TIP729: Mastering the Capital Cycle
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On today's episode, we're exploring a book that's become a classic among value investors and capital allocators, and that's Capital Returns, Investing Through the Capital Cycle by Edward Chancellor. If you've ever wondered why some industries enjoy years of prosperity while others seem to be locked in a cycle of boom and bust, the answer often lies in how capital flows in and out of those industries and how investors react to those capital flows.

Capital Returns distills years of investment letters from Marathon Asset Management, breaking down their capital cycle framework. In this episode, we'll break down the capital cycle approach, why tracking capital expenditures, industry supply, and management incentives can be just as important as analyzing financial statements or competitive modes, and learn practical lessons for applying the capital cycle lens to your own investing process. Whether you're a professional investor or just passionate about understanding how markets work,

I think you'll find these insights valuable and interesting. So with that, I hope you enjoy today's episode on Capital Returns by Edward Chancellor. Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Playthink.

Welcome to the Investor's Podcast. I'm your host, Clay Fink. On today's episode, I'll be chatting about what I learned from reading Capital Returns by Edward Chancellor. Chancellor is the author of several investing books, including The Price of Time and Devil Take the Hindmost, and he put together Capital Returns with the help of Marathon Asset Management, as the book contains a collection of reports written by investment professionals at Marathon, which is a firm based in London that manages over $20 billion in assets. We

We live in a world where asset bubbles and busts of epic proportions seem to just never go away, as economists, policymakers, central bankers, and many people in the financial world are blindsided by them, losing a substantial amount of their hard-earned capital. While economists argue that bubbles can only be spotted after they burst, Marathon Asset Management has developed a relatively simple method for identifying and potentially avoiding them. The

The core of their thesis is to simply follow the money. High returns tend to attract capital just as low returns repel it. As a result, they believe that the resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways. This is what Marathon refers to as the capital cycle. Bubbles tend to attract a splurge of capital spending, leading to excess investment.

Excess investment drives down returns and leads inexorably to a bust. Marathon believes that investors are better off avoiding sectors where investment spending is unduly elevated and competition is fierce, and venture into territories where CapEx is depressed, competitive conditions are more favorable, and as a result, prospective returns are higher. This capital cycle strategy encourages investors to achieve superior returns

either by investing in industries where capital has been taken out or in a business that has strong barriers to entry, preventing competition from entering and driving down business returns. Investing with managers who are able to sensibly navigate the capital cycle is absolutely critical. The best managers understand the capital cycle as it operates in their industries and don't lose their heads in the good times. Chancellor opens up the book by explaining how the capital cycle works in much greater detail.

Let's imagine we have a widget manufacturer called Macro Industries. The firm's doing well, and its returns exceed their cost of capital. The firm's CEO has recently been featured on the front cover of Fortune magazine. His stock options are in the money, and his wife no longer complains about being married to a boring industrialist. Of the nine investment banking analysts who cover the stock, seven have buy recommendations and two have holds.

The shares trade at around a PE of 14, which is below the broader market average, and the stock is held by several well-known value investors. Management expects a strong growth in demand for its products, with emerging economies consuming substantially fewer widgets per capita than advanced economies. So they plan to increase their manufacturing capacity by 50% over the next three years in order to meet that growing demand. The company does a secondary share offering to fund their increased capital expenditures

And the news is appreciated by the market as the share price rises on the announcement, and growth investors have become increasingly interested as well as they expect to see rising earnings in the near future. If we fast forward just five years later, Bloomberg has reported that Macro Industries' CEO has resigned after longstanding disagreements over corporate strategy with a group of activist shareholders.

Activists are sounding the alarm bell on underperforming operations, and the share price had declined by nearly 50% in light of deteriorating profits. Part of Macro's problems stem from overinvestment as the industry is suffering from excess supply, as Macro's long-established competitors have also increased capacity in recent years, and a number of new low-cost producers have entered the industry as well. As the stock is trading below book value,

Analysts now say there's little near-term visibility. Of the three remaining brokerages still covering the stock, two have sell recommendations and one has a hold recommendation. Now, the story of the fictional macro industries highlights how a typical capital cycle plays out. High current profitability often leads to overconfidence among managers who confuse benign industry conditions with their own skill, a mistake that is encountered by the media,

which is constantly looking for corporate heroes and villains. Both investors and managers are engaged in making demand projections, which have a wide margin of error and are prone to systemic biases. In good times, the demand forecasts tend to be too optimistic, and in bad times, overly pessimistic. High profitability loosens capital discipline, and when returns are high, companies are inclined to boost capital spending.

Competitors follow suit, perhaps because they're equally hubristic, or maybe they just don't want to lose market share. Remember that most CEOs are incentivized to grow their business, so they have little reason not to invest when the future looks bright. As Chancellor puts it, "Investment bankers lubricate the wheels of the capital cycle as analysts cover the fast-growing hot industries and bankers earn fees by arranging secondary issues and IPOs, which fund capital spending."

Neither the M&A banker or brokerage analysts have much interest in how things work out over the long term. In a cyclical world, bankers and analysts with short-term incentives tend to think fairly linearly. What's happened in the past one to two years is likely to just continue for the next one to two years. One characteristic of the capital cycle is that there's a lag between a rise in capital spending and its impact on supply.

The delay between investment and new production means that supply changes are often lumpy and prone to being overshot. The capital cycle turns down once excess capacity becomes apparent and past demand forecasts are shown to be too overly optimistic. This leads to lower profits, new management teams brought in, decreased CapEx and industry consolidation. The reduction in CapEx and the industry consolidation is what sows the seed for a recovery in profits.

and the capital cycle eventually starts over again. For a savvy stock investor, this is the moment when a beaten down stock potentially becomes interesting. Although the capital cycle is relatively simple, it's surprisingly common. Industries such as semiconductors and airlines are prime examples of industries that are prone to violent capital cycles. When we look back at history, another prominent example is the housing boom in the 2000s.

