An email exchange with a friend and former colleague of ours reminded us of Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 — a book comprised of edited versions of reports issued by London-based Marathon Asset Management.
Marathon’s investment approach is driven by avoiding investing in sectors, or markets, where investment spending is unduly elevated and competition is fierce, and to put one’s money to work where capital expenditure is depressed, competitive conditions are more favourable and, as a result, prospective investment returns are higher. Simply put, Marathon seeks out sectors where supply is or is likely to become constrained and avoids sectors where supply is likely to increase sharply in the near to medium-term.
The focus on supply over demand, Marathon argues, is because supply is easier to measure and predict than as compared to demand. The following passage from the book, we think, captures, the manager’s investment framework.
“The key to the ‘capital cycle’ approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side.”
This got us to thinking about where is or could supply be potentially constrained. We could not come up with much. The list of oversupplied markets in the world today is seemingly endless. Just consider the following:
- OPEC and other oil producing nations have gone to great lengths to curtail supply of crude and push up spot prices. Even then prices remain moribund — supply from the shale patch in the US just keeps surprising to the upside, overwhelming any robustness in demand.
- Kazatomprom and Cameco, the two largest uranium mining companies globally, have shuttered significant portions of their supply to prop up uranium prices. Prices though remain near the lower bound and the supply cuts have neither made a lasting impact on prices or on buyers.
- An estimated 1.3 billion tonnes of food is wasted globally each year, one third of all food produced for human consumption, according to the Food and Agriculture Organization (FAO) of the United Nations.
- Industry forecasts indicate that steel oversupply in China is expected to rise to 196 million tonnes in 2020, up 13 per cent from 174 million tonnes estimated in 2019.
As we were considering the above, we came across the following passage in a recent issue of Ben Thompson’s Stratechery Newsletter (emphasis added):
“[I]f you are going to take advantage of the Internet transforming one part of the value chain, you had best ensure you are anticipating the transformations in the other parts as well. And, on the flipside, in a world of abundance being able to aggregate demand is more valuable than being able to create supply; it may offend our analog sensibilities that 90 million email addresses are more valuable than real-world factories, but such is the transformative nature of the Internet.”
Marathon’s approach of focusing on supply made sense in a world dominated by physical products and real-world constraints. Today, the top-five companies in the world by market capitalisation are:
- Microsoft
- Apple
- Amazon
- Alphabet (Google)
Other than Apple, none are constrained — at least, as far as their primary businesses are concerned — by supply.
In a world dominated by companies with infinite supply, the key analytical skill in recent years has not been the ability to model supply but rather being able to identify the companies that will best aggregate demand. Machines, with their ability to process big data in near real time, are better placed to understand and determine demand than humans, which may in some part explain the continued under performance of non-systematic, discretionary investment strategies.
Undoing Globalisation
The global spread of the Covid-19 virus is acting as a propellant on the anti-globalisation trend which has been unfolding since the Brexit referendum and the election of President Trump. The shift in attitude toward China and the lack of resilience shown by globally integrated supply chains optimized for profits is likely to lead to a new kind of investment environment.
The kind of investment environment where there continue to be aggregators, especially in technology related sectors, but there is a shift in the supply dynamics of ‘old economy’ sectors where figuring out supply once again becomes a source of alpha.
We highlight two further changes in the investment environment that may arise as the trend toward de-globalisation accelerates.
#1 Capital Expenditures over Buybacks
Much has been written about buybacks, some of it good and some just utter tosh.
Irrespective of one’s view on buybacks, it is easy to understand their appeal at a time when supply is not a concern. Rather than investing excess cash into property, plant and equipment, companies have been, following the Global Financial Crisis, been incentivised to pursue buybacks — the return on investment on buybacks a priori has simply been superior.
As companies look to move supply chains from China and potentially insource critical manufacturing functions, capital expenditures will be prioritised over buybacks. Companies that move first and fastest are likely to be the ones rewarded and the laggards punished.
#2 The Chinese Consumer’s Importance to Rise
Supply chains in China will not be entirely dismantled — China is after all the second biggest single market after the US for most multinational companies and a population of 1.3 billion has to be catered for.
What we envisage is the Chinese leadership finally taking meaningful steps to move away from its (unsustainable) investment led growth model and transforming its economy to be consumption led. This shift is necessary to reduce the need to mothball large parts of the industrial infrastructure on the Mainland.
Such a shift in China’s growth model, however, is unlikely to manifest without tectonic shifts in global foreign exchange markets — is the US dollar index $DXY after almost touching 100 then falling below 97 sniffing this out? It is difficult to say but that is a discussion for another day!
Thank you for reading!
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.