Chancellor says in order to understand the capital cycle approach, one needs to observe how changes in the amount of capital employed within an industry are likely to impact future returns.
He said a capital cycle analysis looks at how the competitive position of a company gets affected by changes on the supply side of an industry. “While attention is typically transfixed by demand prospects, the real returns come from paying attention to the supply side,” Chancellor said in an interview.
He said it’s pointless to determine demand, as experts even after trying to forecast it with numerous tools have failed to do so accurately. But supply side can be calculated much more accurately by taking into account the capacity of key players in the sector, says he.
Edward Chancellor is a renowned financial journalist and author, who has written books like Capital Returns and Devil takes the hindmost- A history of financial speculation, which have been regarded as investment masterpieces.
In his book Capital Returns, Chancellor has masterfully explained the investment approach that was used by Marathon Asset Management London, UK, between 2002 and 2015. The book mainly recommends following a capital cycle approach to investing.
How does the capital cycle work?
Chancellor says a capital cycle consists of two phases: ‘expansion’, where the industry production/servicing capacity is increased, and ‘contraction’ where the capacity is reduced by selling assets.
With excess profitability, a company or industry’s returns start increasing. This excess profitability attracts new entrants and competitors into it and as they start investing, it results in increased capacity. That causes a shift in favour of demand, which leads to a decline in profit and thus, businesses have to exit capacity and consolidate.
When such businesses exit, there is reduced investment and, hence, lower supply, which in turn leads to increase in profits. Chancellor believes investors who can understand this aspect of the capital cycle can take advantage of the change in situation and earn profits.
But he feels brokerages, analysts and many investors operating with short-time horizons generally fail to spot the turn in the cycle, and obsess themselves instead with near-term uncertainty.
“Capital is attracted into high-return businesses and leaves them when returns fall below the cost of capital. 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,” he says.
Chancellor believes there are a few reasons behind this strange behaviour of the capital cycle, which he terms as ‘capital cycle anomaly’. He outlines four key factors that drive the anomaly: competition neglect, base rate neglect, narrow framing and extrapolation.
Competition neglect: Chancellor says when investors respond to a demand increase by raising capacity in an industry, they forget to review the effect of supply increases on future returns. He believes competition neglect is typically strong when companies get delayed responses about the results of their own decisions. This occurs when there is a major time lag between the decision to raise supply and its actual occurrence. Sometimes the time lag is several years in case of a complex mine.
Base rate neglect: Chancellor says investors make the mistake of not taking into account all available information when making an investment decision. “One focuses on current (and projected) future profitability, but tends to ignore changes in the industry’s asset base from which returns are generated,” he says. He believes investors assume all actions can be based on the current facts and conditions, but the truth is that an industry may be still facing the delayed effect of decisions made many years ago.
Narrow framing: According to Chancellor, investors often focus on all company-, sector- or country-specific information that they have gathered to support their investment decisions, which can be termed the ‘inside view’. But he feels one fails to consider looking for examples elsewhere which is the ‘outside view’.
“An inside view considers a problem by focusing on the specific task and the information at hand, and makes predictions 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. In contrast, an outside view considers the problem as an instance in a broader reference class. Rather than seeing the problem as unique, the outside view asks if there are similar situations that can provide useful calibration for modeling,” he says.
Extrapolation: Investors have a tendency to focus on the information placed in front of them (anchoring bias), and then mainly consider the immediate trend up to that point (recency bias). Also, he feels investors have a tendency to draw strong inferences from small samples. Chancellor believes these tendencies lead one to make linear forecasts, despite the fact that most economic activities are cyclical.
The tenets of capital cycle analysis
According to Chancellor, the essence of capital cycle analysis can 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.
The ideal capital cycle opportunity
Chancellor says investors need to spot ideal capital cycle opportunities for investment growth. These opportunities are available where industry conditions are stable with companies abiding by cooperative behaviour. He feels investors should avoid those industries where companies are not willing to cooperate.
“The ideal capital cycle opportunity for us has often been one in which a small number of large players evolve from a situation of excess competition and exert what is euphemistically called “pricing discipline.” he said.
Chancellor says there are some industries which show oligopolistic structures and have a potentially favourable capital cycle, but they are unable to generate good returns because they get caught up in exhibiting ‘tit for tat’ behaviour, and hence, their returns suffer.
Investors can look out for certain characteristics in companies which signal that they can engage in cooperative behaviour.
These characteristics include an industry having very few players, rational management, barriers to entry, lack of exit barriers and non-complex rules of engagement.
According to Chancellor “the really juicy investment returns are to be found in industries which are evolving to this state.”
Why the long game works in investing
Chancellor says there is fierce competition for short-term information due to which investors tend to focus on earnings of a company for next quarter only. In contrast, those having a long-term outlook seek answers with shelf life as they know that whatever is relevant today may not be relevant in 10 years.
“Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings. We seek insights consistent with our holding period,” he says.
So Chancellor encourages investors to examine a company’s advertising, marketing, research and development spending, capital expenditures, debt levels, share repurchase/issuance, mergers and acquisitions to know whether it is worth investing in its shares.
He says there are various psychological forces that long-term investors come up against, and they include strong social pressure from peers, colleagues and clients to boost near-term performance.
Chancellor believes even if investors develop the analytical skills to spot winners, they lack the psychological disposition required to own shares for prolonged periods.
“Long-term investing works not because it is more difficult, but because there is less competition out there for the really valuable bits of information,” he says.
Chancellor warns investors to be careful of following research conducted by investment banks as it tends to accelerate short term trends. But he feels these research can still be of some worth as it can push asset prices to attractive levels for the long term investor focused on the capital cycle.
“Following this research can be to the advantage of long-term investors if it pushes prices to a level where it’s advantageous to buy (if prices have been pushed too low in the short term), or sell (if investors are too optimistic in the short term),” he says.
(Disclaimer: This article is based on various interviews of Edward Chancellor )