What Capital Cycles Mean for Investment

Performance
April 26, 2016
by Robert Huebscher

Study an industry and you will observe that it follows a prescribed capital cycle. As
prices rise, firms invest to expand production capacity; inevitably, overcapacity results
and drives prices down. Investors understand the capital cycle, according to Edward
Chancellor, but dont always heed it. If they did, they would have averted market
crashes, such as those following the dot-com and real-estate bubbles.

Indeed, Chancellor said, the capital cycle is more important to an investment than
valuation.

Chancellor is a London-based financial historian, journalist and investment strategist. He is a columnist

with the Financial Times, and previously worked for Boston-based Grantham, Mayo, Van Otterloo
(GMO), where he was a member of its asset allocation team.

I spoke with Chancellor during his recent visit to Boston, where he was promoting Capital Returns:
Investing through the capital cycle. The book is a collection of investor letters from Marathon Asset
Management, a $50 billion London-based asset manager. Chancellor edited the letters and wrote the
introduction.

Capital-cycle investing is more powerful than strategies based on growth or value orientation,
Chancellor said, and even explains anomalies such as why investors often overpay for growth stocks.

Lets look at some of the examples Chancellor offered to illustrate the power of capital-cycle investing.

The capital cycle in action

A basic precept of the capital cycle, Chancellor explained, is that capital expenditures and equity
returns are inversely correlated. As a company or an industry invests to expand capacity, investors
will be doomed to suffer lower returns.

An early example of this was the British Railway mania of the 1840s. Chancellor said that absurd
demand projections led to over-building of railway lines in England. The prices of railroad stocks rose
and fell in line with the number of railway lines, according to Chancellor, until prices eventually
collapsed and returns were permanently impaired.

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A more recent example was the expansion of the Asian TIGER economies (Indonesia, Thailand,
Singapore, Malaysia and South Korea) in the 1990s. Chancellor said that fixed-asset investments in
those countries closely tracked prices in their equity markets until the markets crashed.

The technology-media-telecommunications bubble was obvious to investors who studied capital-cycle

investing, Chancellor said, because they observed the doubling in infrastructure to support
communications every three months, which was about twice the rate that traffic was actually growing.
Investors who were aware of the growing level of dark fiber unused telecommunications pipelines
were able to easily sidestep the inevitable crash in dot-com stocks.

The real-estate bubble was observable, Chancellor said, by following the ratio of house prices to
income. That rose steadily and was highly correlated to housing supply from approximately 2000 to
2007. Legg Masons Bill Miller bought home builder stocks in 2005 because they were trading at low
price-to-book ratios. But he failed to heed the ominous buildup in the housing supply, according to
Chancellor, and his investors suffered badly.

Capital-cycle red flags

Even if you arent carefully monitoring fixed investments or capital allocations in an industry, you can
still look for signals of a capital-cycle-related bubble. Chancellor gave several examples of red flags:

Watch what investment banks are doing. Investment banks are the investors enemy, he said.
Avoid industries that are characterized by high levels of investment bank activities, such as
mergers and acquisitions, initial public offerings (IPOs) and debt (especially high-yield) issuance.
IPOs, he said, are a capital-allocation decision that often represents a buildup of capacity in a
company or industry. Chancellor said that the recent surge in junk-bond issuance by U.S. energy
companies was a sign of a capital cycle that investors should avoid.
Beware of investor frenzy. Some ways to detect those frenzies are in the themes upon which
investor conferences are based and by growing levels of coverage by analysts or the media.
Look out for high levels of capital allocation, he said, which is the most direct sign of a capital-
cycle that is about to harm investors.
Monitor metrics such as assets, share count, debt issuance, the capital expenditure-to-
depreciation ratio and the return-on-capital. Unanticipated growth in any of those metrics is a
warning sign, according to Chancellor
The recent crash of oil prices illustrated the value of capital-cycle analysis. Chancellor said that
Marathon correctly predicted the oil price collapse, by observing that the ratio of capital expenditures to
depreciation in the oil industry had reached a cyclical high about two years ago. It also observed that
virtually all analysts in the oil industry failed to predict the collapse, and their price forecasts were
nearly perfectly correlated with then then-current price of oil.

Another recent example was in gold mining stocks, according to Chancellor. Merger and acquisition
activity in that industry is directly related to the price of gold. Investors who observed that relationship

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would have known that the acceleration of M&A activity in 2012 would be bad for gold mining stock
prices. Journalists, Chancellor said, are not paid enough to get it right in advance. But analysts
should have known better. Instead, he said, many were focused on the growth in Chinas economy
and missed the implications of the capital cycle.

You dont need supply to increase to destroy returns, Chancellor said. Capital expenditures will do it.

Why capital-cycle investing works

In his introduction to the book, Chancellor provided some data showing the power of a basic capital-
cycle-based investment strategy. Citing research by Societe Generales Andrew Lapthorne, he showed
that annual returns of stocks from 1990-2015 have been nearly perfectly inversely correlated with
asset growth. The more companies invest in assets, the worse the returns are to shareholders.

Academic research, Chancellor wrote, is edging toward the conclusion that the excess returns
historically observed from value stocks and the low returns from growth stocks are not independent of
asset growth. The key insight, according to Chancellor, is that when analyzing value versus growth, it
is necessary to take into account asset growth, at both the company and the sectoral level. He cited
one academic paper that claimed to show that the value effect disappears after controlling for capital
investment.

Why have investors not caught on and arbitraged away the advantages of capital-cycle-based
investing? Chancellor offered several theories in his introduction:

Investors may be infatuated with and driven by a mistaken fetishism for asset growth. They
are overcome by overconfidence, according to Chancellor.
Base-rate neglect may impair investors. They fail to take into account all available information.
In particular, they neglect to consider the implications of increased capacity in an industry in
response to increased demand.
By taking an inside view, investors fail to consider the developments in an industry in which
they may have highly specialized expertise in the broader context of what has happened in
similar industries.
The inside view is linked to investors tendency to extrapolate recent results, according to
Chancellor. Investors tend to make linear forecasts of trends, even when those trends are merely
movements along one part of a mean-reverting cycle. In this respect, Chancellor said that value
investors who rely heavily on cycles of mean reversion in valuation often overlook the impact of
supply effects in the capital cycle.
Executives are rewarded by growth in market capitalization, which often incents them to grow
assets. Investors, who are rewarded by short-term performance, overlook those distorted
incentives.
A prisoners dilemma may spur overcapacity. In an industry that cannot support investment
growth, there is a strong incentive for a firm or even a new entrant to be the first to add

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 capacity.
High-asset-growth companies are often highly volatile, making it difficult for investors to short
their stocks, preventing the arbitrage that would naturally decrease their share prices.
Marathon, Chancellor wrote, has avoided those pitfalls, primarily by taking a long-term approach to
investing. Capital cycles often take a long time to play out. The NASDAQ bubble, for example, started
in 1995, but it didnt burst until the spring of 2000.

But more importantly, it focuses on forecasting supply rather than demand.

Auto analysts in a conventional setting will try to predict factors such as the demand for passenger
cars in China over a 15-year time horizon. No one knows the answers to those questions, Chancellor
wrote. Long-range demand projections are likely to result in large forecasting errors.

Instead, investors should focus on supply rather than demand. Those forecasts are easier to make and
the necessary data is publicly available and well known.

Because most investors (and corporate managers) spend more of their time thinking about demand
conditions in an industry than changing supply, stock prices often fail to anticipate negative supply
shocks, according to Chancellor.

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