will stop wanting or being able to afford a company's products or services, causing its future earnings to wither and die.
• Key Takeaways:
• What it is: The uncertainty surrounding the future volume, price, and consistency of customer demand for a company's offerings.
• Why it matters: It is the primary enemy of predictability. For a value investor, unpredictable earnings make it impossible to confidently estimate a company's intrinsic_value and apply a margin_of_safety.
• How to use it: By analyzing the sources and durability of demand, you can separate businesses with lasting power from those built on fleeting trends.

Imagine you're considering buying one of two small businesses for your retirement. The first is the only toll bridge connecting a bustling city to its largest suburb. Every day, thousands of commuters have to cross this bridge to get to work. They may not like paying the toll, but they have few practical alternatives. The demand for crossing your bridge is predictable, consistent, and insensitive to fads. The second business is a trendy nightclub in the city's most fashionable district. Right now, it's the hottest spot in town. There's a line around the block every weekend. But trends change. Next year, a new club might open with a different theme, and your customers could vanish overnight. The demand is high but fragile and utterly unpredictable. Demand risk is the difference between the toll bridge and the nightclub. It’s the uncertainty that the customers who are buying from a company today will still be there tomorrow, next year, and ten years from now. It’s the risk that a change in technology, taste, competition, or the economy could permanently cripple the flow of revenue into a business. A company that sells electricity has very low demand risk; modern society cannot function without it. A company that sells a viral video game has exceptionally high demand risk; its success is likely a one-hit-wonder. For a value investor, understanding this risk is not just an academic exercise—it is the very foundation of a sound investment. As Warren Buffett's partner Charlie Munger would say, the goal is to find simple, understandable businesses. Simplicity often comes from predictable demand.

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.” - Warren Buffett

This quote gets to the heart of demand. A business that can raise prices without losing customers has incredibly stable and inelastic demand—the polar opposite of high demand risk.

For a value investor, demand risk isn't just one risk among many; it is a foundational threat that can undermine the entire investment philosophy. Here’s why it's so critical:

• It Determines the Predictability of Earnings: Value investing is about buying a business, not renting a stock. The value of a business is the sum of the cash it will generate for its owners over its lifetime. If you cannot reasonably predict future demand, you cannot reasonably predict future earnings and cash flows. A business with high demand risk is like the trendy nightclub—its future is a guess, not an estimate. Value investors hate guessing.
• It is the Enemy of Intrinsic Value Calculation: The entire process of calculating a company's intrinsic value hinges on forecasting those future cash flows. With the toll bridge, you can make a confident forecast based on population growth and inflation. With the nightclub, your forecast is pure speculation. High demand risk turns a valuation exercise into a lottery ticket.
• It Defines the Economic Moat: A strong economic_moat is a durable competitive advantage that protects a business from invaders, just as a real moat protects a castle. What does it protect? It protects the company's ability to earn high returns on its capital. It does this by securing customer demand. A company with a powerful brand, high switching_costs, or a network effect has low demand risk because its customers are locked in, ensuring repeat business for years to come. Analyzing demand risk is, therefore, the first step in identifying a moat.
• It Dictates the Necessary Margin of Safety: The margin of safety is the discount you demand between the price you pay and your estimate of a company's intrinsic value. This discount is your protection against error and bad luck. The greater the uncertainty in a business, the wider your margin of safety must be. A business with high demand risk carries enormous uncertainty, thus requiring a massive, often unattainable, margin of safety to be considered a viable investment.

In short, a value investor's quest is to find wonderful businesses at fair prices. A “wonderful business” is almost always one with low and manageable demand risk.

Assessing demand risk is more of an art than a science. It involves critical thinking and asking the right questions, not plugging numbers into a formula. It is a qualitative analysis that should be done before you even look at a company's financial statements.

