"I have known no wise people who didn't read all the time — none, zero." – Charlie Munger

Capital Account

Print Friendly, PDF & Email

The Capital Account is a collection of excerpts from client letters of Marathon Asset Management, a U.K-based fund that has outperformed the market by ~4.0% since 1986. The firm’s philosophy (as stated on the website) is that the prospect of high returns will attract excessive capital and vice versa and how management responds to the forces of the capital cycle and how they are incentivized are critical to the investment outcome.

The book covers the period from 1993 to 2002 in which Marathon identified at an early stage the inevitable collapse of the technology and telecoms bubble. Marathon also provides a list of common mistakes that investor use when applying the capital cycle approach, including faulty assessments of political and legal conditions, effects of globalization and the influence of new disruptive technologies. Marathon had made a similar mistake on the steel industry by underestimating the impact of the “mini-mill” technologies.  <strong> </strong>

The capital cycle concept could be applied to evaluating the potential returns in certain sectors today (2017) – electric vehicles/solar, oil and natural gas, and tech media.

  • Intro to the capital cycle 
    • A company’s fate is determined by the activities of other businesses
    • When the shares of a company with fine prospects sell at a premium to the underlying replacement cost of the firm’s assets, there is a strong incentive for managers to increase their capital expenditures 
      • Tobin’s q – ratio of stock prices to replacement cost of underlying assets 
    • CEOs frequently assume that their competitive position is stronger than it is and that currently favourable conditions will continue indefinitely
      • The also pay insufficient attention to the changes in the competitive environment or capital intensity to an industry
    • Phases (as illustrated on pg. 8 of the book)
      • 1 – New entrants attracted by prospect of high returns – investors optimistic
      • 2 – Rising competition causes returns to fall below cost of capital, share price underperformance
      • 3 – Business investment declining, industry consolidation, firms exit, investors pessimistic
      • 4 – Improving supply-side conditions cause returns to rise above cost of capital – share price outperformance
    • Investment banks can fuel the capital cycle – New Economy terms like “winner takes all”, “increasing returns”, “network effects”, “first-mover advantage”
    • The 1990s saw the beginnings of the “shareholder value” movement
    • Example of capital cycle happened in early 1990s with pharma companies
      • Large drug companies, including Merck and Glaxo had huge profits from block-buster drugs and high returns inflated stock prices
      • Capital flowed into the sector and management lowered return thresholds for capital spending – the average exclusivity for drugs fell from 7 years to less than 3
        • In 1980, 20 leading drug companies spent $2bn on R&D and 34 drugs were approved.  In 2001, spent $26bn and 28 drugs were approved
    • Second example of the capital cycle happened in telecom in the 1990s
      • 1 – The share prices of telecompanies rose to a premium of their replacement value – KPN Qwest valued at $11bn having only invested $2bn in operations.
      • 2 – When companies are valued at a premium to replacement cost there is a strong incentive to increase investment.  Around $500bn was spent by US telecom firms during the boom, around half of which came from new entrants
        • Created a Catch 22 for CEOs – they could keep spending and shares would stay with market/contribute to over capacity or they could withdraw and share price would collapse
      • 3 – Demand projections are inherently unreliable.  Telecom market analysts said market would double every three months..it was growing fast, but only doubling every year.  Difference over five years between the 2 assumptions is 33,000x
      • 4 – Leading telecom analyst at Salomon Smith – “no matter how much bandwidth is available it will get used”.  Nearly half of the thirty-six companies covered by him went bankrupt by 2002
      • 5 – Investors capitulate to the forces that drive the capital cycle – they continued to buy shares knowing they were overvalued, but didnt want to underperform the index
      • 6 – Capital cycle ends with a shakeout and consolidation.  By 2002, less than 5% of telecom capacity was in use.  Prices fell 70%. Global Crossing had a book value of $22bn was sold for $500mm!
    • It is better to invest in a mature industry where competition is declining than in a growing industry where competition is expanding – example of General Dynamics in the 1990s 
    • There is a Prisoner’s Dilemma in the capital cycle – the threat of excess capacity is heightened if other firms respond by making similar investments, which they may need to do in order to stay competitive – all players end up less well off when each purses its own individual interest and invests in new capacity