Rising housing prices led to significant increases in the supply of homes, so much that the excess stock of new homes was roughly equal to five times the annual production required to satisfy demand for new household formation. Such increases in the supply of homes are justified by references to rosy demographic projections, which led to even bigger divergences from reality in markets like Spain and Ireland.

Spain, for example, saw an influx of immigrants partially due to the housing boom, so investors assumed that these immigration trends would just continue. Well, once the economy entered a depression, you saw the exact opposite. Foreigners started to leave the country instead of entering it.

One thing I've learned with cyclical businesses is that they can be the most expensive when their multiples are at their historical lows, and most cheap when their multiples are at historical highs. The reason is that you need to normalize the earnings. For example, in 2006, at the peak of the housing boom, some value investors purchased home builders at their historic low multiples relative to book value. What they overlooked was that these companies would need to eventually write down many of their assets.

leading to heavy losses. On the surface, the price to book was at historical lows, but had they adjusted for where they were at in the capital cycle, they may have come to find that the stocks weren't near as cheap as they appeared to be at face value. The capital cycle also ties in well with mean reversion, which states that companies that earn above their cost of capital tend to invest more, thereby driving down future returns, while companies that fail to earn their cost of capital behave the opposite way.

This point was recognized by Benjamin Graham and David Dodd in security analysis, and their logic was that high ROIC attracts competition and eventually drives down returns, and low ROIC brings an absence of new competition, which eventually brings returns to higher levels. Ironically, many investors nowadays have become quite skeptical of mean reversion as stock returns in the US have continued to outperform their international counterparts,

Even since 2010, US stocks have looked expensive when viewed from a valuation perspective. Profits have become elevated and they've continued to remain elevated for longer than practically anyone would have expected, leading to robust returns for investors. I was recently listening to a very popular personal finance show on YouTube, and the host was talking about his personal portfolio. And he mentioned how he was heavily allocated to the S&P 500 and the NASDAQ,

And he was then asked for his thoughts on diversifying internationally. The host, he liked the idea of more diversification, of course. I mean, who wouldn't really? But he justified his investment approach by simply saying the returns in the US have just been so much better than international over the past five, 10 years. And this is exactly the type of thinking that reinforces the capital cycle. It's the belief that what has worked well recently will continue to work well in the future.

It's a great example that I think illustrates how humans have this natural tendency to assume that the next five years is going to look a lot like the previous five years, which might be a good assumption in a lot of cases, but sometimes that can really come back to bite you and a lot of things just prove to be quite cyclical. The capital cycle theory also goes counter to the efficient market hypothesis. If markets were truly efficient,

then we wouldn't see such drastic swings that we do in many industries. Chancellor tries to explain this conundrum with a combination of overconfidence, base rate neglect, cognitive dissonance, narrow framing, and extrapolation. In short, it's all driven by human nature. Despite data that suggests that there's an inverse relationship between capital spending and future investment returns, managers often become infatuated with growing their business.

Investors and managers can also be quite overconfident in their forecasts. Yogi Berra once said, "It's tough to make predictions, especially about the future." Now, this is especially the case when forecasting future levels of demand. As I alluded to, people also have this tendency to extrapolate. Behavioral finance research from Daniel Kahneman describes how we anchor on the information placed in front of us and are overly influenced by our immediate experiences.

Another common heuristic is the tendency to draw strong inferences from small sample sizes. Despite the inherent cyclicality of industries, people continue to have a tendency to extrapolate, so it's likely pretty hardwired into us. Managers can also fall prey to underestimating the role that competitors play as overinvestment is not a solitary activity. It's brought about because several players in the industry have been increasing capacity at the exact same time.

This mistake can be described as competition neglect, which is particularly strong when firms receive delayed feedback about the consequences of their own decisions. Competition neglect reminds me of the prisoner's dilemma. Consider a dynamic where an industry can profitably accommodate the expansion by a single player, but no more. If the industry leader is making investments that are highly profitable, then it's not like the other players are just going to sit back and let the leader increase its market share.

They want their piece of the pie too. Because investing for growth can just be so tempting for management teams, it's critical to invest with managers who are disciplined in their capital allocation decisions and don't invest simply because the player next to them is investing. The book shares a few comments from Buffett on this. The first is that most CEOs have risen to the top because they've excelled in an area such as marketing, production, engineering, or sometimes internal politics.

so they may really not have the capital allocation skills required of managers. For Buffett, this is an essential skill to find in managers when investing in a company. Buffett also shared that for a company that retains earnings equal to 10% of the market value, then over the next 10 years, the CEO will have been responsible for more than 60% of all capital at work in that business. Marathon's investment approach is to look for investment opportunities among both

quote unquote value and growth stocks, looking for mispricings in both when their view differs from that of the market. For a value stock, the bet is that profits will rebound more quickly than expected. And for a growth stock, the bet is that profits will remain elevated for longer than the market expects.

While most investors spend the bulk of their time trying to forecast future demand for the companies they follow, Marathon chooses to focus on supply. The reason is that long-term demand projections are likely to result in large forecasting errors. Supply forecasts are far less uncertain than demand and thus easier for them to forecast. Because most investors spend their time thinking about demand conditions in an industry, stock prices often fail to anticipate negative supply shocks.

The aim of the capital cycle analysis is to spot increasing supply in advance of the market. New entrants noisily trumpet their arrival in an industry, a flurry of IPOs concentrated in a hot sector is a red flag, secondary share issuances and increasing debt is another. Marathon is wary of what investment bankers are saying as their main economic function is to supply capital to businesses so they can earn generous fees.

