Tuesday, May 23, 2023

Review of Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15

Two years ago we wrote a post called Sector Rotation Value Strategy, where we pointed out that the level of investment in capacity in an industry (whether it increases because of capital expenditure or decreases because of liquidation of capital investment) has predictable effects on profits. Over-investment in capacity leads to low profits and bad times for an industry, and under-investment leads to high profits and good times. We are not the first people to think of that, of course, although we did apply it with success over the past two years by investing in hydrocarbons and pipelines

It turns out that Edward Chancellor - author of The Price of Time and Devil Take the Hindmost - edited two anthologies of investment reports from Marathon Asset Management. The first was called Capital Account, which covered the period from 1993-2002 and which was published in 2004. This one, Capital Returns, covers the period 2002-2015 and was published in 2015.

The book consists of two parts: first is the "Investment Philosophy," which is selections of Marathon client letters that explain their "capital cycle" investing strategy and apply it to various situations. The second is "Boom, Bust, Boom." Our assessment is that the book is a 5/5, but you need not read Part II. Focus on the first one hundred pages that make up Part I. But even the forward by Neil Ostrer and William Arah captures the point quite well:

Over three decades, our investment philosophy has evolved, but two simple ideas about how capitalism works have always been paramount. The first notion is that high returns tend to attract capital, just as low returns repel it. The resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways - what we like to call the capital cycle. Our job has been to analyze the dynamics of this cycle: to see when it is working and when it is broken, and how we can profit from it on behalf of our clients. The second guiding idea is that management skill in allocating capital is vital over the long term. Picking managers who allocate capital in sensible ways is crucial to successful stock selection. The best managers understand the capital cycle as it operates in their industries and don't lose their heads in the good times. We have found that the kind of opportunities created by capital cycle analysis often have long gestation periods as the timing of the payoff was highly uncertain. 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.

Part I of the book starts with an outline of the capital cycle approach. They go so far as to say that the capital cycle strategy is exploiting a capital cycle anomaly - that there is an inverse relationship between capital expenditure and investment returns, which in turn means that firms with the lowest asset growth outperform those with the highest asset growth. Some key points:

  • Capital cycle analysis is really about how competitive advantage changes over time, viewed from an investor's perspective. 
  • Marathon looks to invest in sectors where competition is declining and capital has been withdrawn, and where depressed investor expectations produce attractive valuations.
  • Corporate events associated with asset expansion - such as mergers & acquisitions, equity issuance, and new loans - tend to be followed by low returns. Conversely, events associated with asset contraction - including spin-offs, share repurchases, debt prepayments, and dividend initiations - are followed by positive excess returns.
  • Firm asset growth is a stronger determinant of returns than traditional value (low price-to-book), size (market capitalization), and momentum... asset growth may explain the phenomenon of momentum reversal.
  • Mean 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.
  • From the perspective of the wider economy, this [capital] 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. 
  • 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.
  • Our goal is to find investments in depressed industries at positive inflection points in the capital cycle and in sectors with benign and stable supply side fundamentals.
  • Industry specialists are prone to taking the 'inside view.' [...] Marathon prefers to employ generalists who look across many industries.
  • The capital cycle enters a dangerous phase when high profitability leads to rising capital spending... increases in [the] capex-to-depreciation ratio and the decline in [cash conversion percentage] served as red flags for investors.
  • The capital cycle partly explains why corporate profitability lags GDP growth. [...] The primary driver of healthy corporate profitability is a favorable supply side - not high rates of demand growth. Hence, it is possible for there to be rapid growth in an industry which brings little or no benefit to investors. In fact, strong growth in demand is often the direct cause of value destruction as it encourages a flood of capital into the industry, eroding returns.

They propound some hypotheses that might explain the capital cycle anomaly, without committing to one in particular. These include: overconfidence, competition neglect, inside view, extrapolation, skewed incentives, and prisoner's dilemma. They point out that "bankers are paid to drive capital cycles" because investment banks get paid to raise capital, not return it to investors. (They would prefer that you remain ignorant of the net issuance anomaly.) 