      • In making capital expenditure decisions have to determine how the competition will react 
    • Capital cycle theory suggest that mean reversion in the business world takes a longtime to play out
    • Study by Sanford Bernstein finds that total shareholder returns are inversely correlated to the firm’s capital expenditures – this also holds true at an aggregate level. When investment % of national income is above average, future economic growth tends to be lower than normal 
    • Capital cycle can also be linked to behavioral finance (diagram on pg. 39) – investors have the tendency to overreact to positive and negative news (super response tendency of Munger)
    • Before taking a position in an out-of-favour sector investors should ascertain whether capital or capacity is actually being removed from the industry.  Some types of industry are more likely to experience a reduction in capacity (service business – quickly, steel business – not quickly as plants just change ownership)
    • Corporate survival instinct is usually stronger than duty to shareholders
      • This also plays into political environment considerations – in an over capacity industry, government may try to keep losers afloat for employment reasons
  • Chapter 1 – Our Capital Thoughts
    •  Marathon’s approach is based on the inverse correlation between profitability and levels of competition – “Morganization”, or consolidation of industries by JP Morgan, Vanderbilit and Pierpoint Morgan
      • US Steel in 1901 was valued at $2,000 per ton of productive capacity compared to $400 today – they were able to double prices and maintain those prices
    • The two most important factors of shareholder value are changes in competition and actions of management
      • In evaluation of normalized profits, Marathon looks at competition but tempers this with where the company is in their product life cycle
      • Then looks at how mgt is compensated – are they compensated on growing the company or return on assets?
    • Tobin’s Q – the stock market does not revert to the mean except in the long-run in the US. – for more than 15 years to the mid 1980’s shares sold well below Tobin’s Q
    • Capital cycle in Thailand
      • In mid-1990s six years of overvaluation in the stock market led to over expansion and a subsquent collapse in values
        • Cement and steel companies were trading at six times book value
        • Companies were also borrowing in U.S. dollars and if they had to borrow in local currency profitability would be negative – also benefiting from temporary tariffs
    • Pitfalls to avoid in capital cycle
      • The capital cycle approach is better at identifying risks in increasing competition and capital than identifying opportunities              
      • Common mistakes include a faulty assessment of political and legal conditions, effects of globalization and the influence of new disruptive technologies
        • United Airlines was prevented from buying US Airways
        • Bankrupt WorldCom was allowed to emerge liability free from bankruptcy as a formidable competitor to AT&T
        • Because of difficulty in assessing what competitors are doing on the other side of the world (example of Asia Pulp spending $10bn for a new plant), Marathon likes to apply capital cycle analysis to industries that are domestic in nature, such as banking    
        • They made a mistake in investing in the steel industry during a consolidation period, but missed the impact of a new “mini mill” technology
    • Europe went through a shift to shareholder value creation in the 1990s
    • The market was also driven by the collapse of the Soviet Union, so 2/3s of the world has adopted capitalism and there is an increasing adoption of technology
    • Value-based management systems stress that the purpose finessing the return on invested capital rather than EPS enhancement should be the key determinant of share repurchase activity
  • Chapter 3 – The Two Tier Market
    • EVA measures can become counterproductive – P&G applied EVA and cut marketing expenses from 25% to 20% and as a result profits have risen faster than sales.  At some point the company must reach an optimal level of marketing spend and cutting beyond this point would be bad for shareholder value but boost EVA
    • In 1998, Marathon noted a Lollapalooza effect that was causing the overvaluation of growth stocks – “new opportunities in emerging markets, collapse of Soviet communism, low interest rates, globalization, mutual fund in-flows from retail investors and more widespread implementation of shareholder value systems”
      • There was a growing gap between value stocks and growth stocks
    • International Tool Works had a great strategy of buying underperforming businesses and improving profitability by picking their most profitable product – “cancer removal”
