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Capital Account is a selection of reports by Marathon Asset Management. The reports introduce their capital cycle approach to investing and explain the impact the cycle had on businesses, markets, and investors during the late 1990s bubble.
The Notes
- History shows how excited investors get about new technology but too much competition can make it a poor investment.
- “Over the long run, share prices are determined by cash flows, which are themselves primarily influenced by the competitive environment of an industry.” — Edward Chancellor
- Why Quarterly Earnings should not dominate thinking:
- Numbers are unreliable — earnings can be manipulated.
- Tiny changes in operations can have a big impact on after-tax profits.
- Three months of profits are tiny compared to the total value of the business.
- It says little about the company’s competitive position.
- “It’s difficult to say anything new or meaningful each quarter about events of long term significance.” — Warren Buffett
- “Over the long run, it is a company’s return on capital, not changes in quarterly earnings, which primarily determines the direction of its share price. The return on capital of any company is largely subject to the state of competition within its industry.” — Edward Chancellor
- “Companies do not exist in a vacuum. Their fortune is determined, to a greater or lesser extent, by the activities of other businesses.” — Edward Chancellor
- Michael Porter’s Five Forces of Strategic Position:
- Bargaining power of buyers/suppliers
- Threat of substitution
- Rivalry between existing companies
- Threat of new entrants
- Note: the five forces add protection — moats — from competition that drives down return on invested capital.
- “When shares are priced on the assumption that existing returns are likely to be maintained or even improved, then a rapid increase in industry capacity should serve as a red light.” — Edward Chancellor
- Corporate management are subject to the same biases as investors — over-optimism and over-confidence. They can believe the company is much stronger than the competition and the current cycle will last forever.
- “A business which sells at a premium, does so because it earns a large return on capital; this large return attracts competition; and, generally speaking, it is not likely to continue indefinitely. Conversely, in the case of a business selling at a large discount because of abnormally low earnings, the absence of new competition, the withdrawal of old competition from the field, and other natural economic forces should tend eventually to improve the situation and restore a normal rate of profit on the investment.” — Graham and Dodd, Security Analysis
- Capital Cycle Theory:
- High returns attract new competition. Investors are optimistic.
- Competition leads to new investment and excess supply, which causes returns to fall below the cost of capital causing share prices to underperform.
- Corporate investment falls, industry consolidates, companies fold, and competition shrinks. Investors are pessimistic.
- Less competition drives returns to rise above the cost of capital as conditions improve causing share prices to outperform.
- Back to high returns attract new competition. Investors are optimistic.
- Notes:
- “Capital Cycle: the business and investment process by which profitable firms attract excess capital and competition, thereby causing their returns to decline. Conversely, unprofitable firms experience a decrease in competition, leading to higher returns.”
- Mean reversion is at the core of the capital market cycle. It takes time to work out — in terms of years. Requires patience and a long-term view.
- The telecom bubble in the late 1990s is a good example of the capital cycle at work.
- “In a deregulated environment, the price of the goods and services will drop to the marginal cost of production and even below for a while.”
- Deregulation first leads to cost-cutting and higher profits, then new entrants increase supply, prices and profits fall, and finally, shakeout, consolidation, and stability.
- “One of the primary cures for poor returns is consolidation, which is either driven by mergers and acquisition activity or by firms leaving the industry. By increasing the average size of firms within an industry, consolidation allows them to exploit economies of scale. This may improve the bargaining power of a business with suppliers and customers, while economies of scale in production reduce fixed costs as a percentage of sales.”
- Stock buybacks and dividends become a better use of capital than continued expansion when valuation falls below replacement cost.
- “According to the capital cycle theory, a lower rate of capital expenditure should bring a corresponding improvement in industry returns.”
