Why Understanding The Product Life Cycle Is Essential To Smart Stock Selection
Guardian film critic Peter Bradshaw wrote in his pan of the recent release Genie, starring Melissa McCarthy, “The whole thing is as bland as cellophane.” 1The lowercase “c” is appropriate in the U.S., where “cellophane” has been genericized. Cellophane with a capital “C” remains a registered trademark in the UK.
It seems like just yesterday – well, no, actually it was in 1934 – that songwriter extraordinaire Cole Porter wrote:
You’re the top
You’re Mahatma Gandhi
You’re the top
You’re Napoleon Brandy
You’re the purple light
Of a summer night in Spain
You’re the National Gallery
You’re Garbo’s salary
You’re Cellophane.
“Bland” was definitely not the adjective Porter would have applied to the versatile wrapping material. Cellophane had been patented in 1912 but it really took off after DuPont chemist William Hale Charch found a way to make it moisture-proof, with sales tripling between 1928 and 1930. The product’s transparency enabled consumers to inspect the quality of meat before purchasing it. Cellophane also became the basis of adhesives such as Scotch Tape and the wrapping material of choice for cigars.
The Rise and Fall of Market Titans: Historical Examples
Cellophane’s sales of cellophane have fallen off since the 1960s, however. The product has lost ground to lower-cost and more environmentally friendly alternatives such as biaxially-oriented polyethylene terephthalate (BoPET) and biaxially oriented polypropylene (BOPP). Its history illustrates the product life cycle, an essential concept in securities analysis.
Even someone with just a few years of investment experience is conscious of cyclicality related to business conditions. As the economy alternates between expansion and recession, demand rises and falls for durable goods and basic materials. The stock prices of companies producing such items likewise fluctuate over the course of the business cycle, but investors can ordinarily be confident that demand for the companies’ goods will rebound from low points as Gross Domestic Product recovers.
Environmental and Social Factors in Product Evolution
Over the longer run, however, demand for many goods is subject to a cycle of Introduction, Growth, Maturity, and Decline. Technological innovation inexorably generates more powerful, more compact, or more cost-effective competing products. For faddish items, it generally proves impossible to sustain the cool factor for very long. Demand for a hot new product may grow at double-digit rates until everyone has one, but after that point demand can be expected to grow only in line with population growth.
Casual observation discerns the product life cycle’s importance in valuing tech companies. Historical perspective makes it clear, though, that the concept applies even in industries that are not as obviously vulnerable to disruption. Once upon a time, after all, marketers of whale oil probably felt sure that demand would hold up as long as people wanted lighting.
Predicting the Next Big Thing: Challenges and Approaches
Another renowned lyricist, Ira Gershwin, wrote in 1938 (“Our Love Is Here to Stay”):
The radio and the telephone
And the movies that we know
May just be passing fancies
And in time may go.
Those fixtures of mid-twentieth-century life have not entirely vanished from the scene, but they have undergone tremendous changes. Companies that were engaged in nationally networked radio programming or manufacturing of telephone booths were compelled to adapt or die. Motion picture studios had to contend with the advent of television and, more recently, streaming.
What This All Means for Security Valuation
In the classic model of equity valuation, a discount rate is applied to a projected future stream of dividends. The chosen discount rate is affected by the extent to which year-to-year demand for the company’s goods is affected by the business cycle. The future dividend stream is assumed to grow indefinitely.
Taking that model of reality too literally can be harmful to your financial health. Expected growth in free cash flow is a key valuation factor for stocks. The product life cycle’s existence guarantees that a corporation’s existing lines of business will not forever continue providing the nice, steady progression envisioned by a simplistic model. To sustain its growth over the long haul, a company’s management must constantly be looking ahead, planning to supplement or replace existing products with new, as yet untried ones.
Some managements will pick the right horses, but others will place wrong bets. Not every product currently in development will prove commercially viable. This means that if you hope to prosper by picking stocks, you must avoid becoming sentimentally attached to the ones that performed well for you in the past. Doing so could doom you to pinning your fortunes on products that are currently exciting enough to have pop songs written about them, but will one day be written off as bland. And in today’s dynamic environment, that transition is likely to occur far more rapidly than in the era of Cole Porter and George and Ira Gershwin.
