Trying to forecast demand is a waste of time, according to financial historian and strategist Edward Chancellor. The secret to successful investing is to focus on supply.
Most investors get everything wrong. That's the key message that came out of my recent interview with Edward Chancellor. They look at valuations worrying endlessly about price/earnings (p/e) ratios and price-to-book (p/b) ratios. But they never think about the capital cycle the way investment flows in and out of sectors, and the one thing that really matters.
The easiest way to explain this is simply to look at the mining and energy sectors over the last decade. Demand rose (thanks to China) and was projected to rise indefinitely. This prompted "enormous surges in capital spending in both those sectors". The result was entirely predictable. That surge in capital spending and hence supply prefigured the collapse in commodity prices and in shares of resources companies. The same happened in the dotcom bubble in the 1990s. There was a surge of spending in technology in particular on laying out fibre-optic cables, 95% of which ended up as excess capacity. In the UK, a large number of alternative carriers with large capital-funding needs listed, and everywhere the telecoms companies were spending vast amounts of money on 3G mobile networks. "That surge in spending anticipated the dotcom collapse."
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The cost of ignoring supply
Another classic example came with the housing bubbles. Cheap money fuelled demand that led to a surge of spending on the construction of residential real estate. At this point, says Chancellor, anyone looking at the numbers for capital spending in the sector would have steered well clear. But in the US in 2006, as the sector started to turn down a bit, "some very well-known investors, in 2005, 2006, started saying US housing stocks are cheap. They're trading roughly at book value'." And they were. But they had also been expanding their capital base by about 25% per year for the previous five years. Supply had soared. And when prices fell as a consequence, that book value "disappeared into a great big hole". Those investors who thought they were buying value got "completely wiped out". They looked at what they thought was value but not at where prices might really go. They extrapolated demand. But they didn't think enough about supply.
Analysts "love to think about and project demand into the future", says Chancellor. Most of their work goes towards this, despite the fact that the numbers are entirely unknowable and all the effort generally wasted. Supply, on the other hand, is much neglected, even though it can generally be very accurately forecast: you can measure future supply by looking at how much the assets inside an industry are growing; by looking at how much debt companies are taking on to expand; by looking at initial public offerings and share issuance; via cash conversion rates (how much profit comes as cash); or simply by looking to see which industries are booming (money follows booms).
They could also keep a close eye on what investment bankers are doing. Bankers generate fees by raising capital. And they are "greedy bastards". They will always keep going until "too much capital has been allocated". If investors really did things right, they would spend 90% of their time on analysing supply, and a mere 10% "fantasising about the more-or-less completely unknowable demand side". They would focus their effort on something they can actually measure. And they most certainly wouldn't have bought US housing stocks in 2006.
Value investors really need to keep all this in mind, says Chancellor: it's where they have to show intelligence, rather than just contrarian instinct. The typical value investor "is full of false modesty". He is prone to saying things such as "I don't know anything about macroeconomics; it doesn't interest me. I just know about stocks". He prides himself on his ability to look at a balance sheet and make a call on that firm. But, says Chancellor, he'd be smarter to raise his head and look around a little at the capital investments of the sector as a whole.
A missed opportunity
Value investors who had done that in 2005 would never have dreamed of buying US property firms in 2006. They would, however, have bought UK housebuilders in 2009. In America, in Ireland and in Spain, "there was a huge investment response" to rising house prices. "Irish and Spanish excess homebuilding was roughly 15 times annual demand," for example. In the UK and in Australia it was different. They had similar price bubbles, but in neither country was there a major supply response. That made their busts different to those in Ireland, Spain and the US in 2007 and to the UK in the 1990s (when there was a supply response). That made the UK builders not value traps, but huge opportunities. If at the time you knew nothing much about the "particularities of the US homebuilders, or the UK homebuilders, but if you just looked at their asset growth, you'd have said, from a capital-cycle perspective, that UK homebuilders were outstandingly attractive". And if you'd bought them you would, of course, have made a fortune.
We mull this piece of hindsight wisdom for a sad moment (neither of us made that fortune). Then I ask for a little foresight wisdom. What sectors are going to be to 2016 as housebuilders were to 2009? Chancellor's first answer to that is gold miners (see ourrecentcover story for more on this Chancellor wrote it).But as I'd quite like it to be the global miners as a whole (see our cover story this week), I push for that.
He isn't convinced. In basic materials such as iron ore there has "been a huge surge of investment", which will keep bringing supply on. That new supply is also mostly very low cost, so there is less incentive to shut mines down. So you have a combination of new low-cost capacity and probably weak demand. The latter is hard to forecast, but Chinese bears (now known as "Pandas", Chancellor tells me) clearly expect lowish demand.
Where Chancellor feels a little more bullish is in the energy sector. There has, he says, been an obvious investment surge here too. But "a lot of it didn't come to anything" except, of course, in America, where fracking took off. The oil majors "hardly managed to replenish their reserves, let alone build up any new reserves" from all their deep holes in the Arctic. However, in the US, dirt-cheap cash and the discovery of fracking meant a sudden huge expansion in supply. The interesting bit now is that these frackers are only profitable at $60-$70 a barrel. So "from the capital-cycle perspective, they are toast". At today's prices, their supply isn't going to be around for long the balance then will rectify itself much faster in oil than in materials.
Time to back tar sands?
So how would he invest on the back of that? It isn't "politically correct", says Chancellor but maybe in the Canadian tar-sand producers. They've invested a lot, but their marginal cost of production is lower than those of the frackers. "So it's conceivable that if you wanted to leverage play on a long supply of oil in other words, a stream of oil coming out for the next 30 years or so, that you should look towards tar sands." One possible stock to look at being Canadian Natural Resources (TSX: CNQ).
Would he look at Russian oil stocks at this point? I ask. They really do look cheap. For a "small exposure", he might. But Russia has a severe corporate governance problem there is "no rule of law"; foreign investors are "extremely low" down Putin's list of priorities; and you can't rely on corporate cash flow ending up with the investors rather than with cronies. Buy stocks in Russia and you might make a lot (it's been one of the best-performing markets this year so far), but you also run a substantial risk of losing the lot. Best, we agree, to stick with the gold miners.
Who is Edward Chancellor?
Edward Chancellor is a financial historian, journalist and investment strategist. He graduated from Trinity College, Cambridge, with first-class honours in modern history, before completing a masters in the same subject at St Anthony's College, Oxford.
He then worked for investment bank Lazard Brothers in the 1990s, before becoming a writer for the Financial Times, the Economist, The Wall Street Journal, Institutional Investor and Breakingviews, among others. In 1999, he published Devil Take the Hindmost, an acclaimed history of bubbles and manias. He won the George Polk Award for financial reporting for a 2007 Institutional Investor article on the risks posed by the American subprime-mortgage bubble.
In 2008, Chancellor joined asset management firm GMO as a member of the asset allocation team, leaving in 2014 to work on a new book. Capital Returns was published in November, and draws on a decade of reports by managers at Marathon Asset Management, a London-based firm that specialises in capital-cycle investing.
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