Capital Cycle is an interesting concept. In the field of investment analysis, capital cycle is used to understand how the amount of capital invested in an industry will impact the future returns from that industry. In other words, capital cycle approach analysis helps to determine how the competitive position of a company will be affected by the supply in that industry.
The capital cycle approach is useful to eliminate the problems caused in the long run. Usually, investors or business owners are too transfixed with the growth prospects, and emphasis on demand that they ignore the changes on the supply side. The growth rate in good times is extrapolated into the future, without giving due importance to the changes in supply. This is when capital cycle comes into picture.
Capital Cycle approach works from the supply side. It forecasts the supply in the future, which is a less challenging