My notes on Capital Returns, a collection of examples from Marathon’s monthly letters tied together with a central thesis that the supply side is key to analyzing cyclical industries.
The book highlights two main concepts:
- 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. The investment manager’s 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.
- 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.
Recent examples of capital cycles:
- Dot-com boom: people thought the Internet traffic was going to double every 100 days - justified capital spending by WorldCom, etc. Telecom networks were plagued with massive excess capacity.
- Daily rates for “Panamax” class ships increased 10x due to China’s growing shipping demand 2001-2007. Supply was delayed - 3 years for a new ship order to be delivered. So between 2004-2009, global dry bulk fleet doubled. Supply increase + global slowdown resulted in a 90% fall in shipping rates. New ships continue to be delivered, shipping industry suffers from poor utilization and low rates.
- Rising home prices after 2002 prompted capital cycle in the homebuilding industry. Housing boom was justified by rosy demographic projections. Homebuilders traded at near book value, looked cheap, but their assets had to be written down after the crash (value trap)
- *regulations can prevent a supply response (ex. UK and Australia)
Quantitative backing:
Fama French new factor “asset-growth anomaly” - companies that invested less delivered higher returns. Companies that have done well often accelerate investment and later underperforms. (which may explain momentum reversals)
Changes in the amount of capital employed within an industry are likely to impact upon future returns. Why?
- High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow – perhaps they are equally hubristic, or maybe they just don’t want to lose market share.
- In a cyclical world, they think linearly. (extrapolation)
Why think about supply?