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More in Value Investing G.U.T Series
Success in value investing is as much about your approach as it is about your ability to run models in Excel. It also depends on your understanding of the business. There are some basic frameworks you can use to analyze any business. I want to introduce a few of these in this series of articles, and finally take some key insights and formulate a portfolio management strategy that a value investor can use in one of the subsequent articles.
We will dispense with the math and the ratio analysis and other such tools value investors use to select investments in this series of articles. Instead, I will focus on some of the very basic principles of business that every investor needs to understand to pick stocks successfully.
Let’s start by looking at the following chart:
4 Phases of the Business Life Cycle
Every business goes through the 4 phases of the business life cycle. This is a very versatile curve. You can change the Y axis to represent Revenues, Profits or Cash Flows. While the values will be different, the shape of the curve will be the same.
Read more: how to get into the stock market
Key points to note:
- The time between start-up to decline is different for different businesses. Some businesses die within few years and some other businesses survive for over 100 years
- The Start-up and the Growth phases are typically net cash sinks, while Maturity and Decline are cash generators
- The business here is defined at a much more granular level than a corporate entity. Each product or service is a business and goes through this life cycle. A company that has multiple products and services, will have its own corporate business life cycle curve which is made up by combining the individual product and service business life cycle curves in its portfolio
An enduring company is built on a portfolio of products and services that is continually refreshed to replace the parts in decline by starting and growing new products and services to take its place. That way, the company on the whole can manage to stay in the growth/maturity phase for a long time by continuous innovation and actively managing its portfolio.
Occasionally, Decline is followed by Revival but it is very rare. The reason being when a business starts moving in the Decline phase, there are already new competitors starting up in the industry to fill the market share vacuum created, if any. Or the industry itself may be in decline.
Value investors typically invest in the businesses in Maturity and Decline phases as they place great emphasis on cash flows. It is important to note that while the company as a whole might be mature, it may have at any time several businesses under start-up and growth stages.
See also: liquidity shares
Expanding Business Life Cycle to Company Life Cycle and Product Life Cycle
The business life cycle concept can also be expanded to a company life cycle or a product life cycle. The 4 phases remain the same, just the granularity differs. For example,
A company can be made up of many businesses. Each of these businesses can have many products. Each individual product has its own life cycle. The portfolio of products at a business level will contain products in different phases of the product life cycle, and they aggregate to form the business life cycle. The portfolio of businesses at the company level will have businesses in different phases of the business life cycle, and together they aggregate to form the company life cycle.
In the next article in this series we look at this deeper from a portfolio perspective using a framework that has come to be known as BCG Matrix. This introduces the concepts of industry attractiveness, portfolio allocation and market share to the mix.