The Under Appreciated Value of Capital Cycle Analysis

In our public markets investments at Volta Global, we are fortunate not to be constrained to a specific strategy or segment of the markets. We are only looking for the best opportunities for long-term capital appreciation, in a completely sector and asset class agnostic manner.

Such opportunities often do present themselves as a result of two situations:

1. Finding truly great businesses with sustainable competitive advantages that are temporarily mispriced due to market “noise” or short-term events (the much espoused “Buffet/Munger approach”).
2. Significant developments taking place in the supply side of an industry that often go unnoticed by the market.

Situation #1 is widely covered, and any student of the markets will be very familiar with those teachings. Situation #2 is less appreciated but equally powerful, and forms the basis of “capital cycle analysis” — an investment philosophy long championed by Marathon Asset Management (and excellently covered in their book Capital Returns.)

While capital cycle analysis is a very simple fundamental concept — companies are impacted by changes in the supply side of the industry in which they operate much more than changes in the demand side — it is also the one that most investors and analysts often ignore. They instead devote a majority of their time and effort into analyzing the demand side, which is much harder to accurately predict, and in the long run much less impactful to a company’s profitability, and thus their stock price.

I strongly recommend reading Capital Returns in its entirety, but the key aspects of the approach can be quickly summarized as follows:

1. Stock prices are mostly driven by long-term levels of profitability, and reward companies that can consistently earn returns above their cost of capital.
2. Changes in the supply side of an industry are more important to profitability than those on the demand side, yet the vast majority of professional analysts and investors are trained to focus their attention on the demand side. The implication then is that changes in the supply side tend to be under appreciated by the market, and slower to show up in company stock prices.
3. Value vs. Growth is a mostly irrelevant construct for capital cycle analysis — high valuations alone are not enough to kill a positive supply side dynamic, and companies in industries going through a lasting positive change in supply side dynamics can sustain high valuations for longer periods of time than the market expects.
4. Many investors are not well suited to performing proper capital cycle analysis, which requires both an “outside view” (tough for industry “experts” to have) and a very long-term perspective (very tough for most active managers to have these days).

A Recent Example: Luxury Goods

Analysts and Investors covering consumer goods absolutely love falling prey to having a maniacal focus on demand at the expense of capital cycle analysis and a supply side approach. Recent performance in the luxury goods sector (best exemplified by names like LVMH, Richemont, etc.) is a great example of this. Read any piece of news from last year in this space and everything focused on how demand for these expensive goods would hold up in the face of a Chinese slowdown and other emerging market buyers that had driven growth for years all of a sudden disappearing as those markets suffered from lower commodity prices and a strong US Dollar. There were no shortage of pessimistic outlooks, calling for the end of the Luxury super-cycle, and pointing to the potential for store closures and inventory reductions at retailers.

Yet, despite all of this bearish commentary, LVMH has returned +41% in the past 12 months, and Richemont +45%, trouncing the overall market. Why are these stocks ripping at the same time that the downturn in demand forecasted by industry “experts” taking place? Mostly because the pending demand weakness (that almost everyone was so focused on) was recognized by the very competent managers running these companies, and the companies have undertaken a process of rationalization on the supply side — closing unprofitable or non-core retail stores early on, consolidating the industry through M&A, cutting back the number of different SKUs and product lines being produced, and aggressively reducing inventory through alternative channels. All of these steps are proactive measures that will continue to enable these companies to earn their historically very impressive returns and protect long-term profitability, rather than suffer as demand enters a cycle of moderation.

Best of all, these supply side measures were very well telegraphed to the market, at least to anyone who was listening and could see them with a capital cycle analysis lens. Articles like this one and this one were mostly interpreted as “gloom & doom” for the industry, and reasons to dump the luxury goods stocks and run for the hills. But if you were a student of capital cycle analysis, you would have recognized that these stories were actually highlighting a very important and positive supply side development for the industry, you would have been more drawn to these stocks while everyone else was shying away. Leaving you sitting on a lovely 40–50% gain in your position in just 12–18 months.

“doom & gloom”? or the opposite?

There are dozens of other recent examples, this is just one I enjoy highlighting to prove a point — capital cycle analysis can be a very profitable investment approach.

The challenge, is that not everyone can, or is willing, to do it properly. It requires being a generalist, with an ability to view the big picture and monitor cross-industry trends and supply side developments. Many sector-dedicated analysts can only take an “insider view” and focus too much of their time on competition or characteristics within the industry itself.

And it also requires taking a long-term view. The monthly or quarterly performance that many active funds are beholden to these days make it very difficult to properly performance capital cycle analysis. Because supply side changes take longer to be reflected in market prices, it requires patience and firm conviction.

Our permanent capital base at Volta Global makes us uniquely suited to this approach, but it can easily be applied by patient, individual investors as well.

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