Edward Chancellor: ‘intelligent contrarians’ should follow the capital cycle

Merryn Somerset Webb talks to Edward Chancellor about how looking at the capital cycle can make you a better investor.

Merryn Somerset Webb talks to financial historian and strategist Edward Chancellor about how following the capital cycle can make you a better investor.

Watch the second part of this interview here: why gold miners are a better bet than conventional miners.

Merryn: Hi. I'm Merryn Somerset Webb, editor-in-chief of Money Week. Welcome to another one of our video interviews. With me today is Edward Chancellor, who is a very experience and well-known financial strategist and investment expert. Also, the author or this week's cover story, or last week's cover story, by the time you see this, which is very interesting, about gold miners.

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And the editor of this most recent book, Capital Returns. It's a series of essays written by very successful money managers at Marathon, and Edward has introduced them beautifully, and then edited them into a great collection. Well worth reading, and it will be on our Christmas book list, when we get to that.

Now, let's talk briefly about the premise of the book, or the way Marathon invests, should I say? They invest on a capital cycle basis.

Ed: Yes. So the capital cycle, what Marathon Asset Management's called the capital cycle, is really to look at companies not from the perspective of their valuation, whether they're cheap or expensive on a PE (price/earnings) basis, or a price to book basis. But really, to look at where the capital is entering into or exiting an industry.

And if you look at things that way, sometimes, you find businesses that look expensive, but are actually quite cheap, because they can sustain returns for a long time. But more to the point, investors often fail to pay attention to the amount of capital that is being spent in an industry.

Now, take, for instance, the global mining industry or the energy oil stocks recently, over the last ten years, there have been enormous surges in capital spending in both those sectors. And that surge in capital spending prefigured both the collapse in prices, in commodity prices, but also the collapse in stock.

So if you look at things from a capital cycle perspective, in other words, capital flowing in to or out of an industry, you're likely to be a better investor.

Merryn: So the basic idea is that as capital flows into an industry, supply of whatever that industry produces is going to up very fast. Then the price of that thing is going to fall, and you want to be in when supply is low, and out when supply is high.

Ed: Yes. The principle is very simple, as you expressed it. In fact, so simple, one shouldn't really need to write a book on the subject.

Merryn: I've definitely made it sound too simple, in that case.

Ed: No, I don't think so. Look, let's discuss a few of these instances over the last 20 years that your readers, viewers, might remember. Go back to the dotcom bubble in the 1990s. There was a surge of spending in technology, in particular, laying out fibre optic cables, both in Europe and in the States, and actually crossing continents too.

In the UK, there were a number of so called alternative carriers, or "altnets" listed, and these are businesses with huge capital funding needs. Now, at the same time, we had the telecoms companies, spending vast amounts of money on 3G mobile networks and so forth. Now, that surge in spending anticipated the collapse, the dotcom collapse.

In fact, it determined the dotcom collapse in 2002. So you got to a situation that, of all the fibre optic cable that had been laid, something like 95% of it was excess capacity. Now, move into the next decade, and you saw a housing boom, and saw a surge of spending on construction, spending on residential real estate.

Not so much in the UK, but certainly in Spain and Ireland and in the US. And what's quite interesting about the US example is that some very well-known investors, in 2005, 2006, started saying "hey, US housing stocks are cheap. They're trading roughly at book value".

This is the lowest range at which they've ever traded, and, you want to hold your nose, and there may be problems in the housing market, but you want to buy those stocks. Now, those stocks, on average, fell roughly 75% from that point to the trough, say four, five years later.

So you could have bought a housing stock of a perfectly respectable company that survived the real estate bust, you could have bought it at a very cheap value, and still lost 75% of your money. And the capital cycle argument is that what you should have been looking for is not the valuation per se, but how much money had been sucked into these businesses in the run-up.

And the truth is that those businesses had been expanding their capital base by about 25% per year for the previous five years, so they were riding for a fall. And we see this time and time again, the markets encourage and fund capital spending, investors cheer it on, then things start turning, turning down a bit. And the value investors come in and say; these stocks are cheap. And then the value investors get completely wiped out.

So if you understand the capital cycle, you stand back from the madness of the crowds, as things are being bid up, but you also avoid the great value traps, which are constantly hitting so called contrary and old value investors.

Merryn: And you also stand back from the demand story on the way up. Because this is the way that these events are sold to investors, that the supply side is rarely mentioned. What is mentioned is the ongoing demand.

Ed: Yes. You're quite right.

Merryn: we extrapolate, and extrapolate, and extrapolate the demand, and never add up how much supply is coming on at the same time.

Ed: And this interesting point is that people, I don't quite know why, but they love to think about and project demand into the future. They love it, I suppose, because well, they like projecting demand because demand is unknowable. And because it's unknowable, then you can have any fantasy you want about it at all, optimistic or pessimistic.

