This post is authored by Shailesh Kumar, a US based value investor.
Investing can be as simple or complicated as you make it. A good investor tries to break things down to the basics so it is easily digested. When you are knee deep in the financial statements analyzing a stock, it is useful to have a big picture perspective to place the stock and the company in the right frame.
As a value investor (and ex Management Consultant), I have found using BCG Matrix and SWOT Analysis incredibly useful to give me a frame of reference. I will introduce the concepts and tie them together in a unified investing philosophy.
But first, why?
If you own a stock, you own the company. How your stock performs is dictated by how the company performs. You need to be aware of the challenges and opportunities facing the business and you also need to know where the business and its products are in their respective lifecycles. This is often a qualitative assessment but if you wish you can also choose to quantify various aspects to help you further fine tune your stock selection. In my experience, quantification is not necessary. Being precise is not the same as being correct.
If you do not have a good understanding of the business and its challenges, you will often find yourself making the wrong investment decisions when the business hits a speed bump. And speed bumps are very frequent. For example, you do not want to sell the stock when you should actually be buying more of it. This might happen, for example, when there is a temporary decline in the business while long term prospects have not changed. If you do not understand the business, you do not know the decline is temporary.
On a very practical level, using these concepts also aligns you with the management, since they are more likely than not using the same principles to make strategic business choices.
The BCG Matrix
In a nutshell, the BCG Matrix segments a portfolio (of products, services, companies, stocks, it doesn't matter) into 4 different parts.
- Question Marks – These are new products or projects that require lot of cash and investment to make them profitable. Think of a pharmaceutical company introducing a new drug. There is R&D, product development, marketing and various other costs involved in bring this product to the market. And when the product does come to the market, it can either be a very successful product (very high margins – a Star) or it can flop (divest – a Dog)
- Star – These are the successful products that are still enjoying low competition and therefore have high growth rates. A company should continue to invest in these products (or services) to capture as much market share as possible before the competition comes in or the market becomes saturated. If in the process the company establishes competitive advantage that allows it to earn higher margins than the competition (for example, a good brand, or a monopoly position, or a better cost structure due to economies of scale), then as the market matures, these products will turn into Cash Cows. If a sustainable competitive advantage cannot be established, the company will see eroding margins over time and commoditization of the business. At some point, these products will have to be divested (Dogs)
- Cash Cows – When the market for a product matures, the market leader is often a company that is able to generate better margins then the competition. A strong brand allows a company to charge higher prices than the competition. In regulated markets, there is often a barrier to entry that stops the competition to enter. Or in case of a product like Microsoft Office, the wide acceptance of the product by itself creates a barrier to entry because the switching costs are too high for the customers. A company that has a Cash Cow product should continue to "milk" the cash cow. These products require little investment and generate tremendous cash flows that can be used to fund new Question Marks or grow Stars.
- Dogs – The products that are unsuccessful or were once successful and were later commoditized are the Dogs that need to be divested. Dogs may still have economic value and can often be sold, spun off or assets repurposed. It is not always necessary to shut them off.
When analyzing a company for investment, it is very instructive to look at the portfolio of products the company offers. Lets take a company like Apple Computers. It is very easy to see that when products like iPhone and iPad were introduced, they were Question Marks that quickly became Stars and have now moved into the Cash Cow category. Today, Apple Computers is busy milking this cow and hopefully use the cash to fund new Question Marks that will help the company grow (and survive) in the coming years. If the Question Marks (also called "pipeline") is bare, that raises a lot of questions about the future of the company. This is why Apple stock has declined sharply as soon as it became clear that the competition is eroding its margins and there does not appear to be anything new in development.
The above also holds true for companies as a whole (and not just the products in its portfolio). Majority of the consumer products companies and retailers that have built a strong brand operate as Cash Cows. Startup companies are Question Marks while a fast growing high tech company (as an example) may be a Star. Commodity businesses and loss making enterprises are Dogs. If a company has multiple products in its portfolio, you need to consider its R&D, innovation and new product introduction cycle to properly segment the company as a whole.
What Does this Mean for a Value Investor
Since value investors focus on good companies and often look for businesses with competitive advantages, they are attracted to Cash Cow businesses. The valuation of the stock has to be attractive as well. These are the businesses where Warren Buffett is more likely to invest in. However, a classic value investor (Warren Buffett is not a classic value investor anymore, mainly because the large size of his portfolio does not allow him to invest in anything other than large capitalization stocks) will also look for mis-pricings in the Dog companies. For example, if a company has $100 million in cash on the books and is only worth $50 million in the market (let's also assume no debt), I will invest in the stock even if the company is breaking even or slightly unprofitable. One of the 3 things will happen with these companies
- They will be acquired by a larger company for assets and I will make a premium, or
- They will fix the business and the stock will appreciate, or
- They will lose more money in which case someone will decide it is better to close the company and return the cash to the shareholders
These situations very rarely arise for a large company.
But if you invest in large companies, you should look at the Cash Cows that you can acquire at an attractive price. However, keep the following in mind.
Some Cash Cows are Long Term and Others can be Temporary
Coca-Cola is a famous example of a long term durable competitive advantage. I would argue that iPhone and other Apple iDevices only offer a fleeting advantage to Apple and it has to continually innovate and bring new products to the market. How do you know if a competitive advantage is sustainable?
This is a very hard analysis to perform, mainly because you cannot predict the level of competition in the future. Even if you could, it is possible that consumer tastes will change. However, you can get a reasonably good idea by performing a Strength, Weakness, Opportunity and Threat analysis, also referred to as SWOT Analysis. This allows you to put both the internal and external environment of the company in perspective.
You can read more about SWOT Analysis here.
Using BCG Matrix to Manage Your Portfolio
Just as a company may have a portfolio of products that it can analyze using the BCG Matrix, you have a portfolio of stocks that you can also analyze using the BCG Matrix. The metrics will have to be amended since you are more concerned with returns and stock prices. Whether you buy, sell or continue to hold a stock will depend on the level of undervaluation (or overvaluation) of the stock compared to its intrinsic value.
This approach of portfolio management, as far as I know, has not been written about in any academic literature and it will take a whole another article to fully describe it. If you are interested in learning more about it, you can read my initial proposal here (and of course I will welcome any comments and feedback as this is still a work in progress).
About the Author: Shailesh Kumar writes about value investing at Value Stock Guide and is focused on finding the most profitable opportunities in the US stock markets. You can read more about him here.