They pay little attention to the capital cycle and instead spend their time trying to forecast next quarter's earnings and occasionally helping their banker colleagues market a new share issuance. Rarely is an investment banker going to share findings that a popular industry is heading for a fall or that an unpopular one is due to prosper. One of the most difficult parts of investing in a cyclical industry is remaining patient as it takes a long time for an industry's capital cycle to play out.

For example, the NASDAQ started reaching lofty valuations in 1995, yet it wasn't until the spring of 2000 that the dot-com bubble finally burst. So now that we've described the capital cycle at a high level, the book gets into a number of different topics in greater detail, including industry case studies, previous investments Marathon has made, great managers Marathon has encountered, how policymakers can impact capital cycles, and much more. In May of 2006,

Marathon released their piece titled, "This Time's No Different: High Commodity Prices Are Eliciting a Supply Side Response." In the years leading up to the spring of 2006, commodity prices were taking off. Copper had increased by six-fold since the end of 2001. The prices of a number of other metals such as iron ore, zinc, aluminum, and gold were also rapidly increasing.

Part of the reason for the price increases was the demand coming from emerging markets like China and India. These economies were experiencing rapid growth and needed these necessary inputs to help fuel their rise. Supply of these commodities was tight as a result of underinvestment in the mid to late 1990s, and many were calling for a commodity supercycle.

making the case that the rise in commodity prices was just beginning. Commodity bulls argued that this cycle was different from previous cycles since better investment discipline was supposedly keeping supply levels in check. Additionally, they argued that there was a shortage of mining equipment, which was a common complaint amongst producers. The rise in commodity prices naturally caught the attention of Wall Street and commodities were now considered a vital part of every investment portfolio,

according to asset allocation experts. Many hedge funds were now commodity experts as well. Banks were doubling the size of their commodities trading staff, and Marathon was bombarded with invitations to attend exotic conferences on specialized areas of commodities. The increasing popularity of commodity-related funds would suggest that retail was getting in on the action as well, as it was the hottest trend to catch.

Marathon believed that the rise in price of a number of commodities was unsustainable and fueled by speculation. If you looked at copper, for example, the cost of production was around 80 to 90 cents per pound. The marginal cost of production was around $1.20 per pound, and yet the price of copper was 360 per pound. Let's take a quick break and hear from today's sponsors.

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All right, back to the show. Robert Leonard : Bowles argued that higher prices were a result of supply shortages and believed that even higher prices were needed to incentivize new production. But mining companies responded exactly how Marathon would have expected. Initially, they were skeptical of the price rises, but later they started investing heavily to bring on new supply. On the demand side, there was certainly strong demand from China,

But part of the issue was that the build-out of their infrastructure was not done very efficiently. With time, one would expect the build-out to be done more efficiently, meaning that it would require fewer commodity inputs. As the prices of commodities would go up, it would be reasonable to assume that there would be a negative impact on demand. Just as high oil prices in the 1970s forced improved oil efficiency on industries, Marathon noted that in Germany,

Demand for copper pipes was believed to have been cut in half from 90,000 tons to 45,000 tons over the previous year as the construction industry transitioned to cheaper PVC plastics. So in this publication, Marathon wasn't necessarily shouting from the rooftops that things were egregiously overpriced. I think they were more so suggesting that investors should tread lightly and not get carried away with extrapolation of frozen futures ahead.

The next excerpt here is from May of 2011, so five years later. It's titled, "Supercycle Woes: The Commodity Industry is Showing the Classic Signs of a Capital Cycle Peak." They write, "A cursory analysis of the capital cycle for the commodity industry, in particular the huge expansion of commodity capital expenditure in recent years and the precarious nature of Chinese demand for raw materials, suggests that the much-hyped commodity supercycle

is entering a downturn." End quote. So the capital cycle had started in the early 2000s when rising commodity prices brought material improvements and returns on equity for mining companies. And since 2006, commodity prices had been elevated with the exception of around one year during the great financial crisis where prices had dropped and quickly rebounded to elevated levels. With the higher returns on equity across the industry,

Total mining capex from 124 companies in the MSCI All Country World Index rose from less than $20 billion 10 years ago to an estimated $180 billion in capex in 2011. So that's a 9X increase over that 10-year time period. Although it takes time for investments to lead to additional supply, the additional supply does inevitably come to the market. For example, between 2010 and 2014,

Global nickel production was expected to climb from 1,000 metric tons to 2,000. And aluminum was roughly 25,000 metric tons, and it was bound to grow to 50,000. Investment makers made sure to get their piece of the pie in the commodity bull market. Between 2005 to 2010, the number of metals and mining's listings increased by 50%, and they've also guided companies along M&A frenzy as the deals in the sector became larger and larger.

Large numbers of IPOs and high M&A activity in any sector tend to occur in the later stages of the capital cycle. Marathon continues here, I quote, "Ever rising amounts of capital are coming into the sector at a time when commodity prices are well above marginal costs of production, even for the high cost producers. When this super cycle turns, there is potentially a long way for commodity prices to fall before they reach their replacement cost."

