The Capital Cycle 2
There is a lag between the rise in capital spending and its
impact on supply, which is a characteristic of the capital cycle. The delay
between investment and new production means that supple changes are lumpy (the
supply curve is not smooth as displayed in 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 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.
Example of Industry Capital cycle
Business investment declines...industry consolidation...firms exit...investors pessimistic
Improving supply side causes returns to rise above cost of capital...share price outperforms
New entrants attracted by prospect of high returns....investors optimistic
Rising competition causes returns to fall below cost of capital...share price under performs
Key Takeaways from 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 in dealing with the capital cycle of the industry they operate in.
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 (governments supporting failing companies and industries). New technologies can also disrupt the normal operation of the capital cycle.
Long term and contrarian investors are better suited to taking advantage of the capital cycle approach.
Resources
Capital Returns
Edward Chancellor
Key Takeaways from 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 in dealing with the capital cycle of the industry they operate in.
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 (governments supporting failing companies and industries). New technologies can also disrupt the normal operation of the capital cycle.
Long term and contrarian investors are better suited to taking advantage of the capital cycle approach.
Resources
Capital Returns
Edward Chancellor
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