Money and Finance

More from Ed Chancellor on focusing on industry supply...

From his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15:

FOCUS ON SUPPLY RATHER THAN DEMAND

Given that the future is uncertain, why should Marathon’s approach fare any better? The answer is that most investors spend the bulk of their time trying to forecast future demand for the companies they follow. The aviation analyst will try to answer the question: How many long-haul flights will be taken globally in 2020? A global autos strategist will attempt to forecast China’s demand for passenger cars 15 years hence. No one knows the answers to these questions. Long-range demand projections are likely to result in large forecasting errors.

Capital cycle analysis, however, focuses on supply rather than demand. Supply prospects are far less uncertain than demand, and thus easier to forecast. In fact, increases in an industry’s aggregate supply are often well flagged and come with varying lags – depending on the industry in question – after changes in the industry’s aggregate capital spending. In certain industries, such as aircraft manufacturing and shipbuilding, the supply pipelines are well-known. Because most investors (and corporate managers) spend more of their time thinking about demand conditions in an industry than changing supply, stock prices often fail to anticipate negative supply shocks [33].

ANALYZE COMPETITIVE CONDITIONS WITHIN AN INDUSTRY

From the investment perspective, the key point is that returns are driven by changes on the supply side. A firm’s profitability comes under threat when the competitive conditions are deteriorating. The negative phase of the capital cycle is characterized by industry fragmentation and increasing supply. The aim of capital cycle analysis is to spot these developments in advance of the market. New entrants noisily trumpet their arrival in an industry. A rash of IPOs concentrated in a hot sector is a red flag; secondary share issuances another, as are increases in debt. Conversely, a focus on competitive conditions should alert investors to opportunities where supply conditions are benign and companies are able to maintain profitability for longer than the market expects. An understanding of competitive conditions and supply side dynamics also helps investors avoid value traps (such as US housing stocks in 2005–06).

[33] Several accounting based measures provide insights into the capital cycle. As observed above, stocks with the fastest asset growth tend to underperform. When a company’s capital expenditure relative to depreciation rises above its average level it may be a sign that the capital cycle is deteriorating (see 1.4 “Supercycle woes” and Chapter 1, “A capital cycle revolution”). A rising gap between reported earnings and free cash flow is another warning sign (see 1.7 “Major concerns”). The Herfindahl Index provides a statistical measure of industry concentration which may reveal changes in competitive conditions. Anecdotal signs prove just as useful in gauging the capital cycle. It’s generally a bad sign when a company starts building a grandiose new head office (see 4.9 “On the rocks”)

...................

Related previous post: Investors should be thinking 90% about supply...

- Five Good Questions For Edward Chancellor About The Book "capital Returns"
Link to video .................... Related book: Capital Returns Related previous posts: Investors should be thinking 90% about supply... More from Ed Chancellor on focusing on industry supply... THE TENETS OF CAPITAL CYCLE ANALYSIS ...

- Investors Should Be Thinking 90% About Supply...
In one of the interviews Edward Chancellor gave recently, he made the comment below, which I think was probably the most practical investing lesson that can be used going forward:Ed: And this interesting point is that people, I don’t quite know why,...

- Ed Chancellor On The Capital Cycle...
From his introduction to Capital Returns: Investing Through the Capital Cycle: A Money Manager's Reports 2002-15, which was released in hardcover today: Typically, capital is attracted into high-return businesses and leaves when returns fall...

- Edward Chancellor Quote
Via the book Capital Account: It is an axiom of capital cycle analysis, however, that future demand is very difficult to project. Partly this is due to the problems that afflict all attempts at forecasting under conditions of uncertainty. But it is exacerbated...

- Edward Chancellor Quote
Via the book Capital Account: The turnaround of General Dynamics [from 1990-1993] and its dramatic share price performance illustrate two key aspects of the capital cycle approach to investment. First, shareholder returns are not necessarily determined...

Money and Finance