The balanced product portfolio

Thinking back to when I studied Business Management as a young 20-something, it always seemed rather pointless when we as students learned about the suite of "MBA tools" which business leaders and executives apparently used to run companies effectively.

We tended to learn the tools simply as lists to be recited in examinations and then forget them as soon as the exams were over, without considering that they might actually have a use in the real world.

You've probably heard of some of them: the SWOT analysis is one good example, where a business identifies its Strengths, Weaknesses, Opportunities and Threats. Whether or not they refer to it as a 'SWOT', every major business which has ever succeeded has carried out this analysis - they wouldn't be applying appropriate corporate governance if they hadn't, and besides, they would likely soon be out of business. 

Some other MBA tools sound like complete gobbledigook (the ridiculous-sounding "Storming, Forming, Norming and Performing" springs to mind) while others, such as 'Porter's Five Forces' have proved to be extremely useful in the world of business over the decades.

In truth, these tools are all useful, for they would certainly have been canned years ago by the Harvards of the world if they weren't.

The Growth-Share Matrix

Commonly known as the 'BCG Matrix' after the Boston Consulting Group which designed it, the 'Growth-Share matrix' was designed to help companies allocate their resources efficiently and effectively manage products and their portfolios. It looks like this:
The theory is that a company should be able to place each of its products in one of the quadrants and thereafter decide how best to deal with it.

In the ideal world, all businesses would have products with a high market share, in a market with high growth. A good example might be Microsoft's Windows product back in the 1990s: it was a booming market which Microsoft had a large share of. Such products are called STARS and can continue to generate great profits for the business.

If further investment is needed to retain the star status, companies should provide it, for they have a star product and Microsoft continued to improve Windows with each successive product in order to maintain market dominance. That is a winning investment.

Sadly, many businesses have products which are in markets with low growth, where they also only retain a small share of the market. These products are known as DOGS - they are unlikely to be profitable and should be divested or ditched.

As is the way of the world, things are rarely this black and white.

Some products, for example retain a high market share in a low-growth industry, and these are known as CASH-COWS. Often reflected by products in mature industries, cash-cows can generate more cash than they take to maintain so companies should look to own plenty of cash-cows. Conventional wisdom says that  these products should continue to be milked while applying as little investment as possible, although not at the expense of new brands.

But what if you have a product which sits in a booming industry of which you only have a small market share? This is known as a PROBLEM CHILD...or sometimes, by those who don't really like business lingo,  such products are know as "question marks". These are products for which are growing rapidly and thus can consume cash, but due to having low market shares they don't generate much cash. 

A problem child could gain market share and become a star, and eventually a cash cow when the market matures and growth slows. But if a problem child fails to become a market leader then it could degenerate into a dog. A problem child should therefore be analysed carefully in order to determine whether they are worthy of the investment necessary in order to grow market share.

Take the example of a small start-up business in China which supplies automotive parts. It is placed in a booming industry but only has a small market share. It probably needs to invest in order to gain market share.

The diversified portfolio

Just like an individual investor, the balanced company with the diversified portfolio can capitalise on its resources. Ideally the company should have:

-stars, the high growth of which represent the future of the business
-cash-cows, to supply the funds for future investment and to keep the business alive
-problem children or question marks - to be invested in to be converted into tomorrow's stars

Dogs, of course, should be divested.

Not dissimilarly, the individual investor should ultimately aim to have cash flow investments to pay for living expenses and to fund new investments, and capital growth investments to create long-term wealth.

Applying this to investment

The BCG Matrix was created in order to help businesses assess products and their place in the market, but investors would do well to be aware of .the principles of market growth and market share. After all, investors own shares in companies and therefore need to understand their future prospects.

To a lesser extent investors can also apply the principles to their own portfolios. In an ideal world, we'd all own star investments which continue to outperform for decades to come.

Other investments, even if they are lacking in growth potential we may elect to hold if they generate a continuing strong cash flow. Examples might include fixed income investments or commercial properties.

A problem child, might be represented by a company which itself needs to undertake investment, restructuring or perhaps a transition to production in order to become a future star. Alternatively, you might own a run-down property which could, through investment, be turned into a desirable, multi-dwelling, outperforming investment.

What if you own shares in a dog? Divest it. Too many investors observe a falling share price and see an opportunity, believing it could 'bounce back'. But a genuine dog investment - a company with low market share and low growth - it is commonly wise to dispose of. A company which cannot generate profits will ultimately be worth $nil, or, in the best case scenario, the net realisable value of its assets.

In the world of real estate, it is popular to say that the superior investment strategy is to "never, ever sell". It's true that due to the material transaction costs involved in acquiring and disposing of property, a well-located property is best held indefinitely.

But if you own a genuine dog, the law of opportunity cost requires that it is disposed of so that funds can be more appropriately allocated elsewhere.

Some property investors like to say "property prices can never crash to zero". Well, I'm afraid that in some circumstances they absolutely can. Ultimately, real estate is only worth what another person is prepared to pay for it, so you need to own investments in locations in the greatest demand. Sometimes it makes sense to dispose a dog investment and re-invest in a superior location.

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