Replacement Cycles: Malfunction & Innovation

In analyzing the sources of supply & demand for an industry one quickly becomes accustomed to the idea that demand moves in cycles. Economic cycles pervade mainstream economic thinking, so it would be natural to expect demand fluctuating with economic environments. As a result either supply or price also moves in cycles. If supply was fixed and demand cyclical, prices would be cyclical. More realistically, supply reacts to realistic expectations of future demand and prices react upwards, but not as intensely.

In most industries, the primary determinant of cyclicality is the volume of goods sold. Thus, an industry might be called “peak-cycle” if the volume of goods demanded are in excess of normalized expectations.

However there also exists other cycles of demand that impact the volume of goods demanded and their respective prices. One of these alternative impacting cycles is “the replacement cycle” which drives demand through a renewal of parts & products.

The simplest example of a replacement cycle is your consumption of water-heaters. Every time you buy a water-heater, you can expect it to last 8-12 years depending on price. As soon as your water-heater breaks, you either take cold showers or buy a new one. Your individual demand for water-heaters moves in a replacement cycle.

Replacement cycles are driven by obsolescence of products. There can be multiple reasons for obsolescence, each with a different cyclical effect. One reason is product-malfunction. I’ve titled these malfunction-cycles. The water-heater is an example of an individual malfunction-cycle of demand. Another reason can be that the product is now vastly inferior to other goods, leading to a required upgrade. I’ve titled these innovation-cycles, or upgrade-cycles.

Both are examples of recurring demand, which is an extremely positive attribute for any market as it lowers uncertainty, leading to lower borrowing costs and higher stability of income. The effects of each cycle, however, differs vastly based on a series of attributes. Each cycle must be analyzed independently.

The Cycle of Malfunction: Economic Cycles, Smoothing, and Catalysts for Bunching.

The cycle of malfunction on an aggregate level is not necessarily cyclical, despite its name. If the purchase of a new water heater was entirely independent of any other variable, water heater replacements would not show cyclicality. Why not?

Seeing as the purchases were not lumped together, but spread out evenly over time, the replacements also occur randomly across time in non-clustered ways. An example could be an extremely short replacement cycle good (though not malfunction-based) is toothpaste. As users generally buy the same amount of toothpaste independent of economic environment, demographics, weather, or most other things – the replacement cycle is flat in nature, leading to highly sustainable income and a lack of cyclicality. This has a smoothing effect on the economic cycle. While toothpaste is not a malfunction-based good, the lesson is that short replacement cycles and random purchasing can smooth out cyclical effects.

Yet most malfunction-goods have inherent cyclicality. Water-heaters are usually bought during housing booms and are also dependent on demographic patterns in home-buying ages. Water-heater demand therefore generally spikes 8-12 years post housing booms. Luckily a series of housing booms, over time, will create something akin to smoothing, as the demand from each boom follows the next.

Importantly, the length of the replacement cycle results in the recurring demand “popping up” at non-cyclical peaks in the next cycle. The cyclicality of malfunctioning-goods with relation to the economic environment is not necessarily procyclical, but often just cyclical independently of current economic conditions.

Malfunction demand is either smooth across time, or has cyclicality depending on the previous economic cycle. The demand can also be related to the current cycle, if replacement of the product can be temporarily postponed for economic reasons.

Sometimes malfunction-based demand have a catalyst for turning cyclical. Fireman-equipment, such as oxygen tanks, are largely a malfunction-good that generally last 15 years but often require premature replacement on a legislative basis. Except for the occasional budget difficulty, demand for oxygen tanks had an extremely non-cyclical tendency. Recurring demand was smooth across many years as each individual firestation had to replace their gear throughout the year, with no relation to the replacement of other fire-stations.

Then the 11th of September attack in 2001 occurred. Post-attack, George W. Bush Jr. made massive budget allocations to renewing all fireman-gear. This has created a clustered replacement-cycle, as all replacement demand now occurs around the same time, increasing cyclicality in the industry of supplying safety gear to firemen.

To conclude: Malfunctioning goods can lead to highly dependable buying patterns. Sometimes the buying will be constant, sometimes it will follow the last economic cycle, the current one, or be entirely independent of economic cycles as a result of historical events.

When buying companies in an industry with goods that are a “must-have” and last long periods of time, consider how the replacement cycle could look based on common-sense reasoning.

The Cycle of Innovation: Tech-Tock, Tech-Tock.

Some industries have demand for replacing products that aren’t even broken. Crazy, right? Not really.

Many can remember their kids begging for an Iphone instead of a flip-phone, products become obsolete all the time without breaking. Innovation can drive efficiency. With large enough efficiency-gains, consumers and businesses alike will overcome sunk-cost thinking and upgrade.

The presence of an innovation-cycle is mostly apparent in industrial components, not consumer-goods. Consumers will not go out of existence if “operating inefficiently”, but many companies in competitive industries will. Thus a product innovation can lead to forced-upgrading if it’s markedly superior to prior products.

Oftentimes there will be one critical component that forces the rest of the adjacent industries into upgrading. Thus the demand for the producing industry is highly linked to the innovation-cycle. If the cycle of innovation is predictable, companies will even stop replacing old products as they await the newest innovation, leading to a “double-effect” of decreasing demand prior to the innovation and catapulting it post-launch.

The easiest example of innovation-cycles/upgrade-cycles would be the PC upgrade cycle, primarily driven by Intel CPU-releases. The latest was Skylake from Intel. The cycle generally renews every 3-4 years (though wise men expect it to begin growing longer, perhaps 5-6 years). At the end of the cycle companies will be reluctant to expand, thus a changing cycle-length throws considerable uncertainty into the mix.

Cycles often have intra-cycle signs that indicate progress, such as Intel’s previous tradition of first releasing a new microarchitecture, then a new process. Thus, a new microarchitecture was unlikely to be released prior to the new process. There is usually plenty of industry research on a specific innovation-cycle.

When looking at bonds & equities for companies that operate in an industry known for product innovations, especially commercially, approximate the position in the upgrade cycle using “tell-tale signs”.

Conclusion & Takeaways

We’ve hopefully demonstrated that demand can have multiple overlapping cyclical aspects that influence each other. These cycles are important adjustments for considering the price of a business when investing.

In general, recurring demand is an extremely attractive feature, but it heavily affects which attributes dominate in the industry.

In industries with innovation cycles, speed is the name of the game. If you’re the fastest at implementing and getting new innovations out, or the fastest at adapting to new product cycles, you generally win. This promotes engineering talent and R&D as a prime determinant of success.

If your business is based on malfunction, then the speed and ease of replacing the product is essential. Often brands and distribution channels dominate as determinants of success. Thus the marketing and sales organization should be a core focus.

I hope the article was informational. I hope you payment will be sharing the article or commenting with constructive criticism.

Good luck, and good investing.

Matthias Herskind.