More on the Capital Cycle

 More on the Capital Cycle

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Competition Neglect

Overinvestment is not a solitary activity; it comes about because several players in an industry have been increasing capacity at the same time. When market participants respond to perceived increases in demand by increasing capacity in an industry, they fail to consider the impact of increasing supply on future returns. “Competition neglect,” according to Harvard Business School professors Robin Greenwood and Samuel Hanson, is “particularly strong when firms receive delayed feedback about the consequences of their own decisions.” The authors of a paper in the American Economic Review sought to explain why so many new entrants into business frequently fail. They found that managers so overestimate their own skills they neglect competitive threats.

This failure to pay attention to the outward shift in the supply curve can be linked to another common behavioural trait, known as “base-rate neglect.” Namely, the tendency of people not to take into account all available information when making a decision. With regards to the workings of the capital cycle, investors focus on current (and projected) future profitability but ignore changes in the industry’s asset base from which returns are generated. At times, this tendency morphs into what psychologists call “cognitive dissonance” – a wilful refusal to consider disconfirming evidence once a course of action has been decided upon.

Skewed Incentives

Skewed incentives exacerbate these well-known behavioural weaknesses. CEO compensation is often linked to short-term performance measures, such as annual changes in earnings-per-share or shareholder returns. Stock prices often react positively to announcements of major capital spending. Companies which invest more often attract premium valuations. The stocks of high asset growth companies often exhibit positive momentum. Executive pay is also frequently linked to a company’s size, as measured by revenue or market capitalization. The incentives are thus skewed for managers to favour growth and to downplay any adverse long-term consequences. There is some evidence that managers with a large ownership stake are more likely to shrink capital employed – through buybacks – if they see few profitable alternatives.

Investors whose compensation is linked to short-term performance are also inclined to myopia. Investment bankers who drive the capital cycle – raising money to finance investment with debt and equity issuance and launching IPOs – are compensated according to their fee generation rather than the outcome their capital-raising activities may have for clients and shareholders. Investment bank analysts serve as cheerleaders; their pay is linked to brokerage commissions, generated by stock turnover. They too have little interest in long-term outcomes.

Fundamentals of Capital Cycle Analysis

Marathon’s approach is to look for investment opportunities among both value and growth stocks, as conventionally defined. They come about because the market frequently mistakes the pace at which profitability reverts to the mean. For a “value” stock, the bet is that profits will rebound more quickly than is expected and for a “growth stock,” that profits will remain elevated for longer than market expectations.

Focus on Supple rather than Demand

Given that the future is uncertain, why should Marathon’s approach fare any better? The answer is that most investors spend the bulk of their time trying to forecast future demand for the companies they follow. The aviation analyst will try to answer the question: How many long-haul flights will be taken globally in 2020? A global autos strategist will attempt to forecast China’s demand for passenger cars 15 years hence. No one knows the answers to these questions. Long-range demand projections are likely to result in large forecasting errors.

Capital cycle analysis, however, 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 – depending on the industry in question – after changes in the industry’s aggregate capital spending. In certain industries, such as aircraft manufacturing and shipbuilding, the supply pipelines are well-known. Because most investors (and corporate managers) spend more of their time thinking about demand conditions in an industry than changing supply, stock prices often fail to anticipate negative supply shocks.

Analyze Competitive Conditions within an Industry

From the investment perspective, the key point is that returns are driven by changes on the supply side. A firm’s profitability comes under threat when the competitive conditions are deteriorating. The negative phase of the capital cycle is characterized by industry fragmentation and increasing supply. The aim of capital cycle analysis is to spot these developments in advance of the market. New entrants noisily trumpet their arrival in an industry. A rash of IPOs concentrated in a hot sector is a red flag; secondary share issuances another, as are increases in debt. Conversely, a focus on competitive conditions should alert investors to opportunities where supply conditions are benign and companies are able to maintain profitability for longer than the market expects. An understanding of competitive conditions and supply side dynamics also helps investors avoid value traps (such as US housing stocks in 2005–06).

Selecting the right Corporate Managers

Marathon is fond of repeating two comments of Warren Buffett. The first being to the effect that most chief executives have risen to the top of their companies because they “have excelled in an area such as marketing, production, engineering – or sometimes, institutional politics.” Yet they may not have the capital allocation skills required of managers. Such skills are essential, according to the Sage of Omaha, since, “after ten years on the job, a CEO whose company retains earnings equal to 10 per cent of net worth will have been responsible for the deployment of more than 60 per cent of all capital at work in the business.” Capital cycle analysis involves keeping a sharp eye on managers to assess their ability to allocate capital. Marathon spends a lot of time meeting and questioning managers to this effect.

Adopt a Long-Term Approach

Capital cycle analysis, like value investing, requires patience. It takes a long time for an industry’s capital cycle to play out. The Nasdaq started bubbling in 1995. Yet it wasn’t until the spring of 2000 that the dotcom bubble finally burst. New supply comes with varying lags in different industries. As we have seen, it can take nearly a decade for a new mine to start producing. Marathon warned of the dangers of rising mining investment back in May 2006 (see 1.3 “This time’s no different” – yet after rebounding in the wake of the financial crisis, the commodity super-cycle didn’t turn down for another five years. Marathon’s long-term investment discipline, with its very low portfolio turnover, is well suited to applying the capital cycle approach.

Capital Cycle Breakdowns

Capital cycle analysis requires patience, a certain doggedness (willingness to be wrong for a long period) and a contrarian mindset. Once the cycle has turned and overcapacity in an industry has been exposed, the progression of events appears inevitable. That’s hindsight bias. At the time, the outcome never seems so certain. Besides, on occasion the normal operation of the capital cycle breaks down. Over the last two decades, the Internet has destroyed many long-established business models – in advertising (Yellow Pages), media (newspapers), retailing (bookshops), and entertainment (music industry and video rental). Investors who underestimated the disruptive impact of new technology have lost money.35 The capital cycle also ceases to function properly when policymakers protect industries (see 5.4 “Broken banks” and 5.5 “Twilight zone”) and under conditions of state capitalism, as found in modern China (see Chapter 6, “China Syndrome”).

The Tenets of Capital Cycle Analysis

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.

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Edward Chancellor,

Excerpt from the Introduction of Capital Returns