Here are five key questions to guide your analysis of any potential investment:

1. 1. Is the Product a “Need” or a “Want”?
   • Think about where the product or service falls on the spectrum from essential utility to discretionary luxury. Companies that provide fundamental needs (e.g., electricity, basic food staples, essential medication) have a built-in, durable base of demand. Companies that sell discretionary wants (e.g., luxury cars, high-fashion apparel, cruise vacations) face demand that can evaporate during an economic downturn.
2. 2. How Durable and Cyclical Is the Demand?
   • Is demand tied to a fleeting trend, or is it based on a lasting human habit? Chewing gum has been a steady business for a century; fidget spinners were a six-month fad. Furthermore, is the demand cyclical? For example, demand for new homes and cars collapses during a recession, while demand for toothpaste and toilet paper remains stable. A value investor prizes non-cyclical, durable demand.
3. 3. How Concentrated Is the Customer Base?
   • Does the company sell to millions of individual customers, or does it rely on two or three corporate giants for 80% of its revenue? The latter situation carries immense demand risk. If one of those key customers goes bankrupt or switches to a competitor, the business could be crippled overnight. A diversified customer base is a sign of lower demand risk.
4. 4. What Are the Switching Costs and Brand Loyalty?
   • How difficult, expensive, or annoying would it be for a customer to switch to a competitor? Your bank has high switching costs (you'd have to change direct deposits, automatic payments, etc.), which reduces its demand risk. Your local gas station has zero switching costs. Similarly, a powerful brand like Coca-Cola or Apple creates an emotional lock-in that makes demand “stickier” and more predictable.
5. 5. What Is the Threat of Substitutes and Obsolescence?
   • Could a new technology or business model make this company's product obsolete? Blockbuster Video had stable demand until Netflix (a substitute) made its entire business model irrelevant. Newspapers had a geographic monopoly on local ads until Craigslist and Google destroyed it. You must always ask: “What could kill this business in the next 10 years?”

Your goal is to build a qualitative picture of the business. By answering the questions above, you can place the company on a spectrum from “Toll Bridge” (low risk) to “Nightclub” (high risk).

A company that ticks most of the boxes in the “Low Demand Risk” column is a candidate for deep analysis. A company that falls squarely in the “High Demand Risk” column should probably be placed in the “too hard” pile and avoided, no matter how cheap its stock seems.

Let's compare two hypothetical companies to see demand risk in action.

• Company A: “Steady Tolls Inc.” operates a network of toll bridges and roads under a 99-year exclusive government contract in a growing metropolitan area.
• Company B: “Chic Gadgets Co.” designs and sells high-end, fashionable smartwatches that are currently very popular with celebrities.

Let's run them through our checklist:

The Value Investor's Conclusion: A value investor would overwhelmingly favor Steady Tolls Inc. for further research. Why? Because you can confidently predict its revenues for the next 10, 20, or even 50 years with a reasonable degree of accuracy. You can build a discounted cash flow model that isn't a work of fiction. For Chic Gadgets Co., it's impossible to know what demand will look like in three years, let alone ten. Any forecast would be a wild guess. Even if the stock looks “cheap” based on this year's record profits, the risk that those profits will disappear is simply too high. The intelligent investor trades the illusion of quick gains for the certainty of durable, predictable cash flow.

(Of analyzing demand risk)

• Focuses on the Business, Not the Stock: This analysis forces you to think like a business owner, focusing on the long-term health and durability of the company's operations rather than short-term market noise.
• Promotes Long-Term Thinking: By its nature, assessing demand risk requires you to look 5, 10, and 20 years into the future, which is the correct timeframe for a true investment.
• Acts as a Powerful Filter: It provides a simple but highly effective first filter to screen out a vast number of speculative or low-quality businesses, saving you time and preventing costly mistakes.

(Of analyzing demand risk)

• It is Subjective and Qualitative: Unlike a P/E ratio, there is no single number for demand risk. Two investors can look at the same business and come to different conclusions. It depends heavily on your own circle_of_competence.
• The “Disruption” Blind Spot: History is littered with companies that had seemingly unassailable demand, only to be disrupted by unforeseen technological change (e.g., Kodak and digital cameras). No demand is 100% guaranteed forever.
• Overconfidence in Past Performance: A company might have 50 years of stable demand, but that doesn't automatically guarantee the next 50. Investors must constantly re-evaluate if the underlying drivers of that demand are still intact. Never assume the past will repeat.

• economic_moat
• intrinsic_value
• margin_of_safety
• circle_of_competence
• pricing_power
• switching_costs
• cyclical_stocks
• predictability_of_earnings