We wrote about why macro is important for stock pickers in our last post. Part of this involves an understanding of the forces that drive demand for the product or service of an underlying firm in our portfolio-- this is a necessary ingredient for us to form conviction. In this discussion, we share with you how we define a trend, other forces that are often confused with trends, and finally how this knowledge translates into portfolio positioning.
Webster defines the word “trend” as a “general direction in which something is developing or changing.” Since this definition is far too vague for any practical use in the investing world, we took it upon ourselves to torture and adapt the meaning to suit our purposes. We find more utility to re-define a “trend” by the following: A phenomenon that exerts an irreversible pressure on penetration rates for a good or service. (Penetration rate = number of customers divided by the total addressable market). Since the total addressable market (TAM) can sometimes be hard to estimate, especially for emerging trends, we tend to be biased towards the broadest definition possible. For goods and services that sell to consumers, our TAM will tend to be the global population and for those that instead sell only to businesses, our TAM will tend to be all businesses. Because our denominator is so large, the level of the penetration rate is of minor importance relative to the shape of the penetration rate over time. Below is the penetration rate of mobile phones over the past decade. All trends over their lifetime tend to exhibit a similar shape. The penetration rate grows faster in the beginning then, after an inflection point, begins to slow.
Trends reflect how our world is changing. If the phenomenon in question can potentially reverse, i.e. the penetration rate starts to go down, it is not a trend. Trends may either accelerate or decelerate but they do not reverse or die, they mature. For example, Henry Ford invented the Model T in 1908. It was the first affordable automobile built for the middle class. Assisted by sociological and industrial realities, the Model T ignited the trend of automobile ownership. Automobiles were once a big idea, but now you wouldn’t think twice about your neighbor driving the latest Honda hybrid.
“I will build a motor car for the great multitude..constructed of the best materials… the simplest designs that modern engineering can devise…. so low in price that no one making a good salary will be unable to own one and enjoy of pleasure in God’s great open spaces. When I'm through, everybody will be able to afford one and everyone will have one. The automobile will be taken for granted...” H. Ford
Henry Ford succeeded in changing what feels “normal” to us. The above quote perfectly sums up the beginning of a trend and the vision of how a trend matures.
What else influences penetration rates?
Other forces that influence penetration rates that are just as important to understand but routinely confused with a trend are either: cyclical, faddish, or one-time shifts1. Since most of the purported consumer behaviors tend to be either cyclical or faddish, we focus on distinguishing them from trends.
Trends vs. Cyclical forces
Cyclical patterns are easy to spot in a time series with penetration rate on the y-axis and time on the x-axis. An undulating pattern is usually always an indication of cyclicality. Seasonality in certain pockets of the retail market, for example, is a clear example of this. Everybody knows a higher proportion of people own Christmas trees in December, but there does not always have to be a clear intuitive reason for the cyclicality. Take homeownership rates in the U.S. below. Although homes are considered an investment asset by many and the cyclicality will inherently be driven by a change in price, it is not the only factor contributing to the cyclicality.
The reasons for this undulation are multi-variate and require an understanding of policy-created incentives, interest rates, securitization of mortgages in the banking sector, economic cycles, and the effect rising and falling prices have on the psychological disposition of buyers. Whatever the reason, homeownership rates are indeed a cyclical force with indeterminate upcycle and downcycle lengths and will never represent a trend. It is important to stay mindful of this because during extended upcycle or downcycle periods, like from 95’ to 08’ with home ownership rates, well-reasoned explanations will start to seep into the zeitgeist claiming that we are in a “new normal.” In 2005 David Lereah published a book famous for all the wrong reasons called “Are You Missing the Real Estate Boom?: The Boom Will Not Bust and Why Property Values Will Continue to Climb Through the End of the Decade.” Many believed more and more people would continue to own homes and that it was virtually impossible for home prices to decrease.
A recent example of how we have used our understanding of cyclical forces to help initiate a portfolio position was our thesis on Donnelley Financial (DFIN). A large part of Donnelley’s business is linked to capital markets activity such as IPOs that are cyclical in nature. Toward the middle of 2020, IPOs had been in a downcycle for quite some time and there were a host of explanations claiming that the private markets had too much capital, appeasing shareholders was too onerous and there wasn’t an advantage to going public. Wall Street Journal published an article in 2017 titled, “America’s Roster of Public Companies Is Shrinking Before Our Eyes | Gusher of private capital, IPO slump and merger boom cause listings to plunge; There’s no great advantage.” This was the prevailing sentiment at the time. While these reasons held some water, it was clear to us that public markets still offered the most accretive way for founders and employees to monetize their ownership. Not to mention it is the biggest scoreboard in …
