Capital Returns

Insights from the book Capital returns.

Hi.

Reading time: About 7 minutes

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“Most economists tend to forecast in straight lines but the economy and everything in the economy runs in cycles.” - Prashant Patel

I am currently reading this wonderful book named Capital Returns. I will be honest as of now I have only finished the introduction but the introduction itself is so powerful that I have learnt a lot and thought a lot about how this relates to the companies that I have looked at. If you have not read the book I am sure that you will end up rethinking your investment especially in the current scenario in India.

The book is written by Marathon Asset Managers. It is a compilation of their letters. The book is a wonderful dive into how long term investors navigate through the cycles. This book is a wonderful introduction to capital cycles in the markets.

“Most economic activity is cyclical — there are trade cycles ,credit cycles ,liquidity cycles, real estate cycles, profit cycles, commodity cycles, venture capital cycles and, of course , industry capital cycles.”- Capital Returns.

I am going to borrow a similar story from the book and convert it into the Indian context.

Let’s come up with a hypothetical company which manufactures cars known as Agility inc. This company is a family operated business run by the Agarwal family. The Agarwal family is featuring in a lot of business articles and front covers of newspapers, they are becoming famous as their stock price is through the roof and they own a sizable stake in the company.

The Agarwal’s start living a lavish life and have no complaints with their life as there is enough money. They can go wherever they want for trips in private jets.

All the ‘sell side’ reports of analysts are saying you should buy the company. The general euphoria around the company does not mean that is overvalued. It is trading at a mere multiple of 8 times well below their peers. Even the value investors are invested in the business.

The company looks at the major shift of cars going electric and see that there will be significant demand for it which is not being met. So the board decides to invest in manufacturing electric cars. (Note: So far they have only made I.C.E[Internal combustion engine] cars)

The company needs additional capital to fund this expansion. So it turns to the market. It raises more capital with the help of an investment bank named Gala Churn inc. The expansion is received well by everyone including growth investors who are excited by the prospect of growth of earnings in the company.

A few years later, there is a report which says that the Agarwal family is selling their stake in the company after a lot of disagreements with the board which is now comprised of a hedge fund which has got a significant ownership of the company.

Over these 5 years the stock has underperformed, their earnings were depressed and the analysts which were recommending to buy the company were now saying that the company has overinvested in the electric transition and the transition to electric was delayed due to errors. Their low cost competitors which have operated for as long as them have also invested in the same transition and have not ended up doing anything special.

The entire market for electric cars has been suffering as there has been a huge disruption in the lithium supply from China. The rising cost of these batteries have cost them big time. Agility inc. is considering a merger with one of their biggest competitors in the country to cope with this downwind. The company which used to have a lot of euphoria and coverage was now covered by a mere 3 broker analysts. Out of which two had a sell recommendation.

These ups and downs are a basic representation of the capital cycle. There is a a wonderful image which explains the industry capital cycle from the book.

Source: Capital Returns

“High current profitability often leads to overconfidence among managers, who confuse benign industry conditions with their own skill - a mistake encouraged by the media.” - Capital Returns.

This is very interesting don’t you think?

A company which invests in making a business better actually ends up in a worse place than they were in before. Capital investment is often looked at as a very important thing in businesses.

But here’s another mind blowing chart.

This chart is the work done by Andrew Lapthorne from Societe Generale. From the book.

Companies with low asset growth outperformed companies with high asset growth!

This is a mind blowing stat to keep in mind. You don’t need to invest more and more capital to grow. The outperformance over the long term is not even minor. It is significant.

All your mergers and acquisitions that a company does and spends capital on might not be the best decision. For that matter even adding a lot of capacity might not be a smart decision. It could be a huge misallocation of capital. Even more so dangerous if the expansion is funded largely by debt.

One thing which drives cyclicality is the ‘honeypot’ thesis of Phil Fisher and also a simple business understanding.

Let’s say tomorrow you want to start a business.

Which business are you going to start a one which earns a return higher than the cost of capital (money needed to run a business) or a business which earns a return less than their cost of capital?

You will of course want to start a company which earns a return which is higher than the cost of capital. When companies do well and earn high return on capital other people enter in the business.

Once this happens the return goes down as competition increases. This leads to over investment and driving down returns of both the companies. (This ties in with the mental model known as tragedy of commons).

This is in some sense also linked to the mental model of mean reversion. Capital investment by competition drives the high profits back down to their mean.

What are the reasons for this very weird capital cycle?

1. Overconfidence: Companies which earn high returns on capital usually think that everything is because of their skill and not because of the supply side situation. This makes them fall under the pre tense that even if there is competition they are superior.

2. Inside view: The inside view is basically when a person considers a problem by focusing on the specific information at hand. Thinking that the situation they are in is unique.

   The outside view is when the person considers a problem as an instance in a broader reference class. Looking for historic patterns which can repeat.

   Most managers/investors think from the inside view. Whereas the right way to look at things is the outside view.

3. Incentives: For the companies who have incentives based on share price for managers have really skewed incentives. This is because investing a lot of capital ends up moving the stock price in a positive way. This may or may not be the best decision for the company but they will end up investing.

4. Extrapolation: Investors tend to think of things in a linear manner due to a lot of psychological biases. But the reality is that things move in cycles and often this leads to mistakes. The tendency to extrapolate things linearly is hard wired.

5. Game theory: When several players expand their operations more often than not every single person who has invested is worse off. As every single players profit goes down with more capital invested.

What are the tenets of the 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 market-clearing process may be arrested. New technologies can also disrupt the normal operation of the capital cycle.

•Generalists are better able to adopt the “outside view” necessary for capital cycle analysis.

•Long-term investors are better suited to applying the capital cycle approach.”-

Palgrave Macmillan. Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 (pp. 20-21). Palgrave Macmillan UK.

This is all simply from the introduction. This introduction itself gave me so much to think about. If you want to be a research analyst I think it is very important to read this book to navigate the capital cycle and understand its importance.

Thank you for reading,

Samvit.