Capital Returns: Investing Through The Capital Cycle was published in 2015 and outlines the capital cycle approach to investing used by Marathon Asset Management. Introduced and edited by financial historian and investment strategist Edward Chancellor the book includes a number of Marathon client essays published between 2002 and 2015. As pointed out by Chancellor, the essays are unashamedly a cherry picked list of client notes chosen with a big dose of hindsight bias. That being said they offer a useful way of illustrating the points made in the introductory chapters and so many of them are also worth a read.
While I initially read this book for its insights into the commodity industry the approach outlined in the book can be applied to almost any sector. The key message in the book for investors in commodities and resource equities is that while attention is typically transfixed by the prospects for demand, the real returns come from paying attention to the supply side. Ignore it at your peril.
The key to the “capital cycle” approach is to analyse how the competitive position of a company is affected by changes in the industry’s supply side. Professor Michael Porter described the “five forces” which impact on a firm’s competitive advantage: the bargaining power of suppliers and of buyers, the threat of substitution, the degree of rivalry among existing firms and the threat of new entrants. Capital cycle analysis is really about how competitive advantage changes over time but viewed from the perspective of an investor.
High current profitability often leads to overconfidence among managers, who confuse benign industry conditions with their own skill – a mistake encouraged by the media, which is constantly looking for corporate heroes and villains. Both investors and managers are engaged in making demand projections. Such forecasts have a wide margin of error and are prone to systematic biases. In good times, the demand forecasts tend to be too optimistic and in bad times overly pessimistic.
High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow – perhaps they are equally hubristic, or maybe they just don’t want to lose market share. Besides, CEO pay is often set in relation to a company’s earnings or market capitalization, thus incentivizing managers to grow their firm’s assets. When a company announces with great fanfare a large increase in capacity, its share price often rises. Growth investors like growth! Momentum investors like momentum!
Investment bankers lubricate the wheels of the capital cycle, helping to grow capacity during the boom and consolidate industries in the bust. Their analysts are happiest covering fast-growing sexy sectors (higher stock turnover equals more commissions.) Bankers earn fees by arranging secondary issues and IPOs, which raise money to fund capital spending. Neither the M&A banker nor the brokerage analysts have much interest in long-term out-comes. As the investment bankers’ incentives are skewed to short-term pay-offs (bonuses), it’s inevitable that their time horizon should also be myopic. It’s not just a question of incentives. Both analysts and investors are given to extrapolating current trends. In a cyclical world, they think linearly.
The delay between investment and new production means that supply changes are lumpy (i.e., the supply curve is not smooth, as portrayed in the economics textbooks) and prone to overshooting. In fact, the market instability created by lags between changes in supply and production has long been recognized by economists (it is known as the “cobweb effect”).
The capital cycle turns down as excess capacity becomes apparent and past demand forecasts are shown to have been overly optimistic. As profits collapse, management teams are changed, capital expenditure is slashed, and the industry starts to consolidate. The reduction in investment and contraction in industry supply paves the way for a recovery of profits. For an investor who understands the capital cycle this is the moment when a beaten down stock becomes potentially interesting. However, brokerage analysts and many investors operating with short time horizons generally fail to spot the turn in the cycle but obsess instead about near-term uncertainty.
There have been a litany of classic capital cycles in action since 2000: the technology bubble of the early 2000’s brought fantastic projections of future bandwidth capacity requirements, the shipbuilding industry (where it takes 3 years for a new ship to be built and delivered) into 2007-08, and then the petrochemical sector after 2011-14 in which operators thought the disconnect between oil and natural gas prices would be permanent. Each bore the hallmarks of a classic capital cycle: high prices boosting profitability, followed by rising investment and the arrival of new entrants, encouraged by overly optimistic demand forecasts; and the cycle turning once supply has increased and demand has disappointed.
But what explains the market inefficiency (Chancellor describes it the ‘capital cycle anomaly’) observed by these examples? Chancellor outlines four key factors that drive the anomaly: competition neglect, base rate neglect, narrow framing and extrapolation.
Competition neglect: When market participants respond to perceived increases in demand by increasing capacity in an industry, they fail to consider the impact of increasing supply on future returns. Competition neglect is particularly strong when firms receive delayed feedback about the consequences of their own decisions. This of course is most likely to occur when there is a significant time lag between the decision to increase supply and it actually occurring – several years if not decades in the case of a complex mine.
Base rate neglect: People tend not to take into account all available information when making a decision. Investors “focus on current (and projected) future profitability but ignore changes in the industry’s asset base from which returns are generated.” Managers make the mistake of assuming all actions stem from the her and now, when in actual fact we may be still experiencing the delayed impact of decisions made many years ago.
Narrow framing: It can be very tempting for the analyst or the manager to focus on all the cherished company, sector or country specific information that he or she has gathered to support the investment decision (known as the inside view). It can be difficult if not impossible for someone wedded to this approach to consider looking for examples elsewhere (the outside view):
An inside view considers a problem by focusing on the specific task and the information at hand, and predicts based on that unique set of inputs. This is the approach analysts most often use in their modeling, and indeed is common for all forms of planning. In contrast, an outside view considers the problem as an instance in a broader reference class. Rather than seeing the problem as unique, the outside view asks if there are similar situations that can provide useful calibration for modeling.
