Follow the capital cycle
The capital cycle is a vital concept to add to your toolbox as an investor. Right now, it says oil firms are cheap
The capital cycle is an extremely useful investment concept. The best read on it is probably Capital Account by Edward Chancellor and Marathon Asset Management. But the good news is that like lots of useful investment concepts, it’s pretty simple. Let’s take the mining industry as an example. Building a mine takes a lot of investment. When metals prices are weak, no one wants to spend money on finding and opening new mines. In turn that means supply dries up. Eventually demand starts to outstrip supply, metals prices start to rise, and so do the earnings of miners. Shareholders get excited. 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 nowhigh metals prices. As a result, the mining sector finds it easy to raise money to fund expansion. But this extrapolation leads to over-excitement and over-production. Eventually supply overwhelms demand. Metals prices fall. Before too long, all the mines opened during the expansion era are no longer profitable or viable. Earnings collapse. Dejected shareholders abandon the sector.
Small miners go bust, big ones rediscover capital discipline. And thus the cycle starts all over again.
Who is being shunned right now?
While the mining cycle makes this very clear, it’s applicable to any industry. As the fund managers at Temple Bar investment trust point out in a recent research note on the capital cycle, it also explains the tech boom and bust in 2000, which paid for millions of miles of optic fibre cable around the world at the cost of shareholders’ wealth. In short, the time to invest is when a sector has been starved of capital – and the time to get out is when investors can’t get enough of it.
So which companies fall into the former category today? Oil companies, says Temple Bar. 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 or better cash generation”. But as oil prices subsequently collapsed, partly due to massive unprofitable expansion of US shale fields, “the industry cut capital expenditure by nearly twothirds”. Now, JPMorgan analysts reckon that current spending is far too low (about $600m short) to keep the market in balance. “Our expectation is therefore that the capital cycle is working in favour of the energy companies.” For more on the sector, see page 18.
“The time to buy is when a sector is starved of capital”