- “Shareholder returns are not necessarily determined by whether a company’s sales are rising or falling, nor whether the market in which it operates is growing or shrinking. Rather, the most important determinant of share price performance is management’s ability to allocate resources efficiently. If a company achieves a higher return on reinvested profits than the market has expected, then its shares will rise, regardless of what happens to turnover.” — Edward Chancellor
- “Profitability is determined primarily by the competitive environment or the supply side, rather than by revenue growth trends. It is better to invest in a mature industry where competition is declining than in a growing industry where competition is expanding.” — Edward Chancellor
- “When companies are valued at a premium to replacement cost there is a strong incentive to increase investment. Or, when a hole in the ground costs $1 to dig but is priced in the stock market at $10, the temptation to reach for a shovel becomes irresistible.” — Edward Chancellor
- “The progress of the capital cycle in the economy is from high stock market valuations and a low cost of equity, to rising investment which produces excess capacity, followed by declining returns and a sinking stock market, ending in the curtailment of investment and recession. The boom carries within itself the seeds of its destruction.” — Edward Chancellor
- “The game of investment, it has been said, is a ‘loser’s game’. The winners are those who make fewer mistakes.” — Edward Chancellor
- “Our thinking goes something like this: if competition declines, then future profitability is likely to increase, which in turn should translate into a higher stock market valuation.”
- Investors should focus on companies with high sustainable returns and companies that can improve below-average returns. Anticipating the direction of a company’s returns is key.
- What affects the direction of profits:
- Changes in competition from one cycle to another. Requires assessing company’s life cycle and whether its product’s life cycle is shrinking or growing — rising profits for a new product can be offset by a short life-cycle.
- The incentives of management. Is management rewarded for “growing the company” or “changes in return on assets”? The latter is more beneficial.
- The valuation of the business. A company’s market valuation influences management. A low valuation can lead to cost-cutting and higher profitability; high valuations can increase capital spending and lower profitability.
- “In short, the sectors we look to invest in are characterized by corporate restructuring, industrial consolidation, a focus on the core business, and a history of underinvestment.”
- Tobin’s Q:
- Tobin’s Q ratio: enterprise value to the replacement cost of a company’s assets.
- “We take the view that a strong relationship exists between stock prices and replacement cost and furthermore, that the best investment returns are achieved when shares sell at a material discount to their replacement cost.”
- Tobin’s Q > 1: assets are valued at more than cost and companies are incentivized to increase capacity. The risk is over-expansion, excess capacity, falling demand, falling profitability, and falling share prices.
- Pitfalls to Capital Cycle Analysis:
- Faulty analysis is often due to misreading political or legal conditions, effects of globalization, or impact of new technologies.
- Bankrupt competition can emerge stronger, with a cleaner balance sheet, as opposed to being liquidated with the assets bought on the cheap.
- Tracking the local competition but failing to account for what global competition is doing.
- Understand how asset life influences the length of the capital cycle. Patience may be needed for an idea to pay off.
- New technology can be disruptive.
- “The real drivers of mean reversion are behavioral, namely, overvaluation tends to attract capital to industries which causes returns to decline and undervaluation has the opposite effect. By linking stock market valuations to corporate behavior and providing us with a model for predicting mean reversion, we find that capital cycle analysis is a truly remarkable investment tool.”
- “When we examine a company as a prospective investment, we analyze both the industry in which it operates from a capital cycle perspective and make an assessment of the individual firm’s management. We attempt to judge whether a sector is attractive, whether our prospective portfolio company is positioned favorably within its sector, and what are the likely returns a company will earn from reinvesting its profits.”
- Questionable practices of management that hurt shareholders:
- Unjustified diversification i.e. diworsification
- Cross-ownership or corporate strategic shareholdings
- Empire building
- Frequent equity issuance, diluting existing shareholders
- Lack of performance-related incentives for management
- “Firms which enjoy increasing returns above their cost of capital are considered to be growth stocks and valued accordingly. If investors see the growth as sustainable, they will also value any incremental capital expenditure by the firm at far more than the nominal amount of those investments. This reflects the stock market’s attempt to value a fixed-asset expansion in relation to the expected return on those assets.”
- New management can revive a company that appears to be bound for the grave if prior mismanagement was the cause of low returns.
