Capital Returns: Investing through the Capital Cycle - Ed Chancellor :: Andree Huk

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As a result, we discovered that our approach has worked best when we invested in a relatively large number of stocks, holding onto them for long periods of time.

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 Schumpeter’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.

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.

The ups and downs of this fictional widget manufacturer describes a typical capital cycle. 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.

Nobel laureate Eugene Fama and his colleague Ken French have suggested adding two more factors to their model: profits and investment. 16With regards to the capital cycle, Fama and French observe that companies which have invested less have delivered higher returns. This finding has been termed the “asset-growth anomaly.” A paper in the Journal of Finance reports that corporate events associated with asset expansion – such as mergers & acquisitions, equity issuance and new loans – tend to be followed by low returns. 17Conversely, events associated with asset contraction – including spin-offs, share repurchases, debt prepayments and dividend initiations – are followed by positive excess returns.

In short, recent research is edging towards the conclusion that the excess returns historically observed from value stocks and the low returns from growth stocks are not independent of asset growth. This leads to a key insight of the capital cycle investment approach: when analyzing the prospects of both value and growth stocks, it is necessary to take into account asset growth, at both the company and the sectoral level. One researcher goes so far as to claim that the value effect disappears after controlling for capital investment.19

The “asset-growth anomaly” can be viewed from the perspective of mean reversion. 20Mean reversion is not driven by the ebb and flow of animal spirits alone. Rather, it works through differential rates of investment. Companies which earn above their cost of capital tend to invest more, thereby driving down their future returns, while companies which fail to earn their cost of capital behave in the opposite way. This point is recognized by Benjamin Graham and David Dodd in Security Analysis (1934), the bible of value investing: A business which sells at a premium does so because it earns a large return upon its capital; this large return attracts competition; and generally speaking, it is not likely to continue indefinitely. Conversely in the case of a business selling at a large discount because of abnormally low earnings. The absence of new competition, the withdrawal of old competition from the field, and other natural economic forces, should tend eventually to improve the situation and restore a normal rate of profit on the investment.

All this suggests that asset allocators should consider market valuation in tandem with the capital cycle. Normally, the two run together. The US stock market in recent years, however, has proved something of a conundrum. Since 2010, US stocks have looked expensive when viewed from a valuation perspective (e.g., the cyclically-adjusted price-earning ratio) largely due to the fact that profits have been above average.

The market inefficiency observed by capital cycle analysis can be explained in terms of the conventional findings of behavioural finance – namely, some combination of overconfidence, base-rate neglect, cognitive dissonance, narrow-framing and extrapolation appear to account for the fact that companies with high levels of investment tend to underperform.

Why do investors and corporate managers pay so little attention to the inverse relationship between capital spending and future investment returns? The short answer is that they appear to be infatuated with asset growth. Corporate expansion fires the imagination of both managers and shareholders.

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.

An inside view considers a problem by focusing on the specific task and the information at hand, and predicts based on that unique set of inputs. This is the approach analysts most often use in their modeling, and indeed is common for all forms of planning.

Capital cycle analysis, however, focuses on supply rather than demand. Supply prospects are far less uncertain than demand, and thus easier to forecast

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.

Industry specialists are prone to taking the “inside view.” Having got lost in a thicket of detail, industry specialists end up not seeing the wood for the trees. They may, for instance, spend too much time comparing the performance and prospects of companies within their sector and fail to recognize, as a result, the risks that the industry as a whole is running. M

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 marketclearing process may be arrested. New technologies can also disrupt the normal operation of the capital cycle.

Please consider buying Capital Returns: Investing through the Capital Cycle - Ed Chancellor.

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