The principal-agent problem seems particularly important to us for explaining the capital cycle anomaly. As we have noted in the past, management compensation scales with firm size. The authors posit that managers with a large ownership stake are more likely to shrink capital employed than hired help managers, although they did not cite any research for this and we have not found anything in the literature that is on point. 

Marathon has historically liked the analog semiconductor business:

  • The analog sub-sector has been a notable exception to the low and volatile returns of the semiconductor industry. [...] How have these companies generated such high returns and to what extent are these returns sustainable? The answer lies in an understanding of the supply side of this industry... As the real world is far more complex and heterogeneous than the digital one, the product design required to capture it has to be more complex and heterogeneous. This means that product differentiation of analog semiconductors is higher and company-specific intellectual property (whether physical or human capital) more important.
  • These factors - a differentiated product and company-specific 'sticky' intellectual capital - reduce market contestability. These strategic advantages are compounded by the fact that analog has a more diverse end market than digital, with a much wider range of products, numbering in the thousands, and smaller average volume size. Such market characteristics make it difficult for a new entrant to compete effectively. Thus pricing power tends to be robust and market positions relatively stable over long periods.
  • Pricing power is further aided by the fact that an analog semiconductor chip typically plays a very important role in a product (for example, the airbag crash sensor) but represents a small portion of the cost of materials.

We have noticed the same thing about analog semiconductors - which is why we posted about Texas Instruments last fall. Something interesting about TI's business is that it has a very diverse product portfolio (80,000 products) and a very diverse customer base (over 100,000). Only 60% of their revenue comes from the top 100 customers. What is great about a product portfolio like this is that it doesn't necessarily pay for a competitor to copy any single one of the chips that TI sells. In other words, each product is its own little competitive castle; you couldn't put TI out of business by copying just once of them.

After the initial discussion of the investing approach and the anomaly which it may be exploiting, the book discusses some major busts, including several that we picked up on this blog, such as shipping, mining, and oil & gas

How the mining cycle played out: initially, mining companies were skeptical of the price rises in the materials they were producing. Marathon points out that miners' capital expenditure as a percentage of cash flow even fell in the early 2000s as commodity prices began to rise. But several years later, investment began to grow. From a 2006 memo: 

"The rise in commodity prices has naturally attracted interest on Wall Street. Commodities, asset allocation experts claim, should be considered a vital part of every investment portfolio. Hedge funds are now commodities experts. [...] The increasing popularity of commodity-related funds suggests that that well known trend-follower, the retail investor, is getting in on the act." 

Annual capital expenditures by miners climbed five-fold between 2000 and the peak of $160 billion about a decade later, mostly in iron ore and coal. These projects had a long lag between conception and development and then delivery. By 2011, the metals and mining sector was at an all-time high as a share of the FTSE index, having tripled from its 1999 low. The bust then happened several years later because of the lag between the beginning of supply investment and the projects delivering product. So, big increases in capital expenditure are the sign that you are in the later innings of the cycle.

In 2012, they wrote about oil: "senior oil executives appear to be anchoring their expectations about the future oil price on current market levels. Total, for instance, has raised its projection for long-term oil prices, which it uses to justify exploration and acquisition spending, from around $20 a barrel a decade ago to a range of $80 to $100."

Then in 2014, "it is difficult to argue that the majors are 'cheap' today. On cash earnings, valuations are much higher than the low earnings multiple suggests - indeed, if forecasts are correct, the majors are trading on a price to free cash flow multiple of 22 times, a premium to the wider market."

As we know, the oil & gas industry subsequently had a huge crash with many insolvencies. There is a Substack that we follow called The Crude Chronicles which wrote about the capex boom period:

The scale of E&P spending in the 2010s blew me away when I created this chart. Capex relative to EBITDA was so high in 2012 (492%) that I had to cut off the left axis in the chart.