Extrapolation: As behavioural economists Kahneman and Tversky demonstrated we have a tendency to focus on the information placed in front of us (anchoring bias), and then mainly consider the immediate trend up to this point (recency bias):
Another common heuristic is the tendency to draw strong inferences from small samples. These weaknesses reinforce the propensity of investors to make linear forecasts, despite the fact that most economic activity is cyclical – there are trade cycles, credit cycles, liquidity cycles, real estate cycles, profit cycles, commodity cycles, venture capital cycles and, of course, industry capital cycles. Our inclination to extrapolate must be hard-wired.
Even if the canny investor has read this book and can see that high asset growth companies tend to underperform there may be a limit to what they can do to profit from it. The ‘limits to arbitrage’ as its known is described by Chancellor:
“fast-growing companies often have volatile share prices and going short volatility can be very expensive – as short-sellers of Internet and technology stocks discovered to their cost in the late 1990s. Furthermore, companies with strong asset growth often have large market capitalizations – as was the case with many of the telecoms companies in the 1990s and more recently with the global mining stocks. Investors who avoid buying high asset grow the stocks may be forced to take large bets against the benchmark.”
The tenets of capital cycle analysis
Most analysts and investors only spend their time considering the demand outlook for particular industries: whats the outlook for oil demand next year, when will commuters switch to electric cars? No one knows the answer to these questions. In contrast the outlook for the supply side is often flagged well in advance and from history the supply-side analyst will know with a reasonable degree of certainty what the lead time will be. According to Chancellor there are 8 tenets of capital cycle analysis:
- Most investors devote more time to thinking about demand than supply. Yet demand is more difficult to forecast than supply.
- Changes in supply drive industry profitability. Stock prices often fail to anticipate shifts in the supply side.
- The value/growth dichotomy is false. Companies in industries with a supportive supply side can justify high valuations.
- Management’s capital allocation skills are paramount, and meet-ings with management often provide valuable insights.
- Investment bankers drive the capital cycle, largely to the detriment of investors.
- When policymakers interfere with the capital cycle, the market-clearing process may be arrested. New technologies can also disrupt the normal operation of the capital cycle.
- Generalists are better able to adopt the “outside view” necessary for capital cycle analysis.
- Long-term investors are better suited to applying the capital cycle approach.
The ideal capital cycle opportunity
According to Chancellor the greatest opportunities for investment growth can occur is where conditions for cooperative behaviour can exist or may evolve, while avoiding those industries where this is unlikely to happen:
The ideal capital cycle opportunity for us has often been one in which a small number of large players evolve from a situation of excess competition and exert what is euphemistically called “pricing discipline.” Having a small number of players is important, since retaliation (say a price cut) is likely to be a more powerful weapon in the hands of a dominant price setter, although barriers to entry are also required to deter opportunistic entrants from taking advantage of any price umbrella.
Certain industries having evolved oligopolistic industry structures, have a potentially favourable capital cycle, and yet persist in generating poor returns. Partly, this is because “tit for tat” is only likely to work where the strategy can be properly discerned. In the auto industry, for example, there is too much noise in the everyday competitive battle. Carmakers have to decide not just on price, but also on specification, customer financing terms, new model launches, service and warranty terms etc., leading to the paradoxical conclusion that product differentiation can be an impediment to achieving supernormal returns. Contrast this with the steel or paper producer, whose product is relatively undifferentiated.
What are the characteristics to look out for in which companies can engage in cooperative behaviour? The perfect setting is a basic industry with few players, rational management, barriers to entry, a lack of exit barriers and non-complex rules of engagement (i.e. a low level of transaction frequency and product differentiation). According to Chancellor “the really juicy investment returns are to be found in industries which are evolving to this state.”
Why the long game works in investing
Competition for short term information is ferocious and tends to focus on the outlook for commodity demand or company earnings next quarter.
Long-term investors therefore seek answers with shelf life. What is relevant today may need to be relevant in ten years’ time if the investor is to continue owning the shares. Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings. We seek insights consistent with our holding period. These principally relate to capital allocation, which can be gleaned from examining the company’s advertising, marketing, research and development spending, capital expenditures, debt levels, share repurchase/issuance, mergers and acquisitions and so forth.
There are a range of psychological forces stacked up against the long-term investor. In particular, there is strong social pressure from peers, colleagues and clients to boost near-term performance. Even if one has developed the analytical skills to spot the winner, the psychological disposition necessary to own shares for prolonged periods is not easily come by. J.K. Galbraith observed that: “nothing is so admirable in politics as a short-term memory.” Why should politics have a monopoly on sloppy thinking? Which makes us think that long-term investing works not because it is more difficult, but because there is less competition out there for the really valuable bits of information.
Chancellor is especially scathing of the research pumped out by investment banks and other institutions. However, as he notes since it tends to accelerate short term trends it can still be worth following as it can push asset prices to attractive levels for the long term investor focused on the capital cycle:
Following this research can be to the advantage of long term investors if it pushes prices to a level where its advantageous to buy (if prices have been pushed too low in the short term), or sell (if investors are too optimistic in the short term).
Overall I’d recommend Capital Returns: Investing Through The Capital Cycle to any investor who wants to get an edge on the competition. As always if you can think about things in a different way to everyone else (more supply focused, less demand), and lean towards time periods where there is less competition (the long term) then there is much greater potential for profits.