Capital Returns

1. Capital cycle analysis reveals investment opportunities and pitfalls

The key to the "capital cycle" approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns.

Supply-side focus. Capital cycle analysis primarily examines how changes in industry supply affect company returns, rather than trying to predict demand. This approach is more reliable because supply changes are often well-flagged and occur with predictable lags after changes in capital spending. Key indicators include:

• Industry fragmentation and increasing supply (negative)
• Industry consolidation and capacity reduction (positive)
• Ratio of capital expenditure to depreciation
• Free cash flow conversion rate
• New entrants and IPO activity in hot sectors

Contrarian perspective. Capital cycle investors often take positions contrary to market sentiment:

• Buying into industries where capital is being withdrawn
• Avoiding sectors experiencing rapid capital inflows
• Looking for inflection points in industry supply conditions

2. High returns attract capital, leading to industry oversupply and profit decline

High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending.

Cycle dynamics. The capital cycle follows a predictable pattern:

1. High profitability in an industry attracts investment
2. Companies increase capacity to capture growth
3. New entrants join the market
4. Supply eventually exceeds demand
5. Prices and profitability fall
6. Capital exits the industry
7. Supply contracts, setting the stage for the next upturn

Recent examples:

• Commodity supercycle (2000s-2010s)
• Shipping industry boom and bust (2000s)
• US housing bubble (early-mid 2000s)

Investors should be wary of industries experiencing rapid capital inflows and capacity expansion, as these often precede periods of oversupply and declining returns.

3. Sustainable competitive advantages can defy mean reversion

Companies with such strong competitive advantages, possessing what Warren Buffett calls a wide "moat," are able to maintain profits, often for longer than the market expects.

Durable advantages. Certain companies can maintain high returns by possessing:

• Strong brands (e.g., Colgate in toothpaste)
• Network effects (e.g., Visa in payments)
• High switching costs (e.g., Oracle in enterprise software)
• Economies of scale (e.g., Amazon in e-commerce)
• Intellectual property (e.g., pharmaceutical patents)

Pricing power. Companies with sustainable advantages often exhibit:

• Ability to raise prices without losing customers
• Products/services that represent a small portion of customer costs
• Limited price-based competition

These factors can create a "virtuous cycle" where high returns fund further investment in competitive advantages, allowing companies to compound value over long periods.

4. Management's capital allocation skills are crucial for long-term success

After ten years on the job, a CEO whose company retains earnings equal to 10 per cent of net worth will have been responsible for the deployment of more than 60 per cent of all capital at work in the business.

Key decisions. Effective capital allocators excel at:

• Organic investment (R&D, marketing, capex)
• Mergers and acquisitions
• Dividends and share repurchases
• Debt management

Alignment of interests. Look for managers who:

• Have significant ownership stakes in their companies
• Employ long-term incentive structures
• Demonstrate a track record of value-creating decisions
• Communicate clearly about capital allocation priorities

Example: Björn Wahlroos at Sampo Group demonstrated superior capital allocation through:

• Well-timed divestitures (e.g., Nokia shares)
• Strategic acquisitions (e.g., P&C insurance consolidation)
• Countercyclical investments (e.g., corporate bonds during 2008 crisis)

5. Meetings with management provide valuable insights into company culture

Forming impressions of the CEO's character, intelligence, energy and trustworthiness can be gleaned using a variety of questioning techniques.

Effective meeting strategies:

• Ask open-ended questions about strategy and competitive landscape
• Observe interactions between executives
• Inquire about past mistakes and lessons learned
• Assess understanding of capital allocation trade-offs
• Look for signs of humility and intellectual curiosity

Red flags:

• Excessive focus on short-term metrics
• Lavish corporate perks (e.g., private jets, expensive offices)
• Unwillingness to discuss failures or challenges
• Overemphasis on industry jargon and buzzwords

Meetings can reveal important cultural aspects like cost discipline, long-term thinking, and alignment with shareholder interests. These factors often have a significant impact on long-term investment returns.

6. Financial crises often result from excessive credit growth and overinvestment

The credit boom created excess capacity in a wide array of global industries.

Crisis precursors:

• Rapid credit expansion
• Asset price bubbles (e.g., real estate, stocks)
• Loosening lending standards
• Financial innovation and complexity
• High levels of leverage

Case study: 2008 Global Financial Crisis

• Subprime mortgage boom
• Securitization of risky assets
• Mispricing of risk in financial markets
• Excessive leverage in banking system

Investors should be cautious when observing signs of credit-fueled booms, as these often lead to painful busts and present both risks and opportunities in their aftermath.

7. Post-crisis policies can impede necessary industry consolidation

The capital cycle ceases to function properly when policymakers protect underperforming industries.

Impediments to creative destruction:

• Ultra-low interest rates
• Government bailouts and subsidies
• Regulatory forbearance for banks
• Political resistance to job losses

Examples:

• European auto industry maintaining excess capacity
• "Zombie" companies in Japan surviving on cheap credit
• US airlines receiving repeated government support

These policies can prolong periods of industry overcapacity and low returns, delaying the natural consolidation that typically follows economic downturns. Investors should consider these factors when assessing the potential for industry recovery.

8. China's investment-driven growth model poses risks for investors

China's credit denouement may occur in a rapid (and cathartic) fashion in the mode of the Asian crisis, or be more drawn out, Japanese-style – but happen it must.

Key concerns:

• Excessive investment as a share of GDP (>40%)
• Rapid credit growth and rising debt levels
• Overcapacity in many industries
• State influence on capital allocation
• Questionable accounting practices

Investor implications:

• Be cautious of Chinese companies with high capex and rapid growth
• Look for businesses less dependent on government support
• Verify financial statements and be wary of related-party transactions
• Consider potential for industry consolidation and improved capital discipline

While China's growth has been impressive, the capital cycle approach suggests caution regarding the sustainability of returns for many Chinese companies and industries.

9. Speculative bubbles are characterized by distinct warning signs

All of the above, combined with the usual anecdotal signals transmitted in meetings with companies and sell-side practitioners, suggests that May 2006 has represented something of a market peak.

Common bubble indicators:

• Rapid price appreciation in assets or sectors
• Proliferation of new financial products
• Increased retail investor participation
• Loosening lending standards
• High levels of M&A and IPO activity
• Extreme valuations justified by "new paradigm" thinking

Historical examples:

• 1990s dot-com bubble
• 2000s US housing bubble
• 2010s cryptocurrency boom

Recognizing these signs can help investors avoid major losses and potentially profit from market dislocations when bubbles eventually burst.

10. Investment bankers often prioritize fees over client interests

Never trust the bankers.

Misaligned incentives:

• Focus on short-term transaction fees
• Pressure to grow deal volume and size
• Conflicts of interest between advisory and trading divisions
• Tendency to promote complex financial products

Investor implications:

• Be skeptical of investment bank research and recommendations
• Question the necessity and terms of major corporate transactions
• Look for companies that allocate capital independently of banker influence
• Be wary of financial innovations that obscure risks or transfer them to unsuspecting parties

While investment banks play an important role in capital markets, investors should approach their activities with a healthy dose of skepticism and focus on the long-term interests of the businesses they own.

Last updated: July 28, 2024