Edward Chancellor part 1: ‘intelligent contrarians’ should follow the capital cycle

 

Published on Mar 23, 2016

Merryn Somerset Webb talks to financial historian and strategist Edward Chancellor about how following the capital cycle can make you a better investor.

Edward Chancellor part 1: ‘intelligent contrarians’ should follow the capital cycle0:08welcome to another one of our video interviews with me today as ever
0:11chancellor who is a very experienced and well-known financial strategist and
0:16investment expert also the author of this week’s cover story or last week’s
0:20cover story by the time you see this which is very intrigued about gold
0:23miners and the editor editor really of this most recent book capitol detergents
0:28a series of essays written by very successful money managers at marathon
0:32and editors introduced them beautifully and then edit them into a great
0:36collection well worth reading it will be on our Christmas book list when we get
0:38to that now that’s what we feel that the premise of the book of the Weimar best
0:43should I say they invested capital cycle basis yes the capital cycle one american
0:51asset management schools capital cycle is free to look at companies not on the
0:57perspective of their valuation whether they’re cheap or expensive on a p/e
1:03basis for price book basis that really to look at whether capital is entering
1:09into or exiting an industry and if you look at things that way sometimes you
1:14find businesses that look expensive but are actually quite cheap because they
1:21can sustain returns for a long time but more to the point
1:25investors often failed pay attention to the amount of capital that is being
1:31spent in an industry now take for the global mining industry or all the energy
1:37oil stocks recently over the last 10 years have been enormous searches in
1:43capital spending in both sectors and that surging capital spending three
1:49figured they’ve the collapse in prices in commodity prices but also the clouds
1:56and stock so if you look at things from a capital cycle respective capital
2:01flowing into or out of an industry you’re likely to be a better in
2:05the basic idea is that as capital flows into an industry supply of whatever that
2:11industry produces is going to go up very fast then the price of that thing is
2:15going to for a new one to be in winter pliers low and outweighs supply of high
2:21yeah I mean the principal is very simple as you expressed it entails a simple one
2:28shouldn’t really need to write a book on the definite time to simple in that case
2:33let’s discuss a few of these instances it will last twenty years that your your
2:42readers viewers might remember go back to the dot-com bubble in the nineteen
2:47nineties
2:49there was a surge of spending in technology in particular laying out
2:54fibre optic cables both in Europe and in the states and actually cross the
3:01crossing continents to that in the UK the world number of so-called
3:07alternative carriers will let listed at least businesses with huge capital
3:13funding needs now the same time we had the telecoms companies spending vast
3:18amounts of money on 3G mobile networks and so forth that surge in spending
3:25anticipated the collapse of the dot-com collapse in fact in determined the
3:31dot-com collapse in 2008 in 2000 2002
3:36you got to a situation then that of all the fiber optic cable that benlate
3:42something like 95% of it was excess capacity now move into the next decade
3:48you for surgery of a housing boom is sourced surge of spending on on on
3:55construction spending residential real estate not so much in the UK but
4:00certainly in in Spain and Ireland and in
4:03in dus what’s quite interesting about the USS example is that some very
4:08well-known investors in 2005 2006 started saying hey housing stocks us’
4:16housing stocks achieve their trading roughly book value this is the low range
4:23at which they had ever traded and you want to make you want to hold your nose
4:27and there may be problems in the housing market but you want to buy these now
4:32those talks on average fell roughly 75% from that point to their trough say for
4:40five years later so you could aboard housings dog of a perfectly respectable
4:45company that actually survived the real estate path you could have bought it at
4:50a very cheap value and still loss of $0.05 your money and the capital cycle
4:55argument is that what you should be looking for is not the valuation as a
5:00how much money had been sucked into these businesses in the run-up in the
5:05truth is that those businesses had been expanding their capital base by about 25
5:10percent per year for the previous five years writing and we see this time and
5:16time again the market’s encouraged and fund capital spending investors chariot
5:23on then things start turning turning down a bit and the value investors come
5:29in and say these stocks are cheap and then the value investors get completely
5:33wiped out so if you understand the capital cycle you you stand back from
5:38the from the sort of the madness of the crowds as things are being bid up but
5:43you also avoid that the great value traps which which which constantly
5:50hitting so-called contrarian or value investment and you also stand back from
5:54the demand story on the way out of this is the way that these these events as
5:59children Vestas that the supply side is rarely mentioned is mentioned is the
6:04ongoing demand
6:05yes you’re quite right extrapolation extrapolate that demand never add up how
6:12much supplies coming up
6:13the same time and this interesting point is that people I don’t quite know why
6:21they love to think that project demand future they loved I suppose because they
6:29like rejecting demands because demand is unknowable because it’s a noble then you
6:34can have any events you want about it at all optimistic or pessimistic but you
6:39know given the nature of mankind those would tend to be optimistic now people
6:44are huge amount of work goes into forecasting demand as our mutual friend