      • Biggest mistake of managers is to expand into new product lines that offer less rewards
    • Growth stocks evaluation is based on the price they pay and if internal cash generation is sufficient to fund the desired growth rate without resorting to external capital
      • These are important, but have to identify operating model – often the biggest shortfall of managers is explaining how they will get the growth
      • Use the decision tree on pg. 93 to evaluate growth stocks
        • Is growth based on:
          • Aggressive capital expenditures – Over supply risk
          • Acquisitions – is the value gap sustainable? – Price of acquisitions increases of valuation of acquiror decreases – Waste Management or Cedant
          • Valuation – What’s the risk of oversupply? Ryan’s Family Steakhouse was one of the class of 1983 restaurant sector growth stocks valued at 4x replacement cost
          • Raising prices – will it erode market share? – Phillip Morris in 1993 cut prices to stem market share erosion – Marlboro Friday
          • Passing or efficiency gains – Is there saturation risk? Walmart and Home Depot – have to understand when the company arrives at the saturation point
          • Substitutionary locomotion (Colgate or Wrigley) – valuation or accounting risk? – Marathon believes this is the safest and most enduring growth model.  Efficiency is important but the savings are redeployed into advertising to generate new demand or innovation to create new products.  Because they are spending money to grow, profitability does not look as high – they are the tortoise rather than the hare    
      • Marathon believes that investment outcomes are not normally distributed, but have “fat tails” – shares spend relatively little time at fair value and lengthy periods of overvaluation are followed by lengthy period of undervaluation
      • When the yield curve is inverted (long-term rates are lower than short-term rates), growth stocks receive a boost because their distant future earnings are discounted back to the present at a lower rate 
    • Chapter 4 – Blind Capital 
      •  Index funds can be created incorrectly – some will weight the total outstanding shares evenly – not taking into account the shares that are not “free-floating” (owned by insiders or large long-term holders)
      • Valuation distorts behavior – “witness the number of business school graduates joining venture capital firms and all those seasoned executives quitting to join dot-com start-ups” – written in 2000 
      • Marathon used the capital flows into the New Economy as a basis for their investments in value companies – because of the long period in underinvestment in these companies, returns will be better in the future
      • Money Illusion (pg. 115) 
        • The common belief is that a lower level of inflation is good for share prices
          • It reduces the cost of borrowing and diminishes uncertainty
          • Bondholders also benefit because it increases the present value of future coupons, thereby raising the price of the bond and reducing its yield
          • The assumption that is hazardous is that lower bond yields make equities more attractive since the relative price of the earnings you get from owning equities has just fallen – yet this assumes earnings expectations do not change when the inflation environment changes
            • Nominal earnings growth will fall when the inflation environment improves
          • Another approach is to use a dividend model dividend (rate of return – earnings growth).  When inflation declines, lower future earnings offset the effect of lower interest rates.
            • This is how the theory holds – but the market for repricing future equity earnings is not efficient
            • Some businesses can actually suffer in times of low inflation as they find it hard to achieve real price increases
          • The false assumption that falling inflation lowers the cost of borrowing is best illustrated by the consumer mortgage market
            • With high inflation, you pay high interest rates in the short-term, but see the capital value of the debt quickly eroded by inflation
            • In times of low inflation, the interest payments may be lower but the debt principal is not paid off so soon  
      • Chapter 5 – Fibre-Optical Illusions
        •  In a deregulated environment, the price of goods and services will drop to the marginal cost of production and even below for a while – this was seen in telecom
        • In 1999, Marathon predicted because of market valuations of telecom companies that the prices would fall and it would become commoditized like electricity
        • In evaluating growth industries (specifically telcom), Marathon looks at:
          • Valuation – What the market is assuming annual earnings growth is based on current prices
          • Based on the goods prices implied by the stock prices, how many consumers will be able to afford the product?
