The Lifecycle Of An Investment

How long do you hold investments for?  If it’s a bond, the maturity of that investment is typically determined when the bond is written.  With stocks, the answer to this question gets a bit fuzzier.  Stocks are investments without a predetermined end-date.

Warren Buffett is often quoted as saying his “favorite holding period is forever”.  That sounds great, but it’s probably unrealistic for most people.  Why?  No empire lasts forever.  The average lifetime of a public company is actually shrinking.  Trying to find a company that lasts “forever” is a needle in a haystack.

Like most people in the public eye, what Buffet says and what he actually does are two different things.  The reality is, extremely long-term investors like Buffett still buy and sell investments at specific times to maximize profitability.

Good investors (like Buffett) are shrewd enough to take advantage of key points in the investing life-cycle to maximize profits.  Just like a plant, animal, or bacteria, every investment has a life-cycle.  Buying at the right time in the business life-cycle can lead to incredible profits for investors.  Buying at the wrong time can lead to intense agony and capital losses.

The Investment Life-cycle

The logic is simple — No business lasts forever, and therefore no investment is going to last forever either.  It stands to reason there will be ideal times during that investment’s life-cycle when investors will enjoy greater profitability and ROI.  Understanding these simple truths puts most investors way ahead of the game of “when to buy and when to sell”.

So what exactly are these different stages of this life-cycle?

The Startup.  This first stage is the very beginning of a venture — when an entrepreneur forms the initial idea based upon a perceived business niche or a invention.  The potential exists, but at this point profitability is non-existent.  It’s anybody’s guess if the startup will turn into something bigger.

A startup business almost always needs a BIG inflow of cash to get started.  Typically this initial cash comes from the entrepreneur, angel investors, and venture capitalists.  Young businesses at this stage are not usually self-funding and initial investors see tons of dilution from follow-on rounds of capital gathering.

Early Growers. During this stage the company has a validated business model and is growing rapidly.  Uber, Lyft, Airbnb (and perhaps Tesla) are a good examples of companies I would put in this category.  They’re well known, and the business is growing rapidly.  Right around this stage is when a company first goes public.  (Early entrepreneurs and VC’s are looking to cash-out with a IPO.)

Usually the profitability of the business at this stage is somewhat questionable.  Profits might not be regular yet, or they could be just on the cusp of profitability.  It’s anyone’s guess if they’ll turn out to be a business titan.  At this point, 100% of cash from operations is used for reinvestment, as is any IPO cash.

“Growth at any cost” is the mantra in this stage.

Market Dominance.  After the company grows large enough, they finally achieve a state of profitability and market dominance.  Companies at this stage are no longer upstarts or challengers, but now a dominant force in the marketplace.  Immediate survival is no longer a question.

Companies at the “Market Dominance” stage are still growing rapidly, but these companies are no longer speculative investments.  They generate regular profits, and investors can now see they will earn a return on invested capital.   If the company is profitable enough, they might also begin buying back shares to offset share-dilution.

Typically these investments are the “rising stars” of the business world, (like Netflix or Facebook) where everyone can see their current success will continue.  However, the certainty of success often comes at a high price.  Valuations of these fast-growers tend to be high.

Often times at this stage the company has grown large enough to be included in a index.

Middle Age.   Companies reaching the Middle Age stage of the business life-cycle have reached the upper bounds of where their initial business will take them.  Profit margins are typically at their highest, but growth has slowed significantly.  Now, the company seeks to grow through acquisitions or by developing new products through R&D.

Usually at this stage the company is generating so much cash they hardly know what to do with it.  You see companies beginning to give back cash to shareholders in the form of dividends and share buybacks (Typically less than 50% of free cash flow).

On the BCG Matrix these companies are often called “cash cows”.  If the company is going to become a successful conglomerate, this stage is typically where it’s done.  Amazon, Apple, and Microsoft would be examples of companies in the “Middle Age” stage that have expanded well beyond their initial niche.

Elderly.  Companies reach the “Elderly” stage when the original business begins to decline.  The company is losing market share to competition, or technological disruption.  Typically I see businesses reaching the “Elderly” stage when their investments just didn’t take-off OR very wrong bets were made by management.  Under-investment is also a potential source of decline.

