The book revolves around the theme of how capital cycles can help predict periods of booms and bursts for an industry. The proposed theory is backed by years of anecdotal references across geographies and sectors, which helps bolster the efficacy of the claim. Let’s dive straight into it.
Demand and supply don’t move in perfect sync. There is a time-lag between their response to each other and this lag leads to cyclical business cycles (economists call it Cobweb Effect). When demand rises, the supply cannot rise instantaneously (eg. building new plants take time). This means the supplier can rise prices of the goods. Higher prices lead to inflated profits. This attracts new entrants and investors into the industry. Hence, a capital inflow. Capex takes place which leads to higher supply. Overtime, this increases the supply to a level that matches, if not supersedes, the demand and the prices fall back to normal level. Now, the investors no longer see any latent value and hence would start exiting the industry and some companies would shut down. This again leads to a situation where demand exceeds supply. And the cycle goes in an infinite loop.
High return tend to attract capital, just as low return repels it
Capital inflows can be witnessed into high return businesses and it leaves when returns fall below the cost of capital. This constant flux of capital is termed as “Capital Cycle”. In the Introduction (by Edward Chancellor), a striking parallel is drawn between capital cycles and Schumpeter’s process of “Creative Destruction” – the function of the burst, which follows the boom, is to clear away the misallocation of capital that has occurred during the upswing.
This capital flow has become much more prominent, thanks to the hardworking investment bankers and brokerage agents. They both earn fees based on deal size and are not interested in long term prospects. So no matter if raising money is good or bad for a company from a long term perspective, they are happy as long as money keeps flowing.
Broader picture here is that we are trying to understand how the competitive landscape evolves with the flux of capital. Michael Porter studies competitive advantage based on 5 forces (bargaining power of buyer, bargaining power of supplier, threat of substitution, degree of rivalry among existing firms, threat of new entrants). The capital cycle approach makes an attempt to understand it from an investor’s perspective.
The investment opportunities so identified often are characterised by long gestation periods, which is in stark contrast to the ever-increasing churn rate in asset management industry. Diversifying into a large number of stocks and holding onto them over a long time has also proved its merit. Although academia has long proclaimed merits of diversification, holding concentrated portfolios is a commonplace in the asset management industry since it demonstrates the conviction of the fund manager in his/her thesis about a stock.
Everyone is obsessed with making demand projections. However, Edward argues that such predictions are prone to high margin of error and systemic biases. This book argues that instead of trying to predict the demand (which is quite volatile and hence, difficult to predict), one should divert his/her attention towards forecasting the supply (since it is stable and can be predicted based on capex plans, etc).
Capital Cycle Anomaly
The academia world obviously has something to say about this style of investment. Many papers have been published where inverse relation between capital expenditure and investment returns have been observed. Although it seems to defy common logic, firms with lower asset growth rate have outperformed those with high asset growth rate.
Certain factors, namely Size, Value, and Momentum have historically beaten the benchmark index. Nobel Laureates Fama and French have also suggested adding Profits and Investments as factors as well. It has been observed that events associated with asset expansion (like m&a, new equity issuance, and new loans) are followed by low returns. On the other hand, events associated with asset contraction (like spin-offs, share repurchases, debt repayments, and dividend initiations) are followed by high returns.
Journal of Finance articles have concluded that asset growth is a better returns indicator than the common value (P/B), size (market cap), and momentum(long and short horizons). Surprisingly, momentum reversal can also be explained by asset growths since most companies undertake expansion when their stock is doing well and later just tend to underperform.
Why does this asset-growth anomaly exist?
I think the answer lies towards the behavioural side of finance. A plethora of factors like cognitive dissonance, base-rate neglect, narrow-framing, and senseless extrapolation. The agency-related issues of skewed incentives amplify this by promoting short term perspective.
Secondly, expansion isn’t solitary. When an industry is booming, many companies expand simultaneously, and investors often neglect the competition.
Competition neglect,” according to Harvard Business School professors Robin Greenwood and Samuel Hanson, is “particularly strong when firms receive delayed feedback about the consequences of their own decisions.
Outward shift in supply curve is often overlooked owing to base-rate neglect. Analysts are so focused upon building demand and profitability assumptions that they ignore the change in an industry’s asset base. This is also linked to cognitive dissonance – wilful refusal to consider disconfirming facts once a course of action has been decided upon.
Narrow framing arises out of “Inside View” (Daniel Kahneman). Michael Mauboussin explains this really well. He says an inside view considers a problem by focusing on the specific task and the information at hand to make predictions. On the other hand, an outside view considers the problem as an instance in the broader reference class. The latter looks for similar situations that can provide useful calibration for modelling. With specialised analysts and industry experts, its highly difficult to get outside view.
Recency bias is found guilty as well. We tend to hold onto information from our immediate experience, which makes our extrapolation highly unreliable. Another heuristic is the tendency t draw strong inferences from small sample size. Humans are also hard-wired to think linearly, when in fact most of the things in nature work in cycles or exponential trajectories. This list goes on!
Competitive Landscape
Now that we’ve established that we wish to focus on supply side to make forecasts, it is important to bear in mind the competitive landscape. Negative phase for capital cycle translates to a rash of IPOs, secondary market issue, or even rising debt in a sector.
Circuit-Breakers
Things won’t always work as expected. A brief overview about some factors that might lead of the malfunction of this investment strategy. Never underestimate the disruptive power of new technology since they can change the entire industry dynamic really quickly. This investing style also begins to faulter, for example, when the government protects certain industries.
In a nutshell, capital cycle analysis requires a contrarian mindset and the patience to hold a position despite the unpleasant short-term outcomes. In the end, it’s the capital allocation skill that’s of paramount importance in any fund manager.
Kashvi Gandhi 