This could pose a problem for benchmark-hugging investors, since the metals and mining sector, up more than three times in its 1999 low, is currently close to its all-time high as a share of the FTSE World Index." So those that were claiming that new paradigm for commodities was here pointed to the continued rise of China as they were consuming around half the global production of iron ore, nickel, copper, and zinc,

which in Marathon's view was not sustainable due to much of that capital spend being wasted. The Chinese industrial sector's return on net operating assets was quite low and it continued to trend downwards. Some industrial industries were seeing CapEx levels at over 100% of operating cash flow and they were over indebted, meaning that a continued rise in investments from these industries was highly unlikely. They close out the publication with, "To our minds,

All this clear evidence that the current chapter in the commodity story appears much closer to its conclusion than the beginning. Then later in February of 2012, in a publication, they had this quote that I just loved, "In the energy markets as elsewhere, there is no cure for high prices like high prices." Now, this is one of the beauties of capitalism. A high price for a good or service signals to the market that it's highly valuable to many consumers,

and high prices tend to reduce demand because less people are willing to pay such prices or they will consume less of that good. If gas prices are high, for example, then some people will maybe do less traveling or just drive less in general. At the same time, high prices also incentivize more supply to be brought to the market to fulfill that demand. Oil might not be economical to produce at, say, $60 a barrel,

but it might be very economical to produce at $120 a barrel. In this case, Marathon was right in 2011 that commodity prices were near their cycle top. Copper was over $4 per pound in early 2011, and it would decline until early 2016 at around $2 per pound. Similarly, nickel fell by nearly 70%, and oil would fall by over 60% over that same time period.

Next, Chancellor shares a case study of a Scandinavian wind turbine maker that experienced the ups and downs of the capital cycle. From a high level, Marathon looks to invest in two phases of an industry's capital cycle. First is the company that earns high returns, and Marathon believes will continue to earn high returns for longer than the market expects. In other words, it's when a good company is able to resist becoming a mediocre company. This can be referred to as a quote unquote, "Gross stock."

In this situation, a mispricing might be present due to an underestimation of the durability of the barriers to entry, an underappreciation of the scale and scope of the addressable market, or management's capital allocation skills are being overlooked. The second type of investment comes from a "value investment" or from the value universe. In this case, the aim is to find companies whose improvement potential is generally underestimated.

In this case, mispricings often stem from the market misjudging the beneficial effects of reduced competition as weaker firms disappear. Alternatively, an unruly oligopoly may tire excess competition and enjoy an outbreak of peaceful cooperation. The turn in the capital cycle often occurs during periods of maximum pessimism as the weakest competitor throws in the towel at the point of extreme stress.

While many investors stay away from industries with low returns on invested capital, companies like Marathon look for opportunities in such industries, which brings us to Vestas Wind Systems, the wind turbine maker. Marathon invested in this company in 2003 when it was suffering from a temporarily weak US market due to a change in tax incentives. Vestas would go on to acquire a local rival and the demand for wind turbines recovered.

The share price of Vestas from the trough in 2003 to the peak in 2008 would go on to increase by over 40 times. But the good news would not last. With the emergence of the great financial crisis, wind farm projects around the world hit their peak. And by 2012, Vestas share price would decline to levels even below where it was in 2003, just nine years earlier. So it would decline by 96%.

from the peak in 2008. Now, this case study helps illustrate that Mr. Market's mood swings can be quite dramatic, both on the upside and the downside, especially in some of these cyclical industries. And this can give investors the potential opportunity to profit both when the stock is quite undervalued and when it's quite overvalued. In chapter two, titled Value and Growth, Chancellor shares a number of excellent publications on labels, the merits of long-term investing,

how conflicts of interest can play to an investor's advantage in digital moats.

I think this talk of value versus growth also ties in well with Marathon's comments on labels. Marathon has often been pigeonholed as value investors. The traditional definition of a value investor is one who solely invests in companies with low valuations as measured by PE, price to book, price to sales, or price to free cash flow. This approach is often associated with Benjamin Graham, who saw unleveled stocks with low price multiples and

that could deliver more than what was generally expected of the market. On the other hand, a growth manager is one who invests at the other end of the spectrum in companies with high stock price multiples and high growth rates. Companies in the marathon portfolio have tended to have below average multiples, but this is not because they are looking for cigar butts. They're simply looking for the best value in the market by comparing the company's estimated intrinsic value to the price offered by the market. Robert Leonard :

Instead of viewing a stock as a growth or value opportunity, instead they determine if the market is efficiently valuing the future prospects of the company. The other issue with the growth versus value stock dilemma is that companies are dynamic. Carvana might have been viewed as a growth stock in 2021 and a dirt cheap value stock in 2023, just two years later. Marathon writes here, "Our capital cycle process examines the effects of the creative and destructive forces

of capitalism over time. A growth stock usually becomes a value stock after excess capital, lured in by large current profitability, brings about a decline in returns. When this becomes extreme, as was the case during the technology bubble, the resultant busts that can turn growth stocks into value stocks almost overnight." So in August of 2007, Marathon wrote about digital moats. They explain how internet companies investing in their competitive positions

can afford to ignore short-term profitability. This write-up ties in well with the episode I did on the book Seven Powers by Hamilton Helmer. In that episode, I talked about how I thought network effect businesses have given us some of the best business models in the world, and it was a reason why I initiated a position in booking holdings. Funny enough, Marathon uses the example of amazon.com and priceline.com

which was the firm that ended up purchasing Booking.com and the company would be rebranded to Booking Holdings down the line. In 2007, Marathon was long both Amazon and Priceline, despite them showing little profitability. The reason was that they were foregoing showing gap profitability to build out their moat and utilize the internet to build a business model that could scale significantly in the future. They right here,

They recognize the importance of securing a dominant position in their respective markets by operating their businesses with low margins in the short term to maximize their earnings potential in the long term.