6:53russell Napier says analyst spent ninety percent of their time thinking in bed
6:58and forecasting tomorrow and 10 percent of their time thinking about supply but
7:04the interesting thing about supply it’s supply actually can be forecast it
7:08because it takes in most industries it takes quite a while for the supply to
7:14come on stream you can see how much assets have grown inside an industry or
7:18in inside any particular business are you can see it through any number of
7:23measures through IPO issuance through secondary shares winds through companies
7:28taking on more debt relief companies going through a boom such as the mining
7:33companies all the help us’ home builders who had a sort of surging profitability
7:37and have reinvested those profits you can measure it technically through
7:41things like looking at current capital spending to depreciation reaches or or
7:48you can look at it for instance again technically you can look at the rate of
7:53profitability reported profitability of the company to its up to its cash flow
7:59the so-called cash convert cash conversion rate and if the company is
8:03generating large profits but not generating any cash for it it’s probably
8:08in a negative things of the capital cycle to the point to get back to what
8:12you were saying is that investors if they knew the right way to approach
8:18would be thinking 90% bad supply
8:22and then fantasizing 10% about the complete or not quite completely but
8:28more or less completely under pooled demands they focus on something they can
8:33actually measure without me like they are patching it’s not a question just
8:43analyst its investment bankers as ever the investment bankers to mister the
8:50investor mean I’m sure your readers viewers know that their worst enemy is
8:55the investment bank not because he is a greedy bastard because we know he’s
9:00gonna bus it but what he really wants to do is to is to generate fees by raising
9:08capital and if you raise capital a new trick in any industry you returns will
9:15not decline at Citi Investment Bank and with the Broker incorporated in
9:21investment banking operations will serve as cheerleader leaders always to the
9:27kick into the capital raising process and will tend to be blind until after
9:32the fact that too much capital is being met Miss allocated
9:37what does this mean for the value investor the ordinary value investors
9:42usually wrong because they picked the wrong point in the cycle to invest yes
9:47and I think this is this is whether value investor has to have to show tiny
9:56bit more intelligence than she appears contrarian into the contrarian instances
10:07you know is we don’t have that the point is it’s a perfectly fine an admirable
10:15trait and we admire it today in like people who run with them but that a low
10:20alone is not enough to deliver you to protect your money what you have to do
10:25is be an intelligent contrarian and the telogen contrarian among other things
10:30will be looking to see how long the capital cycle takes to play hard to get
10:39back to get back to what we were talking about the USA home builders now the USA
10:45who whom building cycle ran for about five years on the upside I mentioned to
10:53you that the stocks were beautifully cheap in 2005 when they were trading at
11:01book and then the book disappear is great because now if you see it was
11:09obviously a bad time to buy stocks in USA 2005 how do you know it was a bad
11:18time then you can see you can see the cheap price but you’re intelligent
11:22contrarian what else do you see that says to you I know how to get there is
11:26no tell you to look this is now this is another area where if you remember the
11:32value investors got it wrong in 2000 around the time the global financial
11:37crisis is the typical value investor says he has is full of false modesty is
11:44I don’t know nothing about macroeconomics it doesn’t interest me I
11:50just know about stocks and so I just know about companies and blah blah blah
11:55I just analyze profit and loss accounts and balance sheets and so we’re actually
12:01a record time of financial crisis in case you hadn’t noticed there was a
12:09great housing bubble now everyone knew there was a housing bubble there was a
12:14remember one of the one of the analysts at the time provided information used to
12:20just provided a child to the number of mentions that has the housing bubble was
12:25the best known
12:27in in the world really apart from Ben Bernanke you didn’t know about it but it
12:35was very when in fact now that housing bubble had led to if you will what I
12:41call a fundamental bubble in the balance sheets of the of the homebuilders so
12:46they yes he’d reported huge mats profitability but they were illusory
12:51profits and you didn’t even really need to know that the nice thing about the
12:56capital cycle bridges ok you can be as dumb as a value investor or link if you
13:03will but Jesse I’m gonna look at companies and see how much they’ve been
13:08expanding their their assets and I get a look at them not just on an individual
13:14basis but I most look at their competitors to and if there’s been
13:19massive expansion of assets never mind how good the story is china or running
13:28out of oil or energy super cycle or god.com future it doesn’t matter how
13:35could the story it doesn’t matter whether the story pans out exactly as
13:40predicted as was the case with the dog comes to that and not with that say the
13:48commodity or the energy you need the energy at the peak oil leases to do try
13:53try not to pay attention to that just look only at the expansion about it’s
13:57now up to you and this not just my argument when I I added another book on
14:07the capital cycle the same people Meriton about ten eleven years ago and
14:13at the time when I was writing the introduction to that book I I looked
14:17around to see if there was any academic research on this subject of the
14:23relationship between investment and returns and the truth was hardly
14:26anything out there at the time but when I came to edit the new book and write a
