Friday, July 1, 2016

Book review: "Capital Returns" by Edward Chancellor

Marathon Asset Management is a successful investment manager in London. It manages seven funds with long track records and, remarkably, each fund has beaten its benchmark by a wide margin over the past three, five, and ten years.

Capital Returns is a collection of letters that Marathon wrote to its investors between 2002 and 2015. The letters discuss individual investments that Marathon made, but they also act as showcases for the firm's investment philosophy, which emphasizes the importance of a phenomenon that it calls the capital cycle.

According to Marathon, the capital cycle has four stages:

• The prospect of high returns attracts new entrants to an industry
• Rising competition pushes returns below the cost of capital
• Business investment declines, the industry consolidates, and some firms exit
• Improving industry dynamics push returns above the cost of capital

Besides the cycle itself, Marathon cares about "how management responds to the forces of the capital cycle and how they are incentivised," i.e., how disciplined they are with regard to capital allocation. It also likes to invest in industries that are insulated from the cycle because they have strong barries to entry. Conversely, it avoids industries in which regulations and political meddling lead to chronic overinvestment.

Despite Marathon's prodigious investing success, I found Capital Returns underwhelming. Three things turned me off the book:

One, it's a greatest hits collection. All of the letters describe profitable investments Marathon made or unprofitable investments it avoided. Presumably there are times when the capital cycle is overwhelmed by other forces, and presumably it's possible to misjudge the cycle, but the book gives no such examples. Failure is often more instructive than success, so that was disappointing.

Two, the ideas are basic. Marathon may be the first firm to make the capital cycle the focus of its investing strategy, but sophisticated investors generally understand the concept. For instance, over the past few years many financial commentators have predicted that overinvestment in the mining industry would reduce its profits.

Three, while the letters are well-written, they're essentially all variations on the same theme. I think the letters are best seen as a form of marketing to Marathon's investors. By writing about the same topic every quarter, Marathon creates an image of thoughtful consistency. But the repetition that makes the letters successful as propaganda makes them tedious as a collection of essays.

Edward Chancellor's comments

Edward Chancellor compiled and edited the essays in Capital Returns. He also wrote its introduction, in which he summarizes Marathon's ideas and offers some of his own opinions. I think this is the best part of the book: it's more succinct than the essays, and his opinions by themselves are worthwhile.

Chancellor posits several reasons why the capital cycle happens. It's human nature to extrapolate the recent past forward. Many industries have low barriers to entry, so they're periodically flooded with new investment. Corporate managers garner higher salaries and greater prestige from managing larger companies, so they have an incentive to reinvest and make acquisitions regardless of likely returns. Investment bankers earn fees when their clients expand, so they likewise favor investment regardless of returns.

He writes that investment drives mean reversion for individual companies, industries, and entire countries:

Firms with the lowest asset growth have outperformed those with the highest asset growth.

Corporate investment in most developed economies... is a significant negative predictor of aggregate profitability.

Provocatively, he argues that value investors owe much of their success to timing the capital cycle:

[E]xcess returns historically observed from value stocks and the low returns from growth stocks are not independent of asset growth...

[M]ean reversion is driven by changes on the supply side which value investors who consider only quantitative measures of valuation are inclined to overlook.

Conversely, when value investors buy statistically cheap stocks but ignore the cycle, they're likely to lose money, as they did with housing stocks in 2006-08.

Drawing on Marathon's ideas, Chancellor makes two recommendations. One is to focus on supply rather than demand:

Supply prospects are far less uncertain than demand, and thus easier to forecast.

Another is to be an investing generalist. "Analysts with highly specialized knowledge of an industry are prone to" looking at their industry in isolation, whereas generalists consider historical comparisons:

[I]ndustry specialists end up not seeing the wood for the trees. They may, for instance, spend too much time comparing the performance and prospects of companies within their sector and fail to recognize, as a result, the risks that the industry as a whole is running.

I would qualify this criticism, however: I think that specialization is actually the key to Marathon's success. But rather than an industry, it specializes in an economic dynamic that affects numerous industries. This gives it focus that generalist lack while avoiding the tunnel vision that afflicts many industry specialists.

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