Capital Account: A Money Manager’s Reports on a Turbulent Decade by Marathon Asset Management

Summary
  1. Relates the story of the 2001 TMT bubble from the perspective of Marathon Asset Management
Key Takeaways
  1. Capital cycle theory – when companies trade at a premium in the stock market to their replacement cost, new investment is stimulated; that demand forecasts are inherently unreliable; that when competition is increasing, there is a great danger of supply exceeding demand; that investment bankers will promote excesses and that investors will capitulate to these developments. After the boom has turned to bust, capital cycle analysis that a period of consolidation in the industry is necessary before returns improve
    1. High returns will attract excess competition, which will in turn lower excess returns
    2. May not be great at spotting rewarding sectors but it will help you spot bubbles and overvaluation; must take a global perspective
    3. Analyze industries within the Capital Cycle framework and quality of management
    4. Reversion to the mean occurs only in the long run
    5. Before taking a position in out of favor sectors which have failed historically to earn their cost of capital, investors should first ascertain whether capital or capacity is actually being removed from the industry
    6. Capital cycle analysis must always be accompanied by a parallel analysis of management reinvestment discipline
  2. The sectors Marathon looks at are characterized by corporate restructuring, industrial consolidation, a focus on the core business and a history of underinvestment – may not be fashionable or exciting but often lead to good results
  3. Take the view that a strong relationship exists between stock prices and replacement cost and furthermore, that the best investment returns are achieved when shares sell at a material discount to their replacement cost (Cemex)
  4. Investment experience shows that the range of investment outcomes is not normally distributed but is characterized by fat tails – shares spend relatively little time at fair value (highest quality companies can be undervalued for decades – WalMart)
  5. Business executives and gate keepers (lawyers, auditors, etc.) are mostly to blame for bubble
  6. Investors who ignore the noise generated by investment banks are likely to be winners
  7. Goodhart’s law – When any single measure of corporate profitability becomes a target for investors and business managers, it becomes useless
  8. EBITDA was popularized during this time as it stripped all “bad stuff” (aka costs) from earnings
  9. Folly of short termism – quarterly figures inherently unreliable, profits generated by a company over a three month period are tiny in comparison to the total value of the business, changes in competitive position cannot be measured over such a brief period of time, earnings can be manipulated
  10. Avoid IPOs, really anything that is being sold to you – most new issues are poor investments or else they wouldn’t take place at all
  11. Ability to allocate capital efficiently is the biggest predictor of share price performance.
  12. Profitability is determined primarily by the competitive environment, or the supply side, rather than by revenue growth trends. It is better to invest in a mature industry where competition is declining than in a growing industry where competition is expanding
  13. The winners are those who make fewer mistakes
  14. Overvaluation (Tobin’s Q = market cap / replacement cost) leads to over expansion which leads to too much supply which lowers profitability
  15. Distinction between innovation and adoption is critical
  16. Over the long run, it is a company’s ROC, not changes in quarterly earnings, which primarily determines the direction of its share price. The ROC of any company is largely subject to the state of competition within its industry.
  17. When shares are priced on the assumption that existing returns are likely to be maintained or even improved, then a rapid increase in industry capacity should serve as a red light. Unfortunately, business people have a tendency to extrapolate from recent trends. The ‘animal spirits’ of the corporate world tend towards optimism and overconfidence. CEOs frequently assume their competitive position is stronger than it is and that currently favorable conditions will continue indefinitely. As a result, they are frequently surprised by their unfavorable consequences of capital expansion in their industry. And professional investors, who mostly take their cue from what management tells them, are also liable to be wrong-footed.
  18. Growth company framework
  19. As one moves down the growth stock decision tree, business risk tends to decline as management has the operating model more under its control. The failure rate of stocks is therefore lower
  20. Substitutionary locomotion model the best – efficiency is at the heart of the model but a substantial amount of ‘savings’ are redeployed either for advertising, to generate new demand, or for innovation, to create more products. Because accelerated advertising or research goes through the profit and loss account, these companies often do not appear to be growing earnings as fast as they might be. In the race of fable, they resemble the tortoise rather than the hare. Management of such companies understand that not all costs are equally bad. They have a rising quality of costs as well as earnings (Colgate, Wrigley prime examples). JNJ, GSK, and Merck raising R&D budgets and might appear to be part of this elite but the issue  is complicated by growing competition in the pharma sector which is shortening life cycles of new drugs
  21. Rising advertising budgets show three things – underlying earnings growth rate that these companies have declared is sufficiently robust to allow for increased expenditure; providing these businesses have not been permanently damaged by the prior decline in advertising outlays, revenue growth should be reasonably robust; since there is little point in promoting a tired product, the rise in advertising spend also implies an increase in product innovation
  22. A successful product must make a consumer’s life easier (razor blades) or more pleasurable (Coca Cola)
  23. Efficiency based model – a key criterion for success is that the company should be profitable enough to expand but not so profitable that competitors are attracted into the field (WalMart, Home Depot)
  24. Price-based growth model – Has pricing power and can increase margins and profits through raising its selling price or reducing input costs (Kellogg, PM)
  25. Growth due to overvaluation – when a company’s shares are trading at many times the replacement cost of the business, there is a great incentive to grow the business
  26. Growth by acquisition – Source of value add is either merger synergies or a valuation arbitrage between share prices of the lowly valued target company and the highly valued predator
  27. Seeing quantum increase in mispricings and it often takes years to revert
  28. Low inflation doesn’t have the magical power to prep markets like many believe
  29. Believes passive investing is dumb as index construction is inherently flawed
  30. One of primary cures for poor returns is consolidation – economies of scale
  31. Capitalism works efficiently only under conditions of genuine competition
  32. 2 handled pump – management talks up the stock, sells at all time highs, sees stock tumble and buys again at lows (Silver Kings)
  33. MacGuffin – something which is just believable enough without being either understandable or clearly measurable
  34. EVA – Economic Value Add; spread between ROIC and cost of capital – bigger –> higher valuation
  35. Leads to some poor incentives – short-term, cut good expenses such as R&D and advertising to momentarily boost earnings
  36. Buybacks becoming increasingly popular but improperly implemented
  37. Turnarounds
  38. Most important criteria for easier turnarounds – intellectually honest management, good capital allocation (declining levels of investment preferred), robust core business, long product lives/loyal customer base, constrained supply side, good balance sheet, constructive fellow investors (bond and equity), properly constructed management incentives
  39. More difficult turnarounds – management in denial, more investment needed, core business troubled, short product lives/disloyal customer base, supply side out of control, bad balance sheet, stubborn investment constituencies, counter-productive incentives
  40. Smooth, incremental growth impossible but market penalizes if can’t deliver
  41. Importance of meeting management – by personally meeting can get to know management on a deeper level by observing tendencies, body language, lifestyle, see if they keep their promises, make sure they’re not formerly investment bankers, encourage a cultish personality, are self-promotion; like some ruthlessness in their managers as well as loyalty, intelligence, flexibility and honesty
  42. Richemont, Bunzl, Reckitt Benckiser, Heineken, Nokia, Intertek, Svenska Handelsbanken
  43. The more overvalued the market is, the more likely acquisitions will be made via shares
  44. What I got out of it
    1. Really great perspective on how Marathon analyzed the bubble in real time, how they kept their patience and viewed the situation in real time and how they avoided the mania and eventual losses