Things in oil and gas are very different now. On Twitter, Shubham Garg points out that the majors' capital expenditures are lower than they were at any time from 2010 through 2019, and are under 40% of cash flow.

The capital cycle approach would tell you that you want to avoid the companies and sectors that are spending the most on capex right now - certainly in relative terms, but probably also in absolute terms. So, it's obviously not a great sign that the tech companies are in a capex arms race and are the biggest capex spenders in the entire economy. Nor is it a good sign that those companies' valuations are so expensive. Byrne Hobart wrote an essay earlier this year about why value investing works:

Despite its shortcomings, book value is a surprisingly good measure of a business—which is why buying low price-to-book-value stocks tends to outperform over time. In other words, if you consistently bet against a sophisticated worldview where Visa, Coca-Cola, and Google have valuable assets that aren't reflected in the balance sheet, and bet on a view that banks, oil companies, and other tangible asset-heavy sectors are the place to be, you will (on average!) make some money over time.

One driver of this is that a company has low returns on capital it will shrink over time, because it can't easily raise more funds and because management's incentive is to shrink the business. Meanwhile, if a company has high returns on capital, it will see those slowly converge with the average over long periods, simply because the more unusually-profitable their first investment category is, the harder it will be for them to get a repeat performance. So, in a sense, book value-based investing is a bet on mean reversion: good industries will attract more capital until they're not so good over time, and there is almost no industry so bad that it can't become good when enough competitors call it quits and leave the market.

Capital Cycle investing theory would tell you to be looking at the companies with the greatest dis-investment right now. And a good proxy for that would be to look at the industries with the worst trailing ten and fifteen year returns: oil and gas, coal, oil services, pipelines, hard rock metal mining, and shipping.

Marathon manages $52 billion, and according to their latest 13F filing, their top holdings include Canadian Natural Resources (#3), Southern Copper (#4), and Franco Nevada (#25). They own smaller amounts of Newmont Mining, Weyerhaeuser, Freeport-McMoRan, and Barrick Gold. But it looks like much of their portfolio is given over to large cap tech and growth. If their approach is to "find investments in depressed industries at positive inflection points," why do they own so much Microsoft, Google, Facebook, Adobe, and Baidu? Did they lose their way?

So what's the opposite of a capital cycle where you have rising capital expenditure encouraged by overly optimistic demand forecasts? The shareholder returns that we track on this blog - the debt reductions, buybacks, and dividends - are all dis-investment. As The Crude Chronicle points out, it is unprecedented to see capital expenditure stay so low when profits are as high as they have been in oil and gas the past two years:

No chart better illustrates this “Doubt” mentality than the spread between upstream capex and crude oil prices that has existed off the 2020 lows. The gap between the two has been filled by a de-capitalization of industry balance sheets in the form of dividends and buybacks. A truly remarkable and first-of-a-kind relationship for the industry. And this lack of a supply-side response has been centered in the U.S. shale patch where rig counts, completions, and footage have yet to respond to price. Both of these are evidence to me of “Doubt” in the longevity and sustainability of the cycle.

A"first-of-a-kind" disconnect between cash flow and reinvestment! We have the opposite of an overly optimistic demand forecast in oil and gas; we have an overly pessimistic demand forecast, because of the energy transition delusion. That pessimism should prolong the capital cycle in the industry; it also implies that we are still in the early innings of the investment, since we have reached neither a point of management optimism and confidence, nor a high proportion of cash flows reinvested in capital expenditure.

1 comment:

CP said...

In general, my preference is to maintain a bullish stance on the supply-constrained segment of the supply chain, specifically focusing on metallurgical coal and metallurgical producers. If necessary, I will hedge my position by shorting the oversupplied segment, which includes steel companies. While steel companies typically have strong balance sheets, similar to metallurgical producers, they have been investing heavily in capacity additions in an attempt to lower carbon emissions from basic oxygen furnace (BOF) production towards electric arc furnace (EAF) production, especially in North America and Europe. This is the classic Capital Returns cycle at play and if you haven’t read the book I highly recommend it.