Amazon.com is the best known and most established of the businesses, having expanded well beyond its origins as an online discount booked retailer. A lot of skepticism surrounds the stock, partly because of its high profile at the time of the internet bubble, and more recently because of the volatile progression in the company's margins. The variation in the margins stems from Amazon's desire to continue to expand its offerings

and the fact that a number of the new services, including AWS and fulfillment by Amazon, have required large upfront investments and will take some time to develop into profitable business units. This investment, most of which is written off as an expense in the accounts, has made margins rather volatile in recent years." So they show here Amazon's net margins over the past few years. It ranges from 0.7% in 2003,

all the way up to 8.5% in 2004 and back down to 1.8% in 2006. So with margins collapsing, Amazon stock dropped from $60 to $40, while sales continued to grow at over 30% per year. Marathon also shared this great analysis on how companies can escape the capital cycle. So when you consider the example of the wind turbine maker earlier,

Presumably, many different players can make a similar product, meaning that there's nothing stopping competitors from arbitraging away any increases in the prices of that particular commodity or product. The way to protect your profits from competitors in this case is to have a product that cannot be easily replicated by competitors.

Marathon gets into a couple of examples in the semiconductor space in their publication titled Escaping the Semi-Cycle, which was published in February 2013. Driven by Moore's law, the semiconductor industry has achieved sustained and dramatic performance increases over the past 30 years, greatly benefiting productivity in the overall economy, but many companies in the industry have been prone to the boom and bust nature of cyclical industries in general.

While the history of the semiconductor industry provides a classic example of the capital cycle, there are companies operating in niches of the industry that have delivered excellent long-term returns for shareholders. The two they outline here in the book here is both US-based companies, you have analog devices and linear technology. So at the time of writing, the semiconductor industry could have been broken down into analog semiconductors and digital semiconductors.

with analog semiconductors making up around 15% of the overall market. Analog semis bridge the gap between the real world and the electronic world. You can think about the physical technologies that would go in mobile phones, automobiles, or the industrial economy. This is in contrast to the digital semis, which operate predominantly in the purely digital world of binary code. Analog devices operated in the analog sector and has consistently generated high margins over many years

even in the most distressed environments. From 2000 to 2012, gross margins averaged 60% and operating margins averaged 25%. Additionally, it was a relatively capitalized business model as just 4% of sales were allocated to CapEx spending. This has helped enable over 100% of net income to convert over to free cash flows. Robert Leonard :

Linear technology has displayed even stronger economics as they commanded an operating margin of around 50%. They have a CapEx sales ratio of just 5% and an average revenue growth of 14% per year since 1990. How have these companies generated such high returns and to what extent are those returns sustainable? The answer lies in understanding the supply side of the industry, which relates to the specifics of their production process, market structure,

Competitive dynamics and pricing power.

The real world is far more complex than a digital one, which makes the product design required to capture it more complex and heterogeneous. This means that product differentiation of analog semiconductors is higher and company-specific intellectual property is much more important. The human capital component is especially hard to replicate because engineering talent deepens with experience. To become an expert in analog semiconductor design takes many years

And the tenure of the average engineer at Analog Devices is 20 years, which forms an important barrier to entry for their business. Additionally, each company's processes are quite distinct. This industry dynamic made it difficult for an experienced engineer to be poached by a competitor without his productivity declining significantly as the learning curve was quite steep. As a result, Marathon believed that research capacity in the world of analog semis

were likely to continue to be constrained. Companies like Analog Devices were able to receive excess returns with little threat of new competition as a result of their differentiated products, their sticky human capital, and a diverse end market with thousands of different products. What also helped with their pricing power was that the analog semiconductor chips plays a critical role in the product for their customers, but it represented a very small portion of the overall cost of materials

and there were high switching costs. Once a process was in place to integrate the analog chips, there was little incentive to try out a competitor that was slightly cheaper or brought more benefits. This oftentimes gave them a product lifecycle of 10 years or more, essentially giving them a high level of recurring revenue. Since the manufacturing processes were much less standardized than most tech components, analog devices was protected from the destructive force of the capital cycle

that has wreaked havoc in the digital semiconductor industry.

And to top it off, Marathon believed that analog devices management team was shareholder friendly and good capital allocators. Now, this publication was from February 2013, and shares of analog devices have performed pretty well ever since, outperforming the broader market. And just by happenstance, analog devices would go on to purchase linear technology for around $15 billion. In chapter three, we get into the critical role that management plays in Marathon's publication titled Cyclical Missteps

They get into how management can fall into the trap of having this tendency to maintain herd-like behavior, following the steps that their competitors are taking. After the wake of the great financial crisis, Marathon was surprised to look back and see just how many companies were buying back shares at cycle peaks, only to raise fresh capital at the trough of the crisis. Too often, when one company decides that buybacks are the thing to do, then competitors are going to play that game too.

By the same token, equity issuance often appears at the same time among multiple companies in the same industry. One reason they act together is that no company wants to see competitors gain a funding advantage. These points tie in well to Will Thorndike's book, The Outsiders, which outlines exceptional managers who have the courage to buck the institutional imperative and allocate capital to the benefit of shareholders instead of simply doing whatever their competitors are doing.

Oftentimes, it's best to partner with managers who invest countercyclically, potentially slowing down or putting the brakes on their investments when the market is hot and prices are rising rapidly, and taking advantage of a crisis by reinvesting in the business while their competitors are caught off guard or buying back shares when the stock is trading below its intrinsic value. This is exactly how Buffett has behaved throughout his career. When he isn't finding investment opportunities, generally markets are frothier.

He's totally fine watching others make big, splashy acquisitions or buying back significant amounts of overvalued stock. When the crisis hits, he's able to deploy large amounts of capital while others are desperate to raise at inopportune times. We talked a lot about aligning incentives here on the show, and Marathon agrees that the best way to get managers to think like owners is for them to actually be owners.

