Graph of the week

Graph of the week

17-01-2020 | Einblicke

The stylized lifespan of businesses and industries

  • Steef  Bergakker
    Senior Portfolio Manager
Like people, businesses and industries go through a cycle of birth, growth, maturity and decline.
Source: Credit Suisse HOLT

The graph above categorizes businesses into four groups that correspond to these life stages. The grouping is a result of the answer to the following two questions:

  • Is the business’s cash-flow return (CFROI) on its investment higher or lower than its cost of capital (real discount rate or DR)?
  • Is the business investing sufficiently in future growth?

The combination of possible answers yields the following four possibilities:

  1. Question marks
    The combination of high growth and an investment return that is below the cost of capital is referred to as ‘question marks’. The business is still generating negative economic value, but is investing heavily in future economic success. However, the result is uncertain. Some businesses succeed, others fail. Well-known examples of companies in this stage are Tesla, Uber and Twitter. This category also includes a remarkably large number of companies from emerging markets.

  2. Stars
    When high investments are coupled with investment returns that are in excess of the cost of capital, a business creates rapidly increasing economic value. From a business perspective, this is the Valhalla, hence the designation of ‘stars’ for this phase. The businesses in this category are usually relatively young companies that have proven their economic worth and can still make significant investments in new growth opportunities. Almost all of the market favorites in recent years are in this category: Apple, Amazon, Facebook, Alibaba, Microsoft, Tencent, etc.

  3. Cash cows
    If businesses are still creating economic value, but have fewer opportunities to make profitable investments, they are referred to as ‘cash cows’. As the company’s profits are no longer being used for new investments, it produces huge amounts of excess cash that can be paid to the shareholders. This category includes companies that have often been operating for decades and, as a result, are having to deal with more or less saturated markets. Well-known household names such as Coca-Cola, Nestlé, McDonald's, IBM and Unilever are typical representatives of this category.

  4. Dogs
    Sooner or later, every business enters a period of stagnation or even decline. Products that for decades sold like hot cakes now often prove difficult to shift and recovering the costs of capital is usually no mean feat. It’s a dog’s life. The common denominator for many businesses in this life stage is that they are active in industries that are losing or have already lost their economic relevance in the current information age. This includes oil, steel, traditional banks, traditional car manufacturers and traditional telecom companies. Exxon Mobil, Royal Dutch Shell, AT&T, Toyota and Citigroup are a few examples of companies in this category. While they may still be giants in terms of market value, they are giants with feet of clay.
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Stage transitions are where the most attractive investment opportunities lie

Of course, this is a stylized representation of the business life cycle. Not every business goes through every stage and not necessarily in a sequential way. The economy is too dynamic for that.

Nevertheless, distilling a complex reality into a simple matrix can help with investment decisions. Sooner or later, businesses that create economic value are rewarded, while those that destroy economic value pay the price. In principle, question marks and dogs are therefore the risky categories and stars and cash cows are the ones that present opportunities.

However, financial markets usually discount this via stock valuation. Cash cows and stars are more expensive than question marks and dogs, so outperformance is not a foregone conclusion. It is mainly the transitions between the different stages of the life cycle that generate opportunities (and risks!) for investors. Investors with the ability to anticipate when companies will transition between the different stages can look forward to exceptional returns.

One way of searching for potential stage transitions of businesses and industries is to study socioeconomic trends.

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