Forecasting demand is essential for spotting the next investment opportunity and spotting a stock that is about to rocket. Inaccurate demand forecasts have cost investors and companies billions.
One of the most high-profile forecasting failures came in the 1970s when US energy providers predicted 7% annual growth in the demand for electricity. New power plants were constructed to meet this increased anticipated demand and investors flocked to the energy industry. However, in the 1980s, the 7% growth failed to materialize. Demand growth was much slower than anticipated. Ultimately, it hurt investors and electrical companies.
These are the four crucial steps to effectively forecasting market demand and spotting investment opportunities while avoiding potential pitfalls.
Define the Total Market
Before you can effectively predict demand, you must first know the market. Defining the market involves identifying the end users and the drivers that drive growth in the market.
It also involves exploring potential product substitutions and determining how consumers would react to a sudden price increase or performance drop. Can users substitute the product for a cheaper alternative? Are they a captive market?
In defining your market, you also need to explore potential technological developments on the horizon. Is automation creeping into the industry? How will this affect the market? Also, it is worth considering newly discovered uses for old materials. For example, graphene has long been used as the chemical compound in pencils, but its use is also being expanded into solar panels, leading investors to flock to the top graphene stocks in the expectation that demand will skyrocket in years to come.
Separate the Market into Groups
Once you have identified the total market, you can separate the market into groups and define the market drivers in that group. For example, the white paper market is made up of several groups. The largest consumer use for white paper is in business forms, making up 25% of the total demand. The other largest groups are commercial printing, envelopes, stationery, books, magazines etc.
Identifying Drivers of Demand
When you have the groups, you need to identify what drivers contribute to the market demand of each group. For example, if you are identifying the drivers for the use of white paper in business forms, the macroeconomic variables will indicate that the number of workers, economic performance, population, and declining copy costs all contribute to increased white paper demand.
With no further spikes in population, workers, economic performance on the horizon, and no indication of further reductions to the cost of copying, it is, therefore, reasonable to conclude that the demand for white paper in the business form sector will continue at the same rate.
Finally, forecasting demand effectively requires sensitivity analysis. Sensitivity analysis identifies what factors would prompt your forecast to change dramatically. It identifies risks, developments in competing technologies, potential increases in supplier costs, and legal challenges.
In the case of the white paper for business forms category, although our drivers all indicate sustained demand, the sensitivity analysis would identify that new paperless technologies will impact these drivers and substantially change our forecast. As a result of new technologies, demand will likely fall dramatically as blockchain technologies and digital contracts and forms replace the need for paper.
Carefully considering each step in total demand forecasting should shape investment strategy decisions. It will create a better understanding of the market and the drivers involved in forecasting. Using these steps, investors will be able to better manage risks.