As I read through "Capital Returns," the book that was edited by Edward Chancellor and summarizes some of the most important lessons acquired by the managers of Marathon Asset Management, I cannot help getting excited about the ideas it encourages and the sound reasoning on which the book bases its arguments.
The book's core idea is that investing cannot be separated from the capital cycle –Â that is, the supply side of the market. Here are some of the most interesting ideas stemming only from the introduction.
"The hallmarks of the 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."
"A key insight of the capital cycle investment approach: When analyzing the prospects of both value and growth stocks, it is necessary to take into account asset growth, at both the company and sectorial level."
A quote from "Security Analysis":
"A business that sells at a premium does so because it earns a large return on its capital; this large return attracts competition; and generally speaking, it is not likely to continue indefinitely. Conversely in the case of a business selling at a large discount because of abnormally low earnings, the absence of new competition, the withdrawal of old competition from the field and other natural economic forces should tend eventually to improve the situation and restore a normal rate of profit on the investment."
"Since 2010, U.S. stocks have looked expensive when viewed from a valuation perspective, largely due to the fact that profits have been above average. Yet U.S. corporate investment has been lackluster since the global financial crisis. With the key driver of mean reversion missing, profits have remained elevated for longer than expected, and the U.S. stock market has delivered robust returns."
"The essence of capital cycle analysis can thus be reduced to the following key tenets:
- 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 meetings 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."
So basically, this book makes us take a different view from what the sell-side analysts offer. It is a view that takes asset-growth for the sector as a key variable to explain returns in stocks. What I like about this approach is how it can be used to explain market returns, such as the example provided with the U.S. stock market (the authors also clarify that the monetary policies have had a great impact on corporate profits and decisions). This approach can certainly prove beneficial as the supply side is generally easier to forecast and to observe than demand. By taking this wider view, we are obliged as investors to think about the competitive stance of a certain company in terms of the whole industry and also on how this industry could be eroded by changes in technology.
Certainly, the book is thought provoking, and nothing can be better for us as investors.
What do you think?