- Buybacks are good when:
- Companies can afford them.
- Used by slower-growing mature companies generating a lot of cash.
- Used for defensive or strategic purposes — to unwind cross-shareholdings or to buyout share classes with specific voting rights.
- Adopted with other approaches to enhance shareholder value.
- Done below intrinsic value and has a meaningful impact on the number of outstanding shares.
- It instills discipline in the company. Buybacks, like dividends, return cash to shareholders so that it can’t be misused by management.
- It’s not used to only offset dilution by employee stock options.
- Law of Large Numbers: big companies should, on average, grow in value slower than small and medium-sized companies. When large caps outperform small/mid caps the trend should not be viewed as indefinite.
- “Growth” stocks eventually reach a point where the market discounts all the good news.
- Marathon did a study on growth stocks in 1998. Over a 33 year period, only 42% of growth stocks maintained their high status after 5 years. Only 19% of growth stocks maintained their high status after a decade. Only 5% maintained their status after 20 years. In other words, growth stocks carry a high probability of failure in the long run.
- Assessing Risk of Growth Stocks:
- Is growth based on capital expenditures? Is it financeable?
- It growth based on acquisitions? Is value-added from merger synergies or valuation arbitrage (high valued acquirer versus low valued target)? Is the value gap sustainable?
- Is growth based on valuation? Does a high valuation tempt management to over-expand the business? What’s the oversupply risk?
- Is growth based on raising prices? Is there pricing power? Will higher prices erode market share?
- Is growth based on efficiency gains? Is the company highly efficient, increasing volume growth, passing cost savings onto the customer, and pressuring the competition? Is the company profitable enough to grow but not so profitable to attract competition? Where is the risk of market saturation? (Example: Walmart)
- Is growth based on substitutionary locomotion? Does the company have a rising quality of costs and earnings? Is there valuation or accounting risk? — “Efficiency is also at the heart of this operating model, but a substantial amount of the ‘savings’ are redeployed either for advertising, to generate new demand, or for innovation, to create more products. Because accelerated advertising or research goes through the profit and loss account, these companies often do not appear to be growing earnings as fast as they might be. In the race of fable, they resemble the tortoise rather than the hare. Management of such companies understand that not all costs are equally bad. While we commonly think of firms in terms of quality of earnings, companies in the ‘substitutionary locomotion’ class have a rising quality of costs as well as of earnings.”
- Note: Business risk tends to fall as you move from the first question in the list to the last because management has more control over the business model. Be aware that you can still overpay for growth.
- “For growth investors, the key investment question is simply can a company surpass the market’s expectation of profits in the long run? Successful growth stocks will be those whose profitability fades at a slower rate than the market’s expectation, unsuccessful ones are those that fail to meet it.”
- “The range of investment outcomes is not normally distributed, but is characterized by ‘fat tails’. We believe that shares spend relatively little time at ‘fair value’. Rather, lengthy periods of overvaluation are followed by lengthy periods of undervaluation.”
- The “Fat Tails” Hypothesis:
- Mean reversion cannot be predicted.
- Mean reversion only occurs in the long run, not in the short run.
- Extreme valuation spreads are not rare nor short-lived.
- The inefficiencies create a large window of opportunity for investors.
- “Overvaluation leads to overinvestment and increased competition.”
- “When the yield curve is inverted (i.e., long-term rates are lower than short-term rates)…growth stocks receive a boost because their distant future earnings are discounted back to the present at a lower rate.”
- “Valuations affect behavior.”
- “Nothing is more annoying than high returns being made by someone other than oneself. The temptation to follow the trend is very strong, but it must be resisted.”
- “…superior investment returns come from one source – the investment outcome must differ materially from that already discounted by the market at the moment when the stock is purchased.”
- “The gap between perception and reality is best thought of as a mispricing. Such mispricings create an opportunity for potential returns for active managers. They can exist at the individual company level, between the companies within an industry (intra-industry spreads), or between countries (geographical spreads).”
