Lesson 6 of 7
The capital cycle
High returns attract new capacity, and new capacity crushes the returns that attracted it. Capital spending against depreciation shows where an industry sits.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- High returns on capital attract new investment, and the new capacity that follows tends to push returns back down.
- Capital spending well above depreciation says an industry is adding capacity; well below says it is shrinking.
- The cycle explains why a high return, on its own, is a reason for caution about what comes next rather than comfort.
Capital moves towards wherever returns are high. That movement is not a side effect of the capital cycle, it is the capital cycle, and it is why a high return on capital rarely persists on its own.
One turn of the capital cycle
- 1High returns on capital
- 2Capital floods inNew projects are funded and ordered
- 3Capacity grows, returns fall
- 4Capital leaves, supply shrinksWeak returns stop new investment
Then back to step 1, High returns on capital.
What happens after the capital arrives
Titman, Wei and Xie, in a National Bureau of Economic Research paper, find that firms which substantially increase their capital investment go on to earn lower benchmark-adjusted stock returns. The effect appears in the years that follow the investment. The authors read it as investors underreacting to managers who overinvest: the effect was stronger at firms with more cash and less debt. It is a firm-level cousin of the capital cycle, not a test of it.
Capital spending against depreciation is the gauge
The framework comes from the fund manager Marathon, whose reports Edward Chancellor edited as Capital Returns. Depreciation is roughly what it costs to keep existing capacity running. Capital spending well above that figure means an industry is adding new capacity beyond replacement, which is the flood stage of the cycle. Capital spending below depreciation means the asset base is shrinking, which is usually the stage after returns have already been squeezed and competitors have started to leave.
The gruesome end of the cycle
Berkshire Hathaway's 2007 shareholder letter sorts businesses into the great, the good and the gruesome. The gruesome is a business that requires large, continuing capital just to keep growing and still earns little or nothing for it. The letter offers the airline industry as its example. An industry that never leaves the flood stage needs new capital indefinitely, never reaching the shrink stage that would let returns recover. That is the version of the cycle that does not turn.
Check yourself
An industry's capital spending is running at 2.5 times its depreciation. What stage of the capital cycle is that?
- Capacity shrinking, ahead of a recovery in returns
- Capacity flooding in, likely to push returns down
- A stable industry with no cycle
Show the answer
Answer: B.
Spending well above depreciation means new capacity is being added faster than the existing plant wears out, which is the flood stage that tends to compete returns down.Titman, Wei and Xie's finding on firms that sharply increase capital investment is that they subsequently earn what?
- Higher benchmark-adjusted returns
- Lower benchmark-adjusted returns
- Returns unrelated to the investment
Show the answer
Answer: B.
Their paper finds that firms which substantially raise capital investment go on to earn lower benchmark-adjusted stock returns in the years after.What did Berkshire's 2007 letter call a business needing continual heavy capital to grow while earning little for it?
- The great
- The good
- The gruesome
Show the answer
Answer: C.
The 2007 letter's third category, the gruesome, describes a business that must keep investing large sums just to grow and still earns little or nothing on the capital.Sources
- Chancellor, editor, Capital Returns: Investing Through the Capital Cycle, 2016.
- Titman, Wei and Xie, "Capital Investments and Stock Returns," NBER Working Paper 9951, 2003.
- Berkshire Hathaway shareholder letter, 2007, on businesses described as the great, the good and the gruesome.
What this leaves out
- The stage table is illustrative and uses round invented ratios; a real industry's turn through the cycle takes years and is rarely this clean.
- Capital spending against depreciation is a gauge, not a rule. A company can also spend heavily to replace ageing plant without adding net new capacity.
- Depreciation is on historical cost, so with inflation even pure replacement spending runs above 1.0x; acquisitions add capacity without showing in capital spending at all.
- The cycle describes an industry's tendency, not a forecast for any one company's returns or its stock.
- Nothing here is advice about any security.