Good examples of companies at this stage might be IBM, GE, Macy’s, or Coke.  They still generate plenty of cash, but they’re definitely on the decline.  Most free cash flow goes to maintaining existing dividends for shareholders.  Usually there is little hope for re-investing in the initial core business.

Liquidation.  The “liquidation” stage is basically “end of life” for a company.  Sales can no longer cover the costs of running the business, and the company is essentially “dead”.  At this point, the assets need to be liquidated and sold-off.  Any remaining creditors will need to be paid.  Think of Sears a few years ago when they were selling off brands and assets.  That’s the Liquidation stage.

Using Our Knowledge Of Life-cycles To Avoid Gambling

While it’s possible for investors to earn good returns on their initial investment from any of the life-cycle stages, some are more like gambling than others.

For example, in the Startup stage entrepreneurs take big risks and commit huge amounts of time and money to an enterprise.  It’s hugely speculative, and that’s why angel investors or venture capitalists rarely commit huge percentages of their net-worth to just one enterprise.  For most small investors (like myself), investing in Startups is too speculative.  If you decide to invest at this early stage, consider it akin to lighting cash on fire.

In my mind, investing in early stage companies is best for people with deep knowledge of the industry, who’ve spent most of their career “in the thick of it”

Similarly, investing in the Elderly and Liquidation stages of a business is something best left to professionals willing to take a company all the way into liquidation.  Hedge funds often play in this space, but Elderly companies frequently attract value investors due to their low market valuations.  These are often “value traps”, something I now focus on avoiding when I invest.

On the other end of the spectrum, small retail investors often get captivated by Early Growers due to a company IPO.  These are also highly speculative investments.  Even though IPO’s are engineered to “pop” on the first day of trading, on-average IPOs do not outperform the market.  There’s even a IPO ETF that gets access to all the best IPO’s and it still hasn’t managed to outperform in 1 yr, 3 yr, or 5 yr periods.

Think of investing in Early Growers like gambling at the tables in Las Vegas.  Sometimes it works out, and sometimes it doesn’t.  The result is not very predictable.

The Safest Places To Invest

In most cases, the Market Dominance stage is going to be one of the safest stages for small investors to invest.  Why?  At this stage the business model becomes predictable.  There’s plenty of growth left, but by this point the business model is validated and customers are unlikely to change their minds.  Believe it or not, customer habits might be one of the most powerful indicators for predicting investing returns.

Investing in Middle Aged companies can be equally as successful, but there are a few slip-ups to look out for — The transition from a high-growth oriented company into a slow-growing “Middle Ager” can sometimes result in a rapid re-pricing of the stock.  Instead of paying a PE of 30 for a stock, investors might only be willing to pay a PE of 14 or 15.

Investors will also need to be on the lookout for signs the original business is falling into decline.  If the company hasn’t expanded into new ventures, they may slowly be slipping into the “Elderly” stage.

However, if new businesses ventures “take-off” they might be able to maintain the “middle age” status for a very long time.  Microsoft, Apple, Disney, and Berkshire Hathaway are all great examples of businesses that have been able to sustain their position for very long periods of time.

In my mind, Middle Agers are one of the best places to invest.  The core businesses see little change and they generate so much cash they can hand it over to shareholders and still invest in R&D and acquisitions.

A Predictable Conclusion

Part of being a good investor is knowing exactly where your wheelhouse lives.  Mine tends to live in companies that are either Market Dominant or Middle Aged.  I can fairly easily predict what those businesses are going to do.

For example — I know that Disney is going to keep making hit movies that make tons of money.  I don’t need to predict the future to know this.  If Disney suddenly started trying to make cell-phones or sell groceries, then I might need to worry a little.

Knowing the stages where I succeed as an investor helps informs me of when I should buy and sell.  This isn’t market timing, it’s about understanding the kind of investment I succeed in.

When my investments tend to creep outside my “circle of competence” is when I run into the most trouble.  I’ve learned this through great amounts of pain and lost money.

Let me spare you the trouble — There are going to be stages of the investing life-cycle only you excel at.  Know what they are and stick to your ‘A’ game.  Investing in stocks might not be where your ‘A’ game lives.  Some investors might do well starting small businesses or speculating on commodities.

It all just depends on your investing skill-set lies.  You don’t need to be good at investing in all stages.  Just one will do.

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