More in Value Investing G.U.T Series
In the previous article in this series, we looked at the lifecycle of a business from startup to growth, maturity and decline. We also learned that value investors typically look at the businesses in the mature and decline stages, although there are always exceptions. In this article, we will build upon this basis to see how companies can and do act in practice to maximize their value growth.
Originally conceived at the Boston Consulting Group by Bruce Henderson, the Growth Share Matrix, more popularly known as the BCG Matrix, attempts to illustrate where a company’s attention and capital should be focused in its portfolio of products and services.
A company reviewing its portfolio of products could segment them in 4 different buckets as follows:
- Question Marks: These are new products being introduced in a fast growing market where the company does not yet enjoy a good market share. Growing this segment of the business consumes cash and the returns are uncertain. Over time, some of these products will turn into Stars, while the rest will have to be killed. Competitive pressures are strong as high growth markets attract a lot of new entrants.
- Stars: These are the products in high growth market where the company enjoys significant market share. Over time, this market will mature and if the company maintains its competitive position, these products will turn into cash cows.
- Cash Cows: High market share and margins in a low growth market means a company can generate high levels of cash flows without much investment. Cash cows are sacred and meant to be protected and the cash generated to be used to fund new Question marks and Stars.
- Dogs: Mostly me-too products in low growth markets where the company does not enjoy any particular advantage and has low market share. Dogs should be sold or divested.
As the company maps out its portfolio in this matrix, it can use the size of each bubble (that represents a product or line of business) to reflect revenues, cash flows or any other metric that might be useful in the context.
Using BCG Matrix at a Corporate Level
A similar analysis can be conducted at a company level. In this scenario, Question marks are often new startup companies with unproven concepts trying to address a new growth market. These companies are often venture funded and may or may not become a sustainable business. Stars would be companies that have attained a dominant share in a growth market and either are already profitable or close to profitability.
On the other hand, Cash Cows are companies that have built a strong moat around their business and even in a low growth market they tend to generate above average returns for the owners. Dogs just hobble along, having perhaps seen better days.
Please note that many Dogs can be revived if appropriate management attention is paid to them. It can be difficult if there are well established competitors in the market, but it can be done. In some cases, Dogs may even turn into Stars, and eventually Cash Cows (for example AAPL). The BCG Matrix is just a framework to visualize the corporate position and is often violated in real world. Nevertheless, it is a very useful tool.
Why Should Value Investors Care?
As a general rule, valuation for Question Marks is difficult, if not impossible as the concepts are unproven. Some Stars may be profitable, and could be undervalued, but their position is not assured as new and improved competition will continue to enter the growing market.
The Question marks and Stars are traditionally the staple of growth investors, while quality investors focus on Stars and Cash Cows. Value investors on the other hand are more likely to find opportunities under Cash Cows and Dogs.
The Cash Cows are the Buffett favorite as he looks for businesses with moat. However, he has very specific reasons to gravitate towards these kinds of companies and they mostly involve the size of the capital he has at his disposal to invest. For other value investors with a smaller portfolio, it would be unwise to ignore the dogs. Significant undervaluations, and potentially high profits are more likely to be found amongst the dogs then in any other class of companies.
In the next article in the series (Part 3), I will adapt and build upon the BCG Matrix and present a model a value investor can use to structure his or her portfolio. I find that while literature abounds on teaching investors how to value companies, very little is written on how a value investor’s portfolio should be structured. Stay tuned.