Marathon has found an increasing number of compensation structures that are linked to EPS growth and total shareholder returns. They believe that this type of compensation structure too often does more harm than good and can misdirect management, especially when compensation is linked to earnings per share growth. They write, "The earnings per share measure is prone to manipulation by unscrupulous executives. It takes no account of risk and encourages value-destroying acquisitions and

and buybacks, especially when interest rates are low. It also encourages the quarterly EPS guessing game beloved by the sell side. At times, it seems that meeting the EPS target has become the main strategic purpose of the company. This is regrettable. Corporate strategy should be all about how best to allocate resources. If a turnaround requires a three-year investment phase, management may not pursue the optimal business plan

if their compensation is linked to interim EPS results.

"While these intertemporal issues can be partly resolved by phasing in performance rewards over a period of years, investor myopia and management's own interests tend to lead to an exclusive focus on the calendar year EPS, which bears no relation to long-term value creation." So I think the main takeaway here is that increasing earnings per share from one year to the next may not be in shareholders' best interest for a host of reasons.

For example, management can cut staff or cut marketing spend to increase CPS, but that might come at a cost of long-term shareholder value. Or accounting shenanigans can be played to increase CPS, which is entirely a waste of time. And if a CEO only plans to stick around for a few years, then plenty of short-term sacrifices can be made for his own benefit, such as levering up to buy back overpriced shares. Linking compensation to total shareholder return is a common share price-based metric

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All right, back to the show. Robert Leonard : It's also not a perfect measure, should you look at the total return or the relative return. And what if shares are overvalued or inflated at the start of the period? And if you do relative performance, what if the broader industry is in a massive slump, meaning that a bonus can be paid even if the share price is flat? Aligning incentives is hard, and the wrong incentive structure can encourage management to play the game of managing EPS or trying to manage their share price

which is why Marathon prefers to prioritize insider ownership as the most direct way to deal with the principal-agent problem, which arises with the separation of corporate management from ownership. Along with high insider ownership, it would be even better if management is required to build up significant shareholdings themselves. HSBC, for example, revamped their incentive structure to offer generous deferred share awards, which vest over five years

and they have to be held until retirement.

Long-term share ownership is believed to be the best way of concentrating the minds of management on the true drivers of value. And it also guards against excessive risk-taking. Next year, I wanted to get into the impact that policymakers can have on the capital cycle. In 2012, Marathon covered how low interest rates were slowing the process of creative destruction, which is a key variable in the capital cycle. They wrote that 10% of British businesses are zombie companies

which are kept alive by ultra-loose monetary policy and the reluctance of lenders to write off bad loans, and the Bank of England suggested that 5% to 7% of outstanding mortgage debt was in various forms of forbearance. The global economy experienced a credit boom in the 2000s, and without proper creative destruction, the economy will have pockets that haven't been purged of inefficient capital allocation. Robert Leonard :

This is particularly apparent in more capital-intensive and cyclical industries. When credit was cheap and animal spirits were unleashed, the desire to push for new capital projects was hard to resist, particularly when peers were engaged in the same race and the stock market was rewarding growth. Unfortunately, such malinvestments as were made during the boom times have proved hard to eradicate in a period when interest rates have remained low

Banks have been reluctant to call in bad debts to avoid losses, and politicians across the Eurozone have done their utmost to prevent unemployment from moving higher. To Marathon, the European auto industry was the poster child of this failure, which appeared incapable of reducing its capacity despite weak demand and dwindling exports to emerging markets, which have been busy boosting their own car production. One French carmaker traded at a tenth of book value

while refusing to shut down their plants due to political resistance.

Politicians have a better shot at reelection if they promise that manufacturing jobs will be kept. Most people would believe that this is a good thing as manufacturing jobs are a sign of a strong and stable economy, ignoring the implications of the potential for malinvestment. From a capital cycle perspective, the time to buy cheap assets is of course near the trough of the cycle after stock valuations have fallen to a fraction of replacement costs and a path opens up for dealing with excess capacity.

The first condition was close to being met in some industries in 2012, but the prospect for the second appeared dim because there were few bankruptcies and little industry consolidation to allow for the supply side to get back to normalized levels. The main lesson is that low interest rates run the risk of allowing zombie companies to stay alive, leading to malinvestment and a waste of resources across the economy.

As a result, Marathon preferred to stick with investing in good businesses with high returns on equity that were tarnished by overall market pessimism. Although their valuations were at a premium to the less profitable businesses, their potential to deliver shareholder value appeared more promising.

One mistake that Marathon has made in analyzing the capital cycle is the impact of new technologies. The internet wreaked havoc on industries like music, newspapers, book freestalling, and travel agencies. All of the pieces might be in place in terms of industry and supply-side consolidation, but it still may prove to not be enough or the investment not be at the right time due to a secular decline in demand. Blockbuster might see their stock fall by 90%,

But that alone does not prevent it from continuing the fall with the rise of Netflix. So in 2013, Marathon wrote, "In recent years, capital cycle analysis has been more useful at picking stocks in companies which can maintain high returns than in finding opportunities among bombed-out industries recovering or not from a supply-side restructuring." For the former, the investment case rests on whether competing capital can enter the sector and boost supply.

eventually driving down industry returns. And then a bit later here, in short, the great strength of the capital cycle approach lies in its adaptability. The basic insight does not change. Namely, both high and low returns are likely to revert to the mean as valuation influences corporate behavior and brings about shifts in the supply side. In Marathon's early years, our discipline was focused on finding stocks where the supply conditions were changing and

More recently, the emphasis has shifted to identifying sectors and companies where the forces of capitalism are blunted and the process of mean reversion is drawn out." I like how Marathon has been open to investing in higher quality companies. I'm reminded of the sort of washout of high growth stocks that we saw after 2021, once cheap capital was no longer available. We were able to see which businesses had stable, high quality free cash flows, and which were simply an output of the low interest rate.