- How much does the internet/social media contribute to the herd effect?
- Watch for disconnects between the stock market and bond market — a high stock valuation but bond valuation priced as junk (Amazon’s stocks saw peak Dotcom bubble prices in 2000 but its bonds were priced at 13% yields. The bond market was basically closed to Dotcom companies).
- “As the stock market periodically misprices physical assets, these miscalculations are likely to be correspondingly greater in the case of intangible assets that are more difficult to measure. Valuation also distorts behavior.”
- “Dominance of one’s market can confer competitive advantage if well-managed. The tricky problem comes in defining the market.”
- “All too often, lack of scale in an unrelated market is used as a justification for a bad deal.”
- In fast-changing industries, investors must understand the assumptions behind current valuations and seek companies with a sustainable competitive advantage.
- Marathon’s ideal stock: Stocks in “industries in which capital expenditure is declining and the share count is shrinking, competition is becoming less intense as a result of industry consolidations, demand is rising and, above all, valuations are compellingly low.”
- Network Effects: a customer’s value depends on the number of other customers that use the product.
- Network Effects on Telecoms: “There are also more subtle network effects: advertising is attracted by high levels of subscription, which funds investment in improving quality to attract more subscribers, thereby completing the virtuous circle.”
- Bearish signs for Dotcom stocks in 1999:
- High valuations – tech stocks discounted 14% earnings growth over the next decade.
- Consumers can’t afford the analyst’s assumptions of “New Economy.”
- Profits are short-lived.
- Historical returns on new technologies are poor.
- High valuations encouraged over-investment — “high stock market valuations have the effect of stimulating capital expenditure and fresh competition. In turn, this may lead to declining industry profits.”
- Patents and intellectual property are not secure.
- Companies turned from organic growth to acquisition-driven growth models and paying high premiums.
- High share turnover for tech stocks — average holding period was 3 months. Anyone with that short of a holding period has little care for the long-term economics of the company and depends entirely on the next bit of news to be good. Huge price anomalies develop when shortening holding periods are widespread.
- The time horizon of Wall Street analysts was shrinking.
- The gold rush mentality and favorable blanket media coverage.
- Increase in public speculation.
- The high number of tech sector IPOs versus other sectors — 60% of IPOs in 1999 were tech and telecom.
- High secondary issuance and existing shareholder dilution.
- Euphoric stock market valuations versus junk bond prices in the bond market.
- High institutional ownership of tech stocks.
- Speculative element — rising stock prices were entirely due to multiple expansion, not earnings growth.
- Record high ratio of insider sellers to buyers in tech stocks.
- Tech companies used high valuations to buy out other companies in all-stock deals.
- “The feedback loop between the debt and equity markets does create potential investment opportunities… As the price of debt falls in tandem with the market value of the equity, the likelihood of debt-for-equity swaps rises to the point where distressed debt can often be viewed as equity in waiting. While traditionally, the upside for debt securities has been limited to face value, under the debt-for-equity swap model, distressed debt is beginning to look more like equity, both with regard to risk and potential returns.”
- The Downside of New Stock Issuance (IPOs and secondaries):
- It’s most often done in the trendy/fad sector after the money’s been made.
- It dilutes existing shareholders at a fair to high price increasing the likelihood they later sell at a lower price after the market corrects.
- New issuance comes with a high price tag from investment banks. Said banks also prefer to issue stock that has recently performed well because it’s easier to sell.
- Companies/investment banks use complex valuation models to price new shares, while selling them to the public using simple valuation metrics.
- Investment banks will dress up an IPO with a well-known strategic investor to add respectability to the new stock.
- “It is a fundamental law of both economics and investment banking that share prices and the supply of equity paper will rise to meet demand.”
- “An understanding of ‘how the game works’ provides us with an edge over the competition. We believe that investment banks destroy value for acquiring shareholders by exploiting weak CEOs; that fads and fashions are hyped in order to drive deals; that the power of the investment banks is sustained by an industry cartel; that skulduggery is rampant; and that the banks’ research encourages momentum strategies which produce ultimately futile stock trading.”