But given the nature of mankind, those would tend to be optimistic. So a huge amount of work goes into forecasting demand. As our mutual friend Russell Napier says, analysts spend 90% of their time thinking about and forecasting demand, and 10% of their time thinking about supply.

Now, the interesting thing about supply is that supply actually can be forecasted because in most industries, it takes quite a while for the supply to come on stream. You can see how much assets have grown inside an industry, or inside any particular business. You can see it through any number of measures.

Through IPO issues, through secondary share issues, through companies taking on more debt, through companies going through a boom, such as the mining companies or the US homebuilders, who have had a surge in profitability, and have reinvested those profits.

You can measure it technically through looking at things, like current capital spending to depreciation ratios. Or you can look at it, for instance, the rate of reported profitability of a company to its cash flow, the so called cash conversion rate. And if a company is generating large profits, but not generating any cash flow, it's probably in a negative phase of the capital cycle.

So the point, to go back to what you were saying, is that investors, if they knew the right way to approach, would be thinking 90% about supply, and then fantasising 10% about the completely, or not quite completely, but more or less completely unknowable demand side.

Merryn: So they'd focus, for once, on something they can actually measure.

Ed: That would make life boring and simple.

Merryn: It would also put an awful lot of analysts out of work, particularly this time of year.

Ed: But actually, it's not the question just of analysts, it's the investment bankers. As ever, the investment bankers are up to mischief. I'm sure your readers, viewers, know that their worst enemy is the investment banker. Not because of the investment banker

Merryn: I think they do.

Ed: is a greedy bastard, because we know he's a greedy bastard. But what he really wants to do is to generate fees by raising capital. And if you raise capital, and you throw it at any industry, the returns wouldn't decline. So the investment banker, and with the broker incorporated into the investment banking operations, will serve as cheerleaders, always, into the capital raising process, and will tend to be blind until after the fact, that too much capital has been misallocated.

Merryn: So what does this mean for the value investor? The ordinary value investor is usually wrong because they picked the wrong point in the cycle to invest.

Ed: Yes. And I think this is where the value investor has to show a tiny bit more intelligence than a pure contrarian instinct. Now, the contrarian instinct, as is

Merryn: We all have that.

Ed: No. You and I have it, but the point is, it's a perfectly fine and admirable trait, and we admire it completely.

Merryn: We admire it.

Ed: And we don't like people who run with that. But that alone is not enough to deliver, to protect your money. What you have to do is be an intelligent contrarian, and the intelligent contrarian, among other things, will be looking to see how long the capital cycle takes to play out.

Go back to what we were talking about, the US homebuilders. Now, the US homebuilding cycle ran for about five years on the upside. I mentioned to you that the stocks were putatively cheap in 2005, when they were trading at book. And then the book disappeared in a great big hole.

Now, so it was obviously a bad time to buy stocks in US homebuilders, 2005.

Merryn: How did you know it was a bad time then? You can see the cheap price, but you're an intelligent contrarian. What else says to you; I know how cheap that is, but I'm not buying it now.

Ed: I'll tell you. So, look, this is another area where, if you remember, the value investors got it wrong around the time of the global financial crisis. The typical value investor says he is full of false modesty he says "I don't know nothing about macroeconomics; it doesn't interest me. I just know about stocks, and so on. I just know about companies, and blah, blah, blah. I just analyse profit and loss accounts, and balance sheets", and so on.

Well, actually, around the time of the financial crisis, in case you hadn't noticed, there was a great housing bubble. Now, everyone knew there was a housing bubble.

I remember one of the analysts at the time, or providers of information, used to just provide a chart of the number of mentions of housing. The housing bubble was the best known fact in the world, really.

Merryn: It was everywhere.

Ed: Apart from Ben Bernanke, who didn't seem to know about it, but it was a very well-known fact. Now, that housing bubble had led to what I call a fundamental bubble in the balance sheets of the homebuilders. So, yes, they reported huge amounts of profitability, but they were illusory profits.

But you didn't even really need to know that. the nice thing about the capital cycle approach is just to say, OK, you can be as dumb as a value investor, or as blinkered, if you will, but just say: I'm going to look at companies and see how much they've been expanding their assets. And I'm going to look at them not just on an individual basis, but I'm also going to look at their competitors too.

And if there has been massive expansion of assets never mind how good the story is, China, or running out of oil, or energy supercycle, or the dotcom future. It doesn't matter how good the story. It doesn't even matter whether the story pans out exactly as predicted, as was the case with the dotcom stuff.

And not with, let's say, the commodity or energy at the peak oil thesis. So try not to pay attention to that, just look only at the expansion of assets. Now, I'll tell you, and this is not just my argument, I edited another book on the capital cycle for the same people, Marathon, about ten, 11 years ago.

