It’s a marathon, not a sprint

This is a review of Capital Returns, a book by Marathon Asset Management, a long-term investment manager, founded in 1986.

It believes in investing based on an understanding of the capital cycle.

The idea is that high returns in an industry attract investment from both incumbents and new entrants, both of which erode margins and reduce profits.

By focusing on the supply side, Marathon attempts to get in and out of sectors at the right time.

In picking the right companies from each sector, it relies heavily on meetings with management, to judge its capital allocation skills, as that is the key factor in its analysis.

According to Marathon, the capital cycle has four stages:

  • The prospect of high returns attracts new entrants to an industry
  • Rising competition pushes returns below the cost of capital
  • Business investment declines, the industry consolidates, and some firms exit
  • Improving industry dynamics push returns above the cost of capital.

Their strategy is based on two observations, summarised on its website:

The first is the observation that high returns in industries tend to attract capital and competition, just as low returns repel them. The resulting ebb and flow of capital affects long-term returns for shareholders in often predictable ways, what we call the capital cycle. 

Since high levels of investment tend to be detrimental to shareholder returns over the long run, Marathon seeks to invest in companies with high returns sustained by barriers to entry deterring investment or companies with low returns in industries where investment is declining.

The second guiding idea is that management skill in allocating capital is vital over the long-term. The best managers understand and seek to alter the capital cycle in their industries through sensible reinvestment choices. Decisions about new capital projects, acquisitions or disposals, and equity issuance or buybacks are critical to the ultimate outcome for shareholders.

History in the present tense

The book charts the application of these two fundamental ideas over the last 20 years by picking a theme, and then offering a series of its internal publications on that theme.

For example, in the chapter “Accidents in Waiting”, you get a series of meeting reports with Anglo Irish bank between 2002 and 2006.

This allows you to follow Marathon’s thinking in real time on a bank that developed some of the worst excesses of banking in the global financial crisis, ending up under state control to avoid bankruptcy.

It has the lovely effect – similar to that of Michael Lewis’ excellent Panic – of helping you to get a very tactile feel of these financial trends in history as understood in the present tense.

This negates the easy and overused hindsight bias, where knowledge of what happened colours your view of the buildup.

What this book does is show how the firm used its underlying principle of investing in the capital cycle to anticipate things before they happen.

Some quotes from its meetings with Anglo Irish include, “this will one day be a super-short” (2002), “This must blow up at some point – surely” (2005), and “still hard to believe in the Irish property investors’ magical abilities” (2006).

The thing I liked most about the book was the way it challenged and developed some of my own views. It was very accessible but I learned a lot. It’s broadened my cognitive arsenal.

One of the themes of this letter so far has been anticipating trouble and identifying opportunity before the change occurs.

This book will help you do that.

The core idea is one that I used on Wednesday to help drive the argument that tech investments were a potentially catastrophic idea at this point, whether they have a bit further to run in the short term or not.

Put it this way, if you see queues outside your local restaurant – the only game in town – you might think that there’s enough demand there for two.

So, you open your own, and you offer a slightly better product at slightly lower prices in order to steal its customers.

For years, the incumbent has seen rising revenues and rising margins as it could raise prices and cram more tables into the same space because there was nowhere else to go.

Now, the sudden entrant of competition means people have a choice, and no longer want to pay more for average food and a cramped environment.

In the global economy a similar effect happens, although it’s obviously much more complicated. Still, Marathon has developed a range of ways to spot this cycle in action and time its investments accordingly.

One particular example that interested me was that of Vestas Wind Systems, one of the largest global wind turbine manufacturing companies.

Source: Capital Returns

Marathon’s first investment in Vestas took place in 2003, when the wind market in the US was suffering due to tax incentive changes. In response, Vestas acquired a local rival, and when demand returned, the share price multiplied by 40x.

As you can see, Vestas’ capital expenditure (capex) rose in line with the share price, both of which charted alongside growing demand for wind power.

Marathon sold some of its holding (though not all) in 2008 near the peak in 2008.