- “Capitalism works efficiently only under conditions of genuine competition. In the world of investment, this requires a large universe of buyers, sellers, and intermediaries. If one or more of these groups consolidate into something approaching an oligopoly, then the operations of the market may become perverted.”
- The Two-Handled Pump:
- Developed by the owners — Fair, Flood, Mackay, and O’Brien — of Comstock Lode silver mine in the 19th century.
- The Comstock Lode was the lowest-cost producer of silver but the owners were still unhappy about the profits. So they decided to take advantage of investors’ greed and fear.
- So the owners spread stories to manipulate the stock price. When the price of silver was high, the stories told of the great prospects of the mine, the stock price would rise above the mine’s value, and the owners would sell their shares and wait.
- Then the owners flooded the mine, watched the shares sink, and bought their shares back at a much lower price.
- Repeating the process increased the owner’s profits at the expense of other shareholders.
- “…an aptitude for spotting absurdities in the stock market…remains an invaluable component in the fund manager’s tool-kit.”
- Economic Value Added (EVA):
- EVA was a method of measuring corporate performance that became popular in the 1990s.
- “Accountability for EVA, published on 1 December 1994 by the Coca-Cola Company: ‘EVA measures the increase in economic profit generated from one year to the next’, given that ‘economic profit is the company’s net operating profit after taxes (NOPAT) minus a charge for operating capital’.”
- A company can increase EVA by cutting costs, raising profits, or a combo of both.
- “Changes in stock market value are correlated with changes in EVA, which is measured by the spread between a company’s return on invested capital and its cost of capital. “
- When a new method of measuring corporate performance becomes popular, there’s a risk that management will base decisions solely on pleasing the model. For example, funding short-term projects because they have a more immediate impact on profits than long-term projects which have a high cost and slower rollout but a greater impact on long-term profits. It may be good for the stock price in the short term, but terrible for the company in the long run.
- Share buybacks were popular with companies focused on EVA. Of course, buybacks were done at high prices.
- Manipulating earnings was also a side effect of EVA. Management would cut marketing budgets or cut/sell R&D projects to boost short-term profits.
- “…we continue to believe that the best investment opportunities lie among companies in the value universe. Not only is it easier to improve corporate profitability from a low level, but investor expectations for value stocks are…extremely pessimistic, especially when compared with the so-called growth companies.”
- “Growth companies derive their market value from two component parts. First, there is the value placed on the profitability of the existing business and secondly the value which comes from developing new business opportunities.”
- “As investors, we strive to differentiate between good costs (that build value) and bad costs (that destroy it). We recognize that a company’s profit and loss statement will not provide an easy answer. For instance, investment in R&D or brand-building through media advertising may not necessarily be bad costs, although they will immediately reduce reported earnings. On the other hand, adding to manufacturing capacity, especially in a commodity business, may be a bad idea despite the accounting convention which capitalizes the cost over the twenty-year life of that asset.”
- “It is a common practice of investors to assume that changes in quarterly earnings per share are a proxy for changes in shareholder value. This approach fails to assess the quality of the earnings.”
- The average mutual fund in the 1950s held shares for about five years or a 15% turnover rate. By 1999, shares were held for an average of eight months, a greater than 100% turnover rate.
- “Trends in the latest data point are all that is important for share performance in a market driven by ‘price-to-news-flow’.”
- Analyzing Turnarounds:
- It starts with figuring out how the company got in trouble.
- Is the management open-minded or in denial about it?
- Easier Turnarounds (in order of importance):
- Intellectually honest management
- Good capital allocation — declining levels of investment preferred
- Robust core business
- Long product life
- Loyal customer base
- Constrained supply side
- Good balance sheet
- Constructive shareholders on the bond and equity side
- Proper management incentives
- Difficult Turnarounds (in order of importance):
- Management in denial
- More investment needed
- Core business in trouble
- Short product life
- Disloyal customer base
- Supple side out of control
- Bad balance sheet
- Stubborn shareholder base — bonds and equity side
- Counter-productive management incentives
- Easier turnarounds tend to be less risky, more transparent, and predictable than difficult turnarounds.
