The Under Appreciated Value of Capital Cycle Analysis

The Under Appreciated Value of Capital Cycle Analysis

In our public markets investments at Volta Global, we are fortunate not to be constrained to a specific strategy or segment of the markets. We are only looking for the best opportunities for long-term capital appreciation, in a completely sector and asset class agnostic manner.

Such opportunities often do present themselves as a result of two situations:

Finding truly great businesses with sustainable competitive advantages that are temporarily mispriced due to market “noise” or short-term events (the much espoused “Buffet/Munger approach”).

Significant developments taking place in the supply side of an industry that often go unnoticed by the market.

Situation #1 is widely covered, and any student of the markets will be very familiar with those teachings. Situation #2 is less appreciated but equally powerful, and forms the basis of “capital cycle analysis” — an investment philosophy long championed by Marathon Asset Management (and excellently covered in their book Capital Returns.)

While capital cycle analysis is a very simple fundamental concept — companies are impacted by changes in the supply side of the industry in which they operate much more than changes in the demand side — it is also the one that most investors and analysts often ignore. They instead devote a majority of their time and effort into analyzing the demand side, which is much harder to accurately predict, and in the long run much less impactful to a company’s profitability, and thus their stock price.

I strongly recommend reading Capital Returns in its entirety, but the key aspects of the approach can be quickly summarized as follows:

Stock prices are mostly driven by long-term levels of profitability, and reward companies that can consistently earn returns above their cost of capital.

Changes in the supply side of an industry are more important to profitability than those on the demand side, yet the vast majority of professional analysts and investors are trained to focus their attention on the demand side. The implication then is that changes in the supply side tend to be under appreciated by the market, and slower to show up in company stock prices.

Value vs. Growth is a mostly irrelevant construct for capital cycle analysis — high valuations alone are not enough to kill a positive supply side dynamic, and companies in industries going through a lasting positive change in supply side dynamics can sustain high valuations for longer periods of time than the market expects.

Many investors are not well suited to performing proper capital cycle analysis, which requires both an “outside view” (tough for industry “experts” to have) and a very long-term perspective (very tough for most active managers to have these days).

Jeff Evans, Volta Global