Value investing techniques for return of multiple times

What is Value investing?

Value investing is an investment methodology that involves estimating the "intrinsic value" of the stock.  The best time to invest is when the intrinsic value is substantially below that of the "market price", since in long term, the share price will reflect the intrinsic value of the stock.

Why there is a difference between that of the intrinsic value and market price?  Under the efficient market theory, there should not be any difference.  However, there are various reasons for this difference:

• Market is irrational - people are greedy, and tend to expect a rising(or dropping) trend to continue
• imperfect information - not all information are used in investment decisions.  Usually investors tend to focus on financial information but overlook underlying factors of business: products, markets, costs, etc
• capital flow - when market sentiment is good, money tend to flow into the stock market rapidly, creating an over demand that will push asset price to an unreasonable level.

Relationship between market price and the intrinsic value

From the above graph, we can see that in long term, the market price will very much follow the intrinsic value of the company, subject to fluctuation.  Hence, there are two key elements in value investing:

1. Invest in companies that there is sustainable growth in the intrinsic value.
2. Take advantage of market fluctuation, buying assets when they are cheap and selling when they become over priced.

Mediocre investor focus in only one of the two above point, while great investor like Warren Buffett will take a balanced approach to find the best investment opportunity.  As he said, "It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price." 

However, most financial and accounting techniques focus on buying cheap asset, as investigating companies for sustainable growth require in-depth knowledge about the company and the industry.  Hence, very often people will simply assume companies grow as fast as they were in future, or make optimistic assumption base on macro-economic trend.  One big example is the dot-com bubble.  While it is true that the Internet is rapidly in early 2000's, assuming all dot-coms will grow in the same rate is terribly wrong. 

Hence, this article will outline two conceptual framework for analyzing attractiveness of businesses, the BCG Matrix and Porter's Five Forces Analysis.

The BCG Matrix

The BCG Matrix can be used to quickly categorize companies and identify what companies will have the greatest investment value.  The figure belows show the basic BCG Matrix chart.

The BCG Matrix

To use the chart, you may put businesses into the four quadrants according to its market growth rate and relative market share.  If the company has several lines of business, you may analyze each company separately. 

• Cash cows are businesses with high market share in a slow-growing industry. These units typically generate cash in excess of the amount of cash needed to maintain the business. They are regarded as staid and boring, in a "mature" market.  These companies usually have a high dividend rate, as there is not much opportunities for the company to invest in.  As the growth rate is low, there will not be much change in intrinsic value of the company, hence not a good choice for investors looking for quick, huge capital gain.
• Dogs are businesses with low market share in a mature, slow-growing industry. These units typically "break even", generating barely enough cash to maintain the business's market share. These companies usually have a low return on asset and low P/B.  Profitability may fluctuate from one year to another, depend on economic environment.  The intrinsic value for these companies are usually low.
• Question marks are growing rapidly and thus consume large amounts of cash, but because they have low market shares they do not generate much cash. The result is a large net cash consumption. A question mark has the potential to gain market share and become a star, and eventually a cash cow when the market growth slows. The intrinsic value will grow significantly in this scenario.  If the question mark does not succeed in becoming the market leader, then after perhaps years of cash consumption it will degenerate into a dog when the market growth declines, result in a huge drop in intrinsic value.
• Stars are units with a high market share in a fast-growing industry. The hope is that stars become the next cash cows. As market is optimistic about the company's future, the P/E and P/B are usually quite high, while dividend rate is low as the company still need funding to grow.  The high growth rate may not mean a good investment opportunity since usually market will pay a premium for grow.  Often the best time to sell is when the market is too optimistic about the future of the company. When growth slows, stars become cash cows if they have been able to maintain their category leadership, or they move from brief stardom to dogdom.

Use of BCG Matrix in Investment

The best investment opportunity may not be the companies that are already in the Stars or Cash cows quadrants, but when companies move from question marks/dogs to stars/cash cows quadrants.  This happens when the competitive advantage of the company significantly improves.  To detect improvements in competitive advantage, we can use another methodology: the Porter's Five Forces Analysis

The Porter's Five Forces

The Porter's 5 forces tools is a simple but powerful tool for understanding where power lies for a business.  With a clear understanding of what forces come into play, you can assess the competitiveness of a company, and hence its profitability.  The five forces are:

1. Threat of substitute products - Are there any substitutions to the company's product so that customers will switch to substitutions easily at a low cost?   Be especially careful when new substitutes are launched, or when substitutes' attractiveness improves over time.  For example, avoid fixed line telephone company when everyone starts to have a cell phone.  
2. Threat of entry of new competitors - Profitable markets that yield high returns will attract competitors.  To prevent new competitor from entering the market, there should be a high barrier to entry which can be in form of technology(patents, high know-how), law rights(monopoly), brand awareness, economic of scale, etc. 
3. Intensity of competitive rivalry - How will competition react to certain behavior by another firm?  Does other firms improve its competitiveness at a faster rate than the company under investigation? 
4. Bargaining power of customers - What is the ability of customers to put the firm under pressure?  If the customer is dependent on the product, it is more likely that the company can charge a high price.
5. Bargaining power of suppliers - What is the ability of suppliers to put the firm under pressure?  Suppliers of raw materials, components, labor, and services to the firm can be a source of power over the firm, when there are few substitutes.  If the company is dependent on one commodity as input, watch out for its long term trend.

Use of the Porter's Five Forces in Investment

When identifying investment opportunities, you should look for changes in business situation that will cause a sustainable shift in the forces that are favourable to the company.  For unprofitable companies, identify the reason of its poor performance.  For example if the competition in the industry is too strong, industry consolidation will be a good sign you should look for, since industry consolidation can reduce the competition intensity. You should also avoid profitable companies that are particularly weak in one of the five forces, since these forces will put pressure on the company.