- “It’s how management allocates capital that determines the success or failure of any turnaround.”
- Sometimes a turnaround story is a company that previously chased an excessively high growth target and failed. Success becomes is simply an issue of cutting costs, ending acquisitions, paying down debt, and letting profit margins slowly rise.
- A turnaround may require “good costs” like higher marketing costs and R&D, which lowers profits margins in the short term (possibly negatively impacting stock price), but, while less predictable, would benefit the company long term.
- Management Incentives:
- Is management rewarded for failure?
- Incentives should correlate with shareholder value, not company size.
- Should be based on long-term, not short-term performance.
- “We favor long-term incentive plans, with appropriate relative performance hurdles.”
- “We believe that any fresh issues of equity should be accompanied by increased management shareholdings on the same terms, preferably with a five-year lock-up.”
- “…bonuses should be deferred until the long-term outcome of a business strategy is realized.”
- Corporate misbehavior is often tied to poor incentives.
- “Those who failed to identify the excesses at the top of the market are not likely to be bargain-hunting at the bottom.”
- Goodhart’s Law: when a measure becomes a target, it ceases to be a good measure.
- “Warren Buffett has often stated that he would rather purchase whole companies than portions of firms in the public markets. This has been perceived to be a comment on valuations, but, in our opinion, it is more consistent with the view that few publicly listed companies are genuinely run for the long term.”
- “What do you do when your competitor’s drowning? Get a live hose and stick it in his mouth.” — Ray Kroc, McDonald’s Corporation
- “…retained earnings over a relatively short period of time account for most of the capital employed in a business.”
- “While it is true that some business franchises are so strong or so weak that management can make only a limited impact, the recent past is littered with examples of good businesses that have been destroyed by inferior managements.”
- Talking with Management:
- “We find it crucial to meet management as often as possible as it lets us assess the characters and motivations of those who are running the businesses. Such personal impressions can be enlightening.”
- Watch their body language.
- Watch how they interact with other managers. Any signs of hostility? Do they get along? Do they allow other managers to talk?
- How do they handle criticism?
- What do their lifestyle or spending habits look like? Do they flaunt their wealth or hide it?
- Are they all promise and no action? Multiple meetings allow for checking past notes to see how liberal management is with the truth.
- Do they love “deal-making”?
- Any signs of delusions of grandeur, cult of personality, or yes-men?
- “We go out of our way to look for management that cares about shareholder value but doesn’t hype its stock.”
- “One learns to apply a filter to all promotional noises and avoid those companies whose executives seem most talented in the art of spin.”
- “We like managers who display a streak of ruthlessness when dealing with problems or competitors.”
- How opulent is the headquarters? How often do they hire advisors? Do they brag about their penny-pinchers?
- “We like meeting management who boast how little money and time they spend on investment bankers and consultants.”
- “Managers who emphasize a corporate culture and explain how they do not wish to dilute it with grandiose mergers always impress us.”
- “We feel more comfortable when a team has been in place for a long time, with a good track record.”
- Do they show humility? Do they discuss the company’s strengths and weaknesses?
- “Does he or she have a coherent plan to deal with the problems? When management has made a mistake, say a terrible acquisition, have they properly analyzed what went wrong and taken measures to ensure that decision-making will be improved in future? We look out for intelligent chief executives with an eye for detail.”
- “Ultimately, we are looking for managers who think and act like shareholders. Finding them is harder than you might believe.”
- “The more overvalued the stock market, the more likely it is that shares will be used as an acquisition currency… While using overvalued shares to purchase equally overvalued companies may not destroy as much value as would appear at first glance, it would be better, from a shareholder perspective, to use the overvalued paper to acquire undervalued assets.”
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