Investing in cyclical stocks can be challenging as fundamentals as well as share prices can underwhelm for fairly long periods. However, they can be rewarding as well if we can understand the cycle. Research by analysts at Marathon Asset Management into this subject got published as a book titled Capital Returns. This blog by Cedric Chin provides a good summary of the book. (the book is a highly recommended read for those who want to go deeper into the subject – for not just investors but also for managers of capital-intensive cyclical businesses).
The book explores the role of capital and its movement into and out of an industry as a key driver of cyclicality in the business. Unlike the average investor who tends to spend disproportionate amount of time analysing the demand side of an industry, this approach focuses on the supply side which tends to get influenced by the flow of capital into the industry.
“The capital cycle is a simple idea with a bunch of fairly profound implications. The basic form goes something like this:
- Capital is attracted to high-return businesses.
- The managers of these high-return businesses become drunk on growth, and expand production in response to their great success. This is rational! It makes sense to pursue growth when there are ravenous customers and large profits for the taking.
- There is a lag between this planned expansion and the actual supply in the market. It takes time to build factories, or to spin up new products. Nobody notices that future supply — across multiple competitors that are all expanding production — will soon outstrip demand.
- The new supply gradually floods the market, and returns fall below the cost of capital. Businesses slash prices to offload supply; company valuations collapse.
- Capital flees the sector because returns suck; companies close down or get bought out; consolidation occurs across the entire industry.
- This sets the surviving companies up for future excess returns.”
Why does this cycle occur? As ever, behavioural science explains a lot of the capital decisions investors and managers make. The post quotes Edward Chancellor’s introduction in the book:
“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 – perhaps they are equally hubristic, or maybe they just don’t want to lose market share. Besides, CEO pay is often set in relation to a company’s earnings or market capitalization, thus incentivizing managers to grow their firm’s assets. When a company announces with great fanfare a large increase in capacity, its share price often rises. Growth investors like growth! Momentum investors like momentum!
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 (higher stock turnover equals more commissions.) Bankers earn fees by arranging secondary issues and IPOs, which raise money to fund capital spending. Neither the M&A banker 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 should also be myopic. It’s not just a question of incentives. Both analysts and investors are given to extrapolating current trends. In a cyclical world, they think linearly.”
How can investors use the capital cycle to their benefit? Marathon provides a two pronged approach:
- Find moated businesses where the effects of the capital cycle are muted relative to market expectations
- Buy into cyclical stocks after a period of supply consolidation
Both have nuances which require specific understanding of the industry. The book delves deeper into this.
As a corollary, the blog emphasises the importance of capital allocation and the role of managements as investors using two case studies – Bjorn Wahlroos of Finland’s Sampo and Henry Singleton of Teledyne.
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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.
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