Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15 by Edward Chancellor
Edward Chancellor provides a deep dive into the "Capital Cycle"; which is the pace of investment within an industry. The concept differs from the better known "Credit Cycle"; which is often found to exhibit itself across an entire economy rather than specific industries. We agree with Chancellors thesis and find it quite useful when thinking about the boom and bust cycles within particular markets.
Here are our key takeaways:
There is an inverse relationship between investment (asset growth) and future returns. Historically, firms with low PE ratios (value) have outperformed. The often cited reason for this is that investors get carried away. However, most of value’s outperformance can be attributed to “differentials in investment”. That is, firms in industries that have been investing heavily in adding capacity will perform poorly because of the subsequent excess supply.
Capital supply is predictable unlike demand for whatever is being produced. This makes monitoring capital investment more useful than trying to forecast demand.
The capital cycle started when firms in a sector start beating earnings expectations repeatedly. Stock prices rise as growth expectations are revised higher. Investors, in turn, encourage capital spending. This eventually leads to excess supply which suppresses margins. This leads to falling profits, growth and stock prices. Increased competition leads to consolidation in the industry as higher cost producers are driven from the market. Bankruptcies and the general fall in stock prices leads to pessimism; which in turn reduces capital investment. This eventually leads to a shortage in capacity which causes an increases in profit margins…thus starting the cycle.
Value investors tend to jump in too early when prices in an industry initially fall because of a belief that stocks are “undervalued” based on low PE, PB, and high dividend yields. However, these measures of “value” are based on illusory earning, overpriced book values, and unsupportable dividends.
The cycle peak is characterized by the point at which it becomes apparent that past demand forecasts are shown to have been overly optimistic. As profits fall, management teams change and capital expenditure are slashed. The industry/sector then moves to a multi-year period of consolidation.
The cycle trough is characterized by low capital spending to depreciation ratios and high cash flow relative to earnings (high cash conversion rate) after years of industry consolidation and low stock prices relative to a multi-year history.
Industries/Sectors can be compared by monitoring the size of aggregate balance sheets…specifically assets. A massive expansion of assets is a sign of trouble. Ignore the story (home prices never go down, the internet is changing everything). Asset expansion is a means of measuring the “madness of the crowds”, as prices are being bid up, and the subsequent value trap when the madness runs its course.