And at the time, when I was writing the introduction to that book, I looked around to see if there was any academic research on this subject of the relationship between investment and returns. And the truth was, there was hardly anything out there at the time. But when I came to edit the new book, and write a new introduction, I actually found quite a lot of new research from finance academics in the States.

And the gist of those findings is that there is an inverse relationship between investment or asset growth and future returns. So we all know, or at least we should all know, that everything else being equal, growth stocks, companies that sell on high price/earnings ratios, and companies that sell high price to book, deliver returns below the market average.

And the converse is that so called value stocks, cheap stocks, are delivered at above average returns. Now, you have to qualify that finding in the light of the new research, which I touch upon in this book, which is to say how much investment has been going on. Because what we now find is that most of the value growth effect belongs to differentials in investment.

So it's not really to do with cheapness, investors' expectations of growth and investors' pessimism. If you will, the historic explanation of value growth anomaly, as they call it, is just, don't investors get carried away? Yes, they do get carried away, but like most findings of behavioural finance, this is a rather facile observation, and you need to go a tiny bit deeper. And, I think, if you go deeper, you start thinking about differentials in capital spending.

Merryn: It's the same thing, isn't it? That investors get carried away at times, when they've heard the story about demand, and when they're hearing the story about the demand, that's when the assets are growing, and when the capital spending is happening. it's facile, but it's not that facile. It is really what's happening.

Ed: You can put it like that, if you want.

Merryn: Thank you.

Ed: I don't like to miss an opportunity to knock behavioural finance people, partly because they just to my mind, they're telling Just So stories. It's investment for dummies, so to speak. And it's amusing.

You can give an amusing talk about investors' expectations, and delve into psychological frailties, and so on. But actually, it's not really to do with the business of investment. The business of investment, yes, it's obviously driven by human beings and human beings are frail and full of folly. We all know that. As I wrote a book, The History of Financial Speculation, which, was very much on that theme.

But the more I think about it, the more I think what's important is not investors' expectations. Yes, they are there, but they're really the epi-phenomenona. It's icing on the cake. What you really need to do is to break through that icing, go back to what I was saying, look in the instance of the capital cycle, and look at the investment cycles.

Because investors may have very high expectations. They may be very ebullient, very bullish, about a particular sector. But if that sector has not attracted a huge amount of capital investing, the chances are that those expectations, those ebullient expectations, will be met.

Now, go back, for instance, to the well, I can give you any number of examples, but I'll go back to the homebuilding example. In the States, in Ireland, in Spain, there was, obviously, a lot of excited expectation about house prices and inflated house prices. You could describe that, in your way, as a investor rationality. But there was a huge investment response.

Now, when we looked at Ireland and Spain, we found that, I think, Irish and Spanish excess homebuilding was roughly 15 times annual demand. So you can see the huge glut of over supply that had built up. Now, American over-building had been roughly five years, we calculated. it's just rule of thumb. And it took roughly five years to burn off. OK, that's fair.

Now, look at the UK, and Australia, for that matter. They both had very similar bubbles, in terms of house prices. So both British house prices and Australian house prices, they followed well, as far as I remember, they went up higher than US national prices. But in neither country was there a demand, was there a supply and response.

So take, for instance, the and I know, this is a field, when I first got into this, into the investment analyst business, I was working for an investment bank in the city in the early 1990s, where, and this was in the aftermath of the great, of a very serious housing bust in the early 1990s.

And one of our clients, Tarmac, had lost a great deal of money; we were raising money for Tarmac. Now, I studied the UK housing market at the time, and what you could see was a huge supply response in the 1990s to the rising house prices, and then the subsequent bust.

Now, fast forward 15 years, what happened? The UK home construction business, or the homebuilders, were immensely consolidated, if you will. Just a handful of companies where there had been, I don't know, let's say 15 or 20 builders, large builders, but probably only about four or five of note, for any number of reasons, it was very difficult to build new houses in the country.

Now, and this points to an interesting opportunity that was created. I can identify it in retrospect. It's better than not at all. Whereas the US homebuilders were value traps, even in 2008, going into the crisis, and in 2009, the UK homebuilders, which had also collapsed in price take Persimmon. I remember looking at its stock, and its stock, I think, perhaps you know better than I, I think it went from about £15 to £3, or something like that.

Merryn: These were phenomenal collapses in these stocks.

Ed: Yes, I know, and it collapsed. But actually, if you looked at Persimmon and the UK homebuilding industry, you see that there actually hadn't been any overdone capital cycle. So these stocks recovered much better. So if you knew nothing about either the particularities of the US homebuilders, or the UK homebuilders, but if you just looked at their asset growth, you would have said, from a capital cycle perspective, that the UK homebuilders were outstandingly attractive.

Merryn: And, of course, that turned out to be the case, they were, in nominal terms.

Ed: I'm giving some hindsight wisdom.

Merryn: Very good of you, thank you.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.