Capital Returns | Marathon Asset Management


Published: 2015

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Capital tend to find its way to companies with high returns and leave companies whose returns are less than the cost of capital. This creates a constant and dynamic capital cycle. This pattern has been observed for a long time and can be explained by the fact that humans have a tendency to extrapolate current trends. Studies in behavioral economics have shown that analysts and investors overestimate how long positive and negative trends are expected to continue. Even experienced executives misjudge the duration of cycles. In good times the market seems to suffer from what investor Francis Chou calls “The Bladder Syndrome” – “the more cash one holds, the greater pressure to piss it away”.

EXTRAPOLATION BUILDS VALUATION. Investors quickly get used to new valuation multiples, expressed in the book by “seven is the new five”, which refers to how 7x EBITDA can become the new normal. This creates bubbles and drives down future returns.

COMPANIES FALLS AS EPICURIANS. A successful company may in the future suffer from a “triple whammy” when: (1) management has “thrown good money after mediocre / bad ideas” which will be punished with lower future return on capital, (2) historically high profitability has attracted gold seekers to the industry which changes the competitive situation for the worse, and (3) historically high profitability may have driven up the valuation, which leads to a multiple contraction when the company is no longer perceived as fantastic.

COMPANIES RISES AS STOICS. A company that has struggled for its survival for several years can sometimes be an excellent investment as a result of: (1) tough times have required management to get rid of unnecessary costs which can lead to higher future profitability, (2) low-profit industries have often forced the weakest players into bankruptcy while few / no new players have entered the market which has eased the competitive situation, and (3) profitability below the cost of capital has driven investors out, which when profitability rises, opens up for multiple  expansion

”Companies which earn above their cost of capital tend to invest more, thereby driving down their future returns, while companies which fail to earn their cost of capital behave in the opposite way” – Benjamin Graham, Security Analysis

FOCUS ON SUPPLY. Entry barriers is what prevent supply from increasing sharply in response to high profitability. The future of supply is less uncertain than demand, and is therefore easier for investors to forecast.

STRONG THREES STANDS. Capital cycle analysis is strongly influenced by J.A. Schempeter’s concept of ‘creative destruction’; competition and innovation create an ever-changing economy that encourages productivity improvements. A recession can be likened to a forest fire that burned down weaker trees so that healthy plants can flourish.

SHIPPING PRE THE FINANCIAL CRISIS. Freight rates on Panamax vessels increased 10x during the period 2001–2007, when China sharply increased its industrial activities. The high profitability meant that many new vessels were built and as these were delivered, freight rates in the spot market fell. As it takes two years from ordering a vessel to delivery, supply continued to increase even after profitability fell, which further aggravated the situation.

WIND POWER PRE FINANCIAL CRISIS. The authors’ fund, Marathon, invested in 2003 in the Danish wind power company Vestas Wind Systems, which share rose 40x during the years up until 2018, due to strong demand. The key figure, Capex-to-depreciation, went from just over 1x in 2005 to almost 5x in 2008. A sharp overcapacity then became a reality for the wind power sector as new capacity was set into operation. In connection with the financial crisis, demand for new projects came to a halt and Vestas’ share fell 96% from its peak.

THE OIL MARKET PRE FINANCIAL CRISIS. Analysts predicted increased energy demand from emerging markets and oil prices were expected to exceed $200 dollars per barrel. The managers of the oil companies had “anchored” their expectations at these levels and therefore continued with drilling and investments. This eventually led to oversupply. The oil companies had also borrowed heavily during the good times, which made them extra sensitive to a sharp correction in the oil price.

STEADY-EDDIE WINS THE RACE. Studies have shown that companies with low asset growth have had higher returns than companies with high asset growth. Low interest rates, for example, mean that more people invest (on weak bases) at the same time as asset prices rise – until reality catches up. The authors of The Journal of Finance believe that a company’s asset growth is a stronger variable for return than traditional value investment (low price to equity), size (market capitalization) or momentum (short and long term).

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