I recently read a book called “Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15” edited by Edward Chancellor.
It is a collection of reports written by investment professionals at Marathon Asset Management. The reports use numerous examples to demonstrate how the capital cycle approach to investments works and how it has provided investors with market-beating returns over a long period of time.
This book is a gem because it offers great insight in one of the most important yet often ignored aspects in security analysis – the supply side, or capital cycle analysis, as used by Marathon.
The book is worth reading although it’s a bit pricey. For readers who just want to learn the big ideas – below are my big idea summary notes.
The key idea is really simple and perhaps does not sound novel to many investors:
The key to the capital cycle approach is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side. Capital cycle analysis focuses on supply rather than demand. Supply prospects are far less uncertain than demand, and thus easier to forecast. In fact, increases in an industry’s aggregate supply are often well flagged and come with varying lags – after changes in the industry’s aggregate capital spending.
Typically, capital is attracted to high-return businesses and leaves when returns fall below the cost of capital. This process is not static but cyclical – there is constant flux. The inflow of capital leads to new investment, which over time increases capacity in the sector and eventually pushes down returns. Conversely, when returns are low, capital exits and capacity is reduced (often through bankruptcy and consolidation); over time, then, profitability recovers.
The applicability of the key idea is what investors should spend more time on. Usually there are a few metrics that you can track to assess the capital cycle:
- Capital expenditure relative to depreciation above its average level – for instance, the ratio of miner’s capex to depreciation rose from 1.1x in 2001 to peak at 3x in 2012.
- Supply or excess supply relative to some form of demand – for example, by the time the U.S housing bubble peaked in 2006, the excess stock of new homes was roughly equal to five times the annual production required to satisfy demand from new household formation.
- A rising gap between reported earnings and free cash flow.
- A rash of IPOs in a sector.
- Secondary share issuance.
- Increase in debt.
- Rising M&A activities.
There are limitations to the capital cycle approach – it can fail at times, usually due to four reasons, as Marathon’s analysts put it:
With hindsight, our capital cycle approach has failed at times when we have underestimated the impact of industries of political and legal interference, disruptive technologies and globalization. To this list of external factors, one can add the self-inflicted wounds of mismanagement. The most common problem is the failure of capital to exit industries with unacceptably poor returns.
Marathon used European Banks and European auto industries as examples of artificial interference of the capital cycle due to political reasons. For instance, French auto manufacturers chose not to shut excess capacity because the benefits would accrue disproportionately to their Italian competitors. In the emerging markets, the identification of “strategic industries” by Chinese politicians has led to excess capacity in various sectors as diverse as solar and wind power, stainless steel, shipbuilding and telecommunication equipment.
As a result, certain markets in the developed world, where competition was seen as regional in nature, have suddenly become global. Thus, capital cycle analysis tends to be more effectively applied to industries which are largely domestic in nature or where the dominant players are inclined to Anglo-Saxon style capitalism.
Finally, there are companies that seem to defy the capital cycle – those are companies that generate consistent high return on capital all the time. Obviously the key here is sustainable competitive advantage, or moat, as Buffett calls it. Marathon’s opinion is that you can generate above average investment returns by investing in a company capable of sustaining high returns beyond the market’s expectations. In other words, the market expects the company can generate 20% ROIC for five years then the high ROIC fades whereas through your analysis, you think the company can sustain a 20% ROIC for longer than five years.