era. Ideally, when you own a great business, they're able to thrive both in good times and in bad times, providing more stable growth and higher quality revenues and cash flows that will stand the test of time once the business or the industry cycle turns the other way. Chancellor included an entire chapter on China and why Marathon has largely avoided investing there. First is that many companies in China are state-controlled, and as a result,

The efficiency of capital allocation in the interest of outside shareholders, which are oftentimes foreigners, tends to be subordinate to the state's policy objectives. This capital misallocation and malinvestments as a result of low interest rates has largely kept firms like Marathon from investing in China. They also point to the disappointing returns for shareholders of Chinese equities despite strong economic growth. For example, the Shenzhen Component Index

which includes 500 of the largest and most liquid stocks in China, is essentially flat or slightly down over the past 10 to 15 years, depending on what exact timeframe you're looking at. So there are six publications here from Marathon related to China, a couple of which I'll touch on here. So in November of 2003, they wrote a piece titled, "Dressed to Impress: Investors Transfixed by China's Growth Prospects Are Buying Flaky Businesses."

Marathon has long been critical of shady practices used by Chinese companies to dupe investors into forking over their money, especially around the time of their IPO. For example, a company called China Telecom appeared cheap with a 4% dividend yield and a 12% free cash flow yield. However, the telecommunications sector regulator had just raised the cost of completing a Hong Kong-originated or international telephone call by a factor of eight,

And that alone added 12% to the company's profits per share. While some might view government support as a positive, Marathon viewed the overreaching government intervention as earnings manipulation and disadvantageous to shareholders. Additionally, Beijing had made life tougher for other companies like China Mobile and PetroChina within months of significant capital raisings for this company. So unfortunately, businesses like China Telecom depended on the kindness of the government

in order to maintain profitability. So in Marathon's view, the intrinsic value was just entirely uncertain to them, making an investment in the company just pure speculation. They write here in their piece titled, "Oriental Tricks," "Earnings manipulation around Chinese IPOs is the norm." Research published by Credit Suisse points out that nearly every mainland listed company

saw its return on capital peak in the year before listing. The investment bank also found that Hong Kong-listed Chinese companies saw their net income margins fall by an average of 40% in the four years after listing, with returns on capital sinking in tandem. As the investment audience is obsessed with China's macroeconomic story, this analysis is likely to fall on deaf ears. A recent survey by the Hong Kong Stock Exchange

shows the remarkable complacency of foreign fund managers about the quality of Chinese IPOs. The majority of respondents saw the financial performance of Chinese businesses as "acceptable or better," while only 10% thought that shareholder rights were widely being abused. "While such attitudes prevail, we should expect the quality of Chinese listings to remain low, if not deteriorate." So to tie in the capital cycle here, Marathon sees the government's push for growth

the very low interest rate environment, and the availability of cheap capital, it's resulted in supply-side excesses. From a broad level, this leads to deteriorating business returns, which translates to poor returns for shareholders. So that's all I really wanted to touch on from the book Capital Returns. I wanted to briefly transition here to share some lessons from Gautam Bade's book, The Joys of Compounding,

This book is an excellent resource for all value investors. And one of the great chapters in the book, it's chapter 20, it's titled, Investing in Commodity and Cyclical Stocks is All About the Capital Cycle, which I'll be touching on here. So while some of the best quality companies consistently grow their intrinsic value by say 12%, 15%, 20% per year, there's still some potential room for investing in commodities and cyclicals because of how violent the upswings can be in share prices.

It can bring potential multi-baggers in the span of just one to two years. So The Joys of Compounding, it's one of my favorite value investing books and Gautam really opened my eyes to the potential of cyclicals in this chapter. The book overall, it draws on some insights from countless excellent books in the value investing space or in the investing space in general. And it's easy to see that Gautam himself was highly influenced by Chancellor's book, Capital Returns. So Gautam shares that when investing in commodities and cyclicals,

You want to look for industries that are in a major down cycle and are starved for capital. So in a major down cycle, you're not going to see many of the red flags associated with the peak of the cycle. During the peak of the cycle, you're going to see things like high levels of IPOs and debt issuance, growing levels of industry coverage by analysts, high levels of capital investment in the industry and sharp growth in assets, share count and profitability. Another great thing about commodities and cyclicals is that for some industries,

the cycles can last for many years. So this can give a lot of investors plenty of time to monitor it and validate where they're at in the cycle. So if you look at industries like sugar and steel, for example, you can enter the cycle even a bit late and still make pretty good returns during the upswing of the cycle. One of the things that Gautam looks out for in the bottoming process of the cycle is when companies have a big earnings miss,

And shares in the commodity or cyclical stock, they actually go up because the sentiment was just so bad that it was just practically priced for bankruptcy at that point. And this is a sign of a company or an industry bottoming out because sentiment just has gotten as bad as it can possibly get.

Gautam shared his own early experiences investing in commodities, and it was a bit counter to his typical investment approach of buying secular growth stocks. He was studying the graphite electrode industry in India, which is a material made from graphite that is essentially in the steelmaking process. In 2017, the industry prospects were looking strong, and Gautam saw a path to huge potential profits for investors during the upswing to come. He was looking at two companies at the time,

We had Graphite India and HEG, and he ended up investing in Graphite India because of its superior balance sheet, larger capacity, and more efficiently run operation bringing in higher profits. But to his surprise, as the industry prospects improved, shares of Graphite India were down while HEG had increased by almost 50%. What he realized was that during an industry upswing, the well-run low-cost producers don't generate the higher returns.

