How the capital cycle can reveal which sectors have the most investment potential

The capital cycle is an extremely useful investment concept. John Stepek explains how it works, and how it can help you.

Before I get started this morning, a quick question – do you fancy coming to work with me and Ben and Merryn and the MoneyWeek team?

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OK back to today – and a useful theory known as the “capital cycle”.

How the capital cycle can help you decide which sectors to invest in

I’ve just been reading an interesting research note from the team at the value-focused Temple Bar investment trust. It’s all about the capital cycle.

The capital cycle is an extremely useful investment concept. The best source for reading about it is arguably “Capital Account” by Edward Chancellor and Marathon Asset Management. 

But if you can’t get your hands on a copy, the good news is that like lots of useful investment concepts, it’s pretty simple: ultimately, it’s an intellectual justification for the idea that there are good times to invest in an industry (when everyone hates it) and bad times (when everyone loves it).

I’ve always found that the easiest way to think about it is with respect to the mining industry. Here’s roughly how the cycle goes. 

Building a mine takes a lot of investment – when metals prices are weak, no one opens new mines. In turn, that means supply dries up.

As supply gets out of whack with demand, metals prices start to rise. The earnings of miners start to rise – shareholders get excited and they throw more money at both established miners and explorers with promising projects, in the expectation of juicy future returns.

As the boom continues, miners are, in effect, rewarded for expanding. Shareholders want to see newer and bigger projects which can be justified by now-high metals prices. Extrapolation leads to over-excitement and over-production. Eventually, supply overwhelms demand and metals prices fall. 

Before too long, all the mines opened and projects laid out during the expansion era are no longer profitable or viable. Earnings collapse. Dejected shareholders abandon the sector. The small miners go bust, the big ones rediscover capital discipline. And thus the cycle starts all over again.

It’s easiest to envisage this process with miners. But in reality, it applies to any sector you care to think about.

The Temple Bar team points out that it also explains the tech boom and bust at the turn of the century. Investor exuberance about internet-related stocks meant that these companies were able to raise “huge amounts of capital which was frequently invested”.

This all helped to lay millions of miles of optical fibre, which in turn ended up being great news in the long run. But in the short term, there was too much of the stuff, and bust followed boom as sure as night follows day.

Oil companies have been starved of investment capital

In short, when investors are excited about an industry, companies effectively get paid to invest and expand. You can see this happening right now (or at least, it was happening up until very recently). No one cares about profits – they care about building out “networks” and “audiences”.

This might all be less capital intensive than building factories, but as anyone who is competing in the attention economy right now can tell you, you have to spend money to build and retain an audience. And what with all the competition in the sector, that only becomes more expensive.

What’s interesting is that “data” has often been described as the “new oil” in this brave new world. One way to think about today’s bubble is that companies involved in exploring, producing and refining data have had loads of capital flung at them and have been encouraged to expand.

Meanwhile, the companies trying to explore for and produce “real” oil have been starved of capital. As Temple Bar’s report points out, when oil prices hit $100 a barrel in 2013-2014, oil company earnings rose, but “poor capital discipline by the industry meant that the increase in earnings did not translate to either a higher return on capital of better cash generation.”

However, as oil prices fell (partly because of massive unprofitable expansion of US shale fields), “the industry cut capital expenditure by nearly two-thirds.”

Overall, “analysts at JP Morgan believe that current capital expenditure plans are $600m lower than that required to keep the market in balance. Our expectation is therefore that the capital cycle is working in favour of the energy companies”.

It’s yet another good reason to believe that this “rotation” from growth to value has legs in the long run – almost regardless of what happens with interest rates and inflation.

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