Investing Thoughts and Wisdom (mostly from others) – Part 27
I have a file full of notes and excerpts from investors that I’ve collected over the years. I’ve been meaning to organize it for a while, and now that this newsletter is started, I’ll use it as a reason to gradually do so (in several parts). [Previous posts: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, Part 8, Part 9, Part 10, Part 11, Part 12, Part 13, Part 14, Part 15, Part 16, Part 17, Part 18, Part 19, Part 20, Part 21, Part 22, Part 23, Part 24, Part 25, Part 26.]
I used to read through this file a lot, but it got to be pretty long, which led me to summarize the key parts of my own philosophy (as of the present time) in a blog post titled Final Decision Checklist.
Please note: Nothing here should be considered investment advice or the best way to invest. These are things I’ve saved as reminders and notes to myself that I’ve found helpful in the past, and think they are worth sharing in case any of you happen to get an insight from any of it.
Industry Supply and the Capital Cycle…
Edward Chancellor, in an interview with “MoneyWeek” in 2015:
Ed: And this interesting point is that people, I don’t quite know why, but they love to think about and project demand into the future. They love it, I suppose, because… well, they like projecting demand because demand is unknowable. And because it’s unknowable, then you can have any fantasy you want about it at all, optimistic or pessimistic.
But given the nature of mankind, those would tend to be optimistic. So a huge amount of work goes into forecasting demand. As our mutual friend Russell Napier says, analysts spend 90% of their time thinking about and forecasting demand, and 10% of their time thinking about supply.
Now, the interesting thing about supply is that supply actually can be forecasted because in most industries, it takes quite a while for the supply to come on stream. You can see how much assets have grown inside an industry, or inside any particular business. You can see it through any number of measures.
Through IPO issues, through secondary share issues, through companies taking on more debt, through companies going through a boom, such as the mining companies or the US homebuilders, who have had a surge in profitability, and have reinvested those profits.
You can measure it technically through looking at things, like current capital spending to depreciation ratios. Or you can look at it, for instance, the rate of reported profitability of a company to its cash flow, the so called cash conversion rate. And if a company is generating large profits, but not generating any cash flow, it’s probably in a negative phase of the capital cycle.
So the point, to go back to what you were saying, is that investors, if they knew the right way to approach, would be thinking 90% about supply, and then fantasising 10% about the completely, or not quite completely, but more or less completely unknowable demand side.
In his introduction to the book Capital Returns, Chancellor also gives several recent examples where a focus on supply instead of rosy demand projections would have allowed one to better grasp the risk one was taking investing in particular stages of those industry cycles, including the telecoms in the late 1990s, shipping in the 2001-2007 period, and the homebuilding industry that peaked in 2006. The below excerpt on the homebuilding boom is a good example showing the capital cycle and the importance of focusing on industry supply:
Rising house prices after 2002 prompted another capital cycle in the US homebuilding industry. By the time the US housing bubble peaked in 2006, the excess stock of new homes was roughly equal to five times the annual production required to satisfy demand from new household formation. Spain and Ireland, whose real estate markets had even more pronounced upswings, ended up with excess housing stocks equivalent to roughly 15 times the average annual supply of the pre-boom period. Whilst under way, housing booms are invariably justified by references to rosy demographic projections. In the case of Spain, it turned out that recent immigration had largely been a function of the property boom. After the bubble burst and the Spanish economy entered a depression, foreigners left the country by the hundreds of thousands.
Several well-known “value” investors who ignored capital cycle dynamics were blindsided by the housing bust. In the years before US home prices peaked in 2006, homebuilders had grown their assets rapidly. After the bubble burst, these assets were written down. As a result, investors who bought US homebuilders’ stocks towards the end of the building boom when they were trading around book value – towards their historical lows – ended up with very heavy losses [5]. From a capital cycle perspective, it’s interesting to note that although UK and Australia experienced similar house price “bubbles,” strict building regulations prevented a supply response. Largely as a consequence, both the British and Australian real estate markets recovered rapidly after the financial crisis [6].
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[5] For instance, the large US homebuilder KB Home experienced a 28 per cent compound annual growth in assets between 2001 and 2006. By summer of 2006, its shares were trading at 1.2 times book. From that point, KB’s book value declined by 85 per cent, and its shares, already well below their peak, fell a further 75 per cent
[6] The fact that UK housing supply didn’t respond to the British housing bubble is reflected in the superior performance of UK homebuilding stocks relative to their US counterparts over the last decade
And more from Chancellor in Capital Returns:
FOCUS ON SUPPLY 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 [33]....
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[33] Several accounting based measures provide insights into the capital cycle. As observed above, stocks with the fastest asset growth tend to underperform. When a company’s capital expenditure relative to depreciation rises above its average level it may be a sign that the capital cycle is deteriorating (see 1.4 “Supercycle woes” and Chapter 1, “A capital cycle revolution”). A rising gap between reported earnings and free cash flow is another warning sign (see 1.7 “Major concerns”). The Herfindahl Index provides a statistical measure of industry concentration which may reveal changes in competitive conditions. Anecdotal signs prove just as useful in gauging the capital cycle. It’s generally a bad sign when a company starts building a grandiose new head office (see 4.9 “On the rocks”)].