It's the higher cost producers because they show a higher percentage gain in profitability as the commodity price rises. A rising tide lifts all boats, and those that are beaten down the most likely have the biggest gains ahead. It's much easier to go from, say, a 5% profit margin to 10% than it is to go from a 20% profit margin to 40%. What got them also missed was that HEG's promoters, which I interpret as the insiders here, they

They were buying shares from the open market in 2017, which can be a good method to identifying a turning point to an industry's fortunes. After going down the rabbit hole and understanding all of the industry dynamics, he saw a huge opportunity by shifting his capital to HEG even after its big rise in share price. He shares a Munger quote here in the book that relates to betting big on your best ideas. "A few major opportunities will usually come to one,

who's continuously searching and waits with a curious mind. And then all that's required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past." So just before the end of 2017, Gottem believed that a severe supply deficit was expected to persist for a long time, which would be beneficial for the producers.

The Indian government had also announced plans to impose an export duty on graphite electrodes in India, and this had sent up shares of HEG up by 270% in less than five months. He exited his position as he believed that the shares were more fairly priced, locking in his profits knowing that commodity stocks aren't something you want to hold for the long run. Then just a few weeks later, he came across a news report that graphite electrodes were being sold in India

for over $14,000 per metric ton and that the supply situation was becoming even tighter. This came as a surprise as he had assumed that fair prices were around $10,000 per metric ton. After realizing that the stock was still far undervalued, Gautam re-entered the position with half the allocation he had at the time he exited, capturing another 60% gain in the weeks that followed, giving him a total profit of more than 350%.

There were many lessons to be drawn from such a transition to investing in commodities and cyclicals. First is just the tremendous benefit of lifelong learning and being open to new opportunities that might lie outside of your current investing repertoire. Had Gautam stuck with his bread and butter investments of secular growth stocks, then he would have missed better value opportunities such as investing in HEG.

The other big lesson was overcoming a host of behavioral biases such as the anchoring bias, commitment and consistency bias, and status quo bias. Had he exited thinking he was a genius for locking in a profit, then he might not have been open-minded when he discovered new information that might have suggested that the stock was still undervalued. As John Maynard Keynes said, "When the facts change, I change my mind. What do you do, sir?"

In today's investing landscape, I would argue that flexible thinking is essential to be a successful investor. Flexible thinking is the ability to keep an open mind when encountering new facts or situations and being adaptive to changing a viewpoint from previously held thoughts or beliefs, however strongly held those beliefs are. In building Berkshire, Munger has said that there has never been a master plan.

He and Buffett were always taking in new information and being willing to change their opinion when warranted. Scott Fierston wrote in his book, Dead Companies Walking, I quote, "Failure terrifies people. They'll do whatever they have to do to downplay it, wish it away, and just plain pretend it does not exist. Most of the time, they'll go on living in denial long after the truth of their predicament becomes obvious," end quote. Munger's also known for saying, I quote,

I think that one should recognize reality even when one doesn't like it. Indeed, especially when one doesn't like it." I've seen a number of times when an investor finds himself holding a losing stock and he finds ways to justify holding onto it, even when the facts are telling him that they should probably move on. When your investment thesis continues to change as you're holding onto the stock, then it's probably best to move on and overcome such aversion to losses. Most stocks end up underperforming the market

and losing money. And it's important to recognize that reality when you find yourself holding a loser. Unpleasant facts don't cease to exist just because they're ignored.

Gotem writes here in his book, "Good investing requires a peculiar balance between conviction to follow your ideas and the flexibility to recognize when you've made a mistake. You need to believe in something, but at the same time, you need to recognize that you will be wrong a considerable number of times over the course of your investing career. The balance between confidence and humility is best learned through extensive experience and mistakes. Always respect the person on the other side of the trade and ask yourself,

Why does he or she want to buy or sell? What does he or she know that I don't? You must be intellectually honest with yourself at all times." One thing that Munger did really well to help keep himself rational was to understand the opposite side of an argument better than the person holding that argument does. Your opinion is more credible when you can also clearly articulate the contrary view. And this way of thinking is quite unnatural to our biological hardwiring

since we tend to look for evidence that confirms our existing beliefs. Related to this, I think one of the things that the best investors get right is thinking probabilistically. They aren't only thinking of the potential upside, they're also considering the chance in the potential magnitude of the downside as well. To help with probabilistic thinking, I think there needs to be a really good understanding of history and how that plays into the investments that you're analyzing today. Robert Leonard :

With some investments, you might read a stock pitch with a good story that seems really compelling, but it might overlook the base rates of success for such an investment. Or if this company is successful, it might overlook the downstream impact of competition coming into the market and dragging down the business's returns. Taking base rates into account helps keep one's initial enthusiasm after learning about an exciting story. Another mistake I see is investors sitting on the sidelines because they believe that the market is overvalued.

Sitting on the sidelines in cash because one believes that a market crash is coming, in my opinion, is really a fool's errand. And I think that the base rate of consistently being able to predict the direction of the market over the, say, a three-month or 12-month timeframe is extremely low. And I've spoken with some investors who have been wrong about this for many years, only to double down on their hypothesis that now the market is even more overvalued than it was before.

I believe that to maximize my chances of long-term investment success, I need to be fully invested. And one of the reasons I believe that is because I think there's always a good opportunity to earn a higher return than you would by simply holding cash. Remember that it's the pessimist that sounds smart, but it's the optimist who makes money.

That wraps up today's episode on capital returns by Edward Chancellor. I hope you enjoyed the discussion. And if you'd like to learn more, then I would highly recommend picking up the book. So with that, thank you for your time and attention today, and I hope to see you again next week.

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