          • Technology profits are inherently short-lived – returns will be high at first until there is more competition
        • There is a feedback loop on increasing stock prices (mental math mistakes) – Investors with stock market profits are emboldened to take greater risk than they would with their original capital
        • There are so many examples of “New Era” thinking – Marathon wrote about how tech investors were making the same mistakes just made after Asian crisis (mid 1990s) in 2000s
        • Negative feedback loop – In the early 2000’s after tech bubble and 9/11, commercial banks became more short-term focused (because they had removed credit risk from their balance sheets and generating income from originating and managing loans – not lending) and as a result looked for a new way to rate credit. KMV was a pioneer in the field and used a default risk analysis based on equity pricing volatility (used analytics from Black Sholes model).
          •  This can cause a feedback loop where shareholders bail out as the bond ratings decrease.      
    • Chapter 6 – The Croupiers Take
      •  Marathon stays far away from companies led by CEOs/CFOs that were former investment bankers
        • Vivendi – lead by former Lazard banker Jean-Marie Messier – bought Seagram and spunoff an old utility business
        • Telefonica – lead by Juan Villalonga  – Bought Endemol (owner of “Big Brother franchise) for 44x earnings.
      • Bank regulations – Glass-Steagall Act of 1933 required seperation of commercial lending and securities operations and then Citigroup prompted the appeal
      • The self-imposed dependence by the fund management industry on investment banks resembles what is called “Stockholm Syndrome”
        • Named after robbery and hostage crisis in Stockhom in 1973 in which four bank employees – some of them later testified on behalf of their captors
        • This was seen by investment banks when soft commissions were introduced (unbundled research fees and trading commissions) – large funds opposed to change!
        • Similarly, fund managers fear the withdrawal of access to stock recommendations and meetings with top-rated analysts
        • Fund managers has a select few brokers whom he trusts implicitly – reciprocity tendency
      • “Macguffins” – Used by Alfred Hitchcock – deliberately mysterious plot objectives
        • The millennium or Y2K bug is a good example of a modern-day MacGuffin – investment bankers and tech consultants used it to make a shitload of money
      • Warren Buffett – Its easier to make money through the “monetisation of hopes and greed” than through creating real business value”
    • Chapter 7 – Making Up the Numbers
      • Marathon looks at firms with high profitability and believes valuations will decline because there are fewer incremental inefficiencies to wring out of the business and more capital will be attracted to the industry
      • EVA discriminates against projects with long lead times
      • The EVA trend was seen in Coca Cola, Hershey and Heinz in the mid 1990s – they slashed marketing budgets and bought back shares at huge earnings multiples – there was a focus on increasing earnings per share, not return on investment 
      • The focus on EPS and option programs also fueled buy-backs – executives wanted their options to vest
        • If the cost of Merck’s buybacks were capitalized, the assets would increase by 40% and the return on capital would decline proportionately
      • Marathon uses a checklist to distinguishes between easy and hard turnarounds (pg. 200)
        • Hard – Management in denial, more investment needed, bad balance sheet, counter-productive incentives, core business troubled, short product lives
        • Easier – Intellectually honest management, good capital allocation/declining levels of investment, robust core business, constructive fellow investors                                                                 
        • Example of HCA vs. American Greetings turnaround
    • Chapter 8 – Mismanagement
      • Marathon cautions against the “rank and yank” technique employed by firms like GE – it can cause cheating and mistrust between employees
      • Marathon oddly values in-person meetings with management – they think they can understand the characters and motivations
        • They look for – people who display a streak of ruthlessness when dealing with problems or competitors, avoidance of consultants, tenure of top management, analyze mistakes 
    • Chapter 9 – Valuing the Dream
      • Using stock to finance a deal means the risk of overpayment is shared by both acquiring and selling shareholders, in proportion to the percentage of the combined entity that ends up with each shareholder group

About the author


Add comment

By BoardofBooks
"I have known no wise people who didn't read all the time — none, zero." – Charlie Munger

Recent Posts

Recent Comments




Buy This Theme
Skip to toolbar