It did so because capex had risen to 5x depreciation, having previously been at one. In true capital cycle form, recent trends in growing demand had encouraged Vestas’ management to invest in more supply capabilities to meet the growing demand.

As it did so, so did all its competitors – management teams mostly tend to be alike.

Unsurprisingly, this industry-wide ramp-up in supply capacity led to over-supply, and as that relationship changed, profitability crashed, and with it, Vestas’ share price to the tune of 96%.

What’s happened now, seven years later?

I don’t know what Marathon included or didn’t in its calculation of capex to depreciation, but here are Vestas’ latest cash flow statement lines for investments made and depreciation/amortisation (2019/2018/2017/2016).

Source: Yahoo Finance

The change is not as drastic as in the previous cycle.

Depreciation and amortisation were DKK 402 million in 2013, while capex that year was DKK 239 million, for a ratio of 0.6. According to the book, it was as low as 0.4 at one point in 2013.

The levels of capex to depreciation is now around 1.4, so it’s still 2-3x higher than it was at its low points, though not as high as it was in 2008.

This is the kind of thing Marathon will be tracking in real time (much more precisely than me) in order to decide when or if to make its next move regarding the company.

Marathon held on to its remaining position throughout the fall, but this helped it to buy more after a promising series of meetings with the new Swedish CEO in… you guessed it, 2013, when Marathon increased its holding by 90% to become the company’s largest shareholder.

The note from 2014 records a subsequent 360% share price rise, but that will be far higher now.

It writes,

The example of Vestas shows how a company can morph from a ‘value’ buying opportunity into being an expensive ‘growth’ stock, and then return to cheap value again in a few years. Investors can take advantage of Mr. Market’s shifting moods. Our Vestas experience also shows the value of well-timed contrarian purchases, notwithstanding the valid questions around our failure to sell more near the peak.

I find that to be a very valuable and instructive example.

Before I finish, a word on investment banks, and bankers. A theme through the book is a dislike and mistrust of them.

Marathon writes that:

… besides generating fees for themselves, the main economic function of an investment bank is to supply finance to capital-hungry businesses, for which they earn generous fees. They are essentially paid to drive the capital cycle, not to worry about the negative long-term consequences that capital expansion may have for their clients.

Brokers meanwhile pay little attention to the capital cycle, which operates beyond their short-term time horizon. Instead, they spend their time trying to calculate next quarter’s earnings, which is good for generating turnover and commissions.

It’s a sentiment I tend to agree with, and describes smartly the inherent systematic failure of these banks, which are built on short-termism and greed, hence their long history of spectacular criminality and unscrupulousness in the name of profit.

Anyway, I haven’t even had time to cover the management meetings side of things, but here are a few quotes from a manager Marathon respects hugely for his appreciation of the capital cycle, Johann Rupert of Richemont. They are from earnings calls or meetings with analysts (emphasis added).

“[On successfully exiting pay TV] Never confuse luck with genius.”

“[On acquisitions] Our job here is to create goodwill, not to pay other people for theirs.”

“[On share-financed takeovers during the TMT bubble of 2000] It’s like a child selling his dog for $1m except he gets paid with two severed cat’s paws.”

“[On uncertainty about the future] So anybody who’s going to ask, so what do you think the next year looks like, why don’t you just not ask the question because we’re not going to answer any. And it’s not because we’re coy or funny. We don’t know.”

“Recessions occur because the investment bankers provide capital at too low a cost which leads to overcapacity and a slump”.

And finally, here are some summarising points in bullet form to try and convey all of the wisdom contained in the book in as few words as possible:

  • Focus on supply rather than just demand
  • Analyse competitive conditions within an industry
  • Beware the investment banker, and their “in-house propagandist” – the brokerage analyst
  • Adopt a long-term approach
  • Select the right corporate managers.

I wholeheartedly recommend it for some lockdown literature.

Have a great bank holiday everyone,

Kit Winder
Editor, UK Uncensored

1 Comment
  1. […] I think it’s a great example of the capital cycle in action – as outlined in my book review of Capital Returns last Friday, which you can read here. […]

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