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How does a business come to exist?

Course Section 1 - Lesson 3

In the first two lessons, we looked at a series of revolutionary companies: Ford: which made cars when no one owned a car, and social media sites like Facebook before people connected online.

Today these products seem inevitable. But in the last video, we discussed why it could be challenging to make money by investing in companies with revolutionary products.  

  1. It's hard to be sure that a product will gain widespread adoption, and 

  2. Once a product does go mainstream, it's often the case that the first company to market isn't the one that ends up as the market leader.  

While investing in these companies can be a profitable investment strategy (and one that we'll talk about later in the course), these types of companies can often serve as a source of a lot of investment risk in your portfolio.  

In this lesson, I want to take a big step back from looking at revolutionary companies and instead refocus our attention on relatively dull businesses.    

Businesses are Born to Meet a Need

Every successful business in existence operates to meet a demand that wasn't being met by society. Sometimes the demand is easy to spot, like the desire for a more efficient means of transportation - as we saw with Ford motor company. But just as often, the demand can be hard to see for outsiders. Companies that supply restaurants with food, remove waste from our cities, and transport natural gas are essential for nearly every city today.  

There are thousands of companies that most people rarely think about that enable modern society. Companies like utility operators that generate electricity and clean water for our homes or textile manufacturers that create the cloth for apparel companies are rarely on our minds. If we do think about them, it can seem as if these companies have always been there, quietly operating in the background. But that's not the case.

These companies have only arisen because there was a need that wasn't being met in society.  

Needs Change Over Time, and so do the Businesses that Meet Them

It's easy to think that your local power company, for example, has always been in existence, but of course, that's not true. Your local power company set up operations once there was enough demand to offset the cost of building the power plant and the infrastructure necessary to deliver the power to the homes & businesses in your town.  

Imagine for a second that a new generation of solar panels was developed that could power an entire home for a one-time cost of $100. In this alternative reality, it's easy to estimate where demand for traditional sources of electricity would go - it would go to zero. As demand for the local power company's product fell eventually, the power company would reach a point where it was no longer profitable for them to keep running their generators, and they would shut down the plant.

It's essential that when we are thinking about businesses and potentially investing in these businesses that we understand that they only exist because demand for their product or service exists.

The Mindset of Demand

As a new investor, you must maintain a mindset of identifying where the demand for a company's products is coming from. Demand is the sort of thing that can exist for decades and then evaporate seemingly overnight. There are sources of demand that are more stable than others. Three that immediately come to my mind are food, water, and shelter. When you evaluate a company to invest in, you will need to make a judgment call about how stable the demand for that company's products will be in the future.  

As an investor, I like relatively boring companies because demand tends to be easier to estimate for these company's relative to their more exciting peers. When we get into lesson 3 and begin evaluating companies, you'll see that most of the work we will do is eliminating as much risk as possible from the investment decisions that we make. By choosing investments with stable demand, we can eliminate a giant source of risk early in the process.

All Companies Eventually Fail

In 2018, Jeff Bezos, the founder and CEO of Amazon.com generated a lot of press by stating that Amazon would fail. He wasn't saying that his business was currently facing trouble, only that eventually, something would come along that would force his now dominant company off of its pedestal. According to Bezos, companies tend to last for about 30 years. There are many exceptions to this statement, but the idea behind it is sound. Companies don't last forever, and you should not treat the companies you invest in as if they will. 

Mark Complete