14:32new introduction I actually found quite lot of new research from finance
14:38academics in the states and the gist of those findings are that there is an
14:44inverse relationship between investment or asset growth and future returns so we
14:52we all know when you said you should also know that everything else being
14:57equal growth dogs companies that sell on high price-earnings ratios and companies
15:04that sell high price to book deliver returns play the market average and corn
15:12is that so-called value stocks she stalks deliver above-average dance now
15:20you have to qualify that finding in the light of the new reserves which itouch
15:26porn in this book which is to say how how much investment has been going on
15:33because what we now side is the most of the value growth effect belongs to
15:38differentials in investments it’s not really to do with cheap
15:46investors expectations of growth and investors pessimism the used if you will
15:52the historic explanation of value growth a nominee is just aren’t investors date
16:03investors get carried away as they do get carried away but like most findings
16:08of behavioral finance is a rather facile observation and you need to get a bit
16:15deeper and I think if you go deeper you start thinking about differentials in
16:19capitals in capital spending the same thing ever to get carried away at times
16:27when they’ve heard the story about the demand and when the hearing the story
16:31about the demand
16:32that’s when the assets are growing and when the capital spending is happening
16:35so it’s something that is really what happening you can put it there if you
16:42want but I like thinking I don’t like to miss an opportunity to know they will
16:47finance people it partly because they they just to my mind there telling just
16:52so stories it’s it’s it’s sort of investment for dummies and it’s amusing
16:57you can give them an amusing talk about how in the investor’s expectations and
17:03delve into new psychological frailties and so that actually it’s not really to
17:10do with the business investment business investment yes it is obviously driven by
17:15human beings and human beings are frail and full of fully we all know that as
17:20you know which which which day with a very much on that theme but the more I
17:28think about it the more I think that what’s important is not investors expert
17:34expectations yes they are there but they’re really the the epic phenomenon
17:40the icing on the cake
17:41what you really need to do is to sort of breakthrough that I think and look at
17:45again go back to what I was saying is look in the instance of of the capital
17:50cycle it looking to look at the investment side because investors may
17:55have very high expectations they made me very valiant very bullish about a
18:02particular sector but if that sector has not attracted huge mad capital investing
18:09the chances are that those expectations is it boland expectations will be met
18:15now go back to France to the white give you any number of examples but get back
18:21to the home building
18:22is in the in the states in Ireland in in Spain there was obviously a lot of
18:29excited expectation about how house house prices in inflated house prices
18:36and you could you could describe that in in your way as a sort of investor rash
18:41and see but there was a huge investment response not yet when we looked at
18:46Island and Spain we found that I think I rations and Spanish excess whom building
18:55was roughly fifteen times and you’ll demand so you can see the huge glut of
19:04oversupply the build-up American overbuilding had been roughly five years
19:12we calculated that means just rule of fun and it took roughly five years to
19:16burn off that’s fair
19:18now look at the UK UK hat and and Australia for that matter they both had
19:23very similar bubbles in terms of house prices so you may view British house
19:31prices and Australian house prices they followed by the as far as I remember
19:35they went up higher the new s national crisis but in neither country was there
19:42is demand was a resupply response to take for instance the and I know but
19:48this is the field where I know when I first got into this in turn investment
19:54analysts business I was working for an investment bank in the city in the early
20:01nineteen nineties where and this was in the aftermath of the Great of a very
20:07serious housing bust
20:081980 and one of our clients tarmac had lost weight of money we were raising
20:14money for time I know what I and I started the UK market at the time and
20:20what you could see was a huge supply spots in the nineteen nineties to the
20:24rising house prices and then the subscript bus now fast-forward 15 years
20:30what happened the UK construction is this will the home builders were
20:37immensely consolidated just a handful of companies whether been hiding there
20:42let’s say fifteen or twenty builders large bids for the problem in about 45
20:47of note that any number of reasons it was very difficult to build to build new
20:55houses in the country now and this points to an interesting opportunity
21:01that was created I can identify it in retrospect is that there where is the
21:07USA where the USS homebuilders were value traps into even in 2008 going into
21:19the crisis in 2009 the you the UK Home Builders which had also collapsed in
21:26pricing is it take persimmon I’m looking at it stop it stop I think we’re better
21:32than I i think he went from about 15 pounds 23 pounds or something
21:37phenomenal collapsed but actually if you looked at persimmon and I and the UK
21:45homebuilding industry you see that that she had indeed any overdone capital
21:51cycle since these stocks recovered much better if you knew nothing about either
21:58of you know the the particularity that the USA homebuilders all the all the UK
22:04hopeful but you just looked at their asset growth you just said the capital
22:09cycle respective that the UK bill is where we’re in outstanding
22:15attractive and of course that turned out to be the case they were nowhere in
22:20sight with it