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).
The Capital Cycle’s Key Tenets (from “MoneyWeek” article with Chancellor):
Capital cycle analysis can be boiled down to the following key tenets:
Changes in supply drive industry profitability
Demand forecasts are more prone to error than supply forecasts
Yet investors devote more time to considering demand than supply
As a result, share prices often fail to anticipate changing profitability
The value/growth dichotomy is false: differences in firm and industry asset growth is key
Management’s capital allocation skills are paramount
Meetings with management often provide valuable insights
Investment bankers facilitate the capital cycle, largely to the detriment of investors
Policymakers influence the capital cycle, largely to the detriment of investors
New technologies may disrupt the normal operation of the capital cycle
Generalists are more able to adopt the “outside view” necessary for capital cycle analysis
Long-term investors are better suited to applying the capital cycle approach
When the Capital Cycle May Not Work (5.6 in Capital Returns):
5.6 CAPITAL PUNISHMENT (MARCH 2013)
The capital cycle ceases to function properly when politicians protect underperforming industries
The credit boom created excess capacity in a wide array of global industries. If the capital cycle had been operating smoothly, the subsequent collapse in share prices and demand ought to have led to consolidation and capital withdrawal. This has not always been the case, despite notable exceptions in certain industries (e.g., US homebuilders). Errors of capital cycle analysis can lead to mistaken share purchases. Still, they help us adapt and evolve our investment discipline. With hindsight, our capital cycle approach has failed at times when we have underestimated the impact on industries of political and legal interference, disruptive technologies and globalisation.
To this list of external factors, one can add the self-inflicted wounds of mismanagement. The most common problem is the failure of capital to exit industries with unacceptably poor returns. In the latest cycle, the forces of creative destruction have been moderated by aggressive monetary easing and low interest rates. This has allowed weak firms to continue in business, servicing what are likely to prove unsustainable debt levels. This situation contrasts with the end of previous economic cycles when interest rates have risen to stave off inflationary pressures leading to mass bankruptcy. The effect has been exacerbated in a number of territories (notably Europe) by forbearance on the part of banks whose appetite for further write-downs is already constrained in an environment of rising regulatory capital requirements.
Matters tend to get worse when politicians enter the picture. Jobs in manufacturing, unlike financial services, hold a particular allure for the political classes in many developed economies. Lack of growth and overcapacity in mature industries would ordinarily require restructuring and consolidation, particularly as off-shoring is more prevalent in more basic, labour-intensive industries. Nostalgia for a past golden age of “honest” jobs and the politicians’ hunger for votes fuel protectionist instincts. Nowhere is this more apparent than in Europe, where nationalistic urges are irresistible.
Managers in politically sensitive industries struggling with excess capacity can face a prisoner’s dilemma. Why should a French automotive manufacturer shut capacity when the benefits accrue disproportionately to its Italian competitor? Or, the Swedish paper company draw back to the advantage of its Finnish rival? Why not wait for others to deal with the capacity problem? In the emerging markets, the identification of “strategic industries” by Chinese politicians has led to excess capacity in various sectors, as diverse as solar and wind power, stainless steel, shipbuilding and telecommunications equipment. As a result, certain markets in the developed world, where competition was seen as regional in nature, have suddenly become global. Because of the difficulty of assessing what motivates competitors under conditions of state capitalism, capital cycle analysis tends to be more effectively applied to industries which are largely domestic in nature or where the dominant players are inclined to Anglo-Saxon style capitalism (as is the case in the global beer industry).
New technologies often interfere with the smooth operation of the capital cycle. The Internet has wreaked havoc on many industries, including music, regional newspapers, book retailing and travel agencies. Marathon has suffered in a number of cases where the benefits of supply side consolidation in distressed sectors was insufficient to offset a secular decline in demand. Fortunately, the capital cycle approach is well attuned to identifying superior Internet business models which can sustain high returns of capital. An understanding of the power of network and scale effects that protect companies from the chill winds of competition has led to successful investments in a number of Internet businesses including Amazon, Priceline and Rightmove. (Although, to date Amazon has proven better at destroying profits in other businesses than in generating any for itself.)
In recent years, capital cycle analysis has been more useful at picking stocks in companies which can maintain high returns than in finding opportunities among bombed-out industries recovering (or not) after a supply side restructuring. For the former, the investment case rests on whether competing capital can enter the sector and boost supply, eventually driving down industry returns. What we have seen in a number of cases is that dominant businesses often become more powerful when they have well managed, proprietary assets. Examples here include Nestlé, Unilever, and McDonald’s. It has helped that the durable cash flows generated by such businesses have the bond-like characteristics investors crave in the current environment of low interest rates.
In short, the great strength of the capital cycle approach lies in its adaptability. The basic insight doesn’t change. Namely, both high and low returns are likely to revert to the mean as valuation influences corporate behaviour and brings about shifts in the supply side. In Marathon’s early years, our discipline was focused on finding stocks where the supply conditions were changing. More recently, the emphasis has shifted to identifying sectors and companies where the forces of competition are blunted and the process of mean reversion is drawn out.