The Capital Cycle
The Capital Cycle has to do with the ebb and flow of
capital. Typically, capital is attracted into 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; over time, then, profitability recovers. From the
perspective of the wider economy, this cycle resembles Schumpter’s process of “creative
destruction” – as the function of the bust, which follows the boom, is to clear
away the misallocation of capital that has occurred during the upswing.
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. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry's supply side. In his book, Competitive Advantage, Professor Michael Porter of the Harvard Business School writes that the "essence of formulating competitive strategy is relating a company to its environment." Porter famously 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 , viewed from an investor's perspective.
To continue our discussion, 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 - not wanting to lose market share while getting caught up in the spending frenzy themselves. CEO pay is often set in relation to a company's earnings or market capitalization, thus incentivizing managers to grow their firm's assets. Share prices rise as additional capacity is added, growth and momentum investors jump on board.
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 while increasing their commissions. Bankers earn fees by arranging secondary issues and IPO's, which raise money to fund further capital spending. Neither the M&A bankers nor the brokerage analysts have much interest in long-term outcomes. As the investment bankers' incentives are skewed to short-term payoffs (bonuses), it's inevitable that their time horizon will shrink. It's a question of incentives and human nature. Both analysts and investors are given to extrapolating current trends, thinking linearly in a cyclical process.
to be continued...
Resources
Capital Returns
Edward Chancellor
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. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry's supply side. In his book, Competitive Advantage, Professor Michael Porter of the Harvard Business School writes that the "essence of formulating competitive strategy is relating a company to its environment." Porter famously 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 , viewed from an investor's perspective.
To continue our discussion, 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 - not wanting to lose market share while getting caught up in the spending frenzy themselves. CEO pay is often set in relation to a company's earnings or market capitalization, thus incentivizing managers to grow their firm's assets. Share prices rise as additional capacity is added, growth and momentum investors jump on board.
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 while increasing their commissions. Bankers earn fees by arranging secondary issues and IPO's, which raise money to fund further capital spending. Neither the M&A bankers nor the brokerage analysts have much interest in long-term outcomes. As the investment bankers' incentives are skewed to short-term payoffs (bonuses), it's inevitable that their time horizon will shrink. It's a question of incentives and human nature. Both analysts and investors are given to extrapolating current trends, thinking linearly in a cyclical process.
to be continued...
Resources
Capital Returns
Edward Chancellor
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