When you want to pare down your risk

As a rule, when looking for investments, you want companies that can offer above-average growth relative to their peers. 

This could be done by producing better or cheaper products, or through improved efficiencies that enable growing margins that are ultimately better than the competition.  

But, ultimately, this growth will also hit a wall as a company begins to dominate its market and squeezes out whatever efficiencies it can.

It has then become a mature company. 

Mature is not necessarily bad for an investor because it offers a more stable business model and, ideally, a higher dividend yield.  

Of course, a company can try and avoid this growth stall via expansion into new markets and geographies through either organic growth or acquisitions. 

This comes with risks, especially if the acquisitions are large – as we’ve seen recently on the JSE with a number of (frankly, second-rate) deals in the offshore space.  

There is, however, another aspect you also need to consider as an investor, and that is inelasticity of demand.

Basically, it means that demand is fairly static. For example, milk is very inelastic in that if you have it in your coffee or cereal every morning you’re very likely to continue to do so. 

The opposite is true of hamburgers, which you can eat when times are good and avoid when they’re not.  

With inelastic demand, changing economic conditions may see you switch to a cheaper brand, or health reasons may see you move to a lower-fat milk, but you’re not suddenly going to start having your coffee black to cut costs – nor are you going to add milk to the coffee because you’re feeling wealthier after a salary increase.   

Therefore demand can be very static, only really growing with population or demographic growth.

You can see this demographic growth in a country that is experiencing changes such as a fast-growing middle class that may be changing diet habits – like starting to drink more milk than was previously the case.  

This inelastic demand has its pros and cons for investors. On the one side, it provides you with fairly predictable returns, especially if the company is able to control input costs. 

Input costs are very dependent on the industry the company operates in, so be careful here.  

With inelastic demand the issues to watch are brand power and what, if any, pricing power that gives the producer. Staying with milk: Clover has very strong brand power, but the price of its milk is at the top end of the range – a consumer under financial pressure may shop down to a cheaper brand as they are of the view that milk is milk. Why pay a premium?  

Another fairly inelastic product is petrol. Here there is government-controlled pricing so while we may have our preferred brand, it really is more about convenience or loyalty rewards that come with that brand, as the price remains the same. 

Further, while we can to a degree manage how much petrol we use by maybe going out less on weekends, much of our travel is getting to and from work where we have limited choice (we could car pool or try public transport, but transport habits do not change easily).  

An investment portfolio full of inelastic products won’t be thrilling, but they can serve a purpose in a portfolio in that profits should be fairly stable, and hence the share prices should also be fairly stable. 

In theory, they would also hold up better in weak markets while lagging strong markets.  

The risk, aside from shopping down where possible, is the extras that the company offers. 

Clover has a number of extras such as yoghurt and the like, which are very much a discretionary spend and therefore subject to variances in consumer demand, which is driven by consumers’ financial situation.

This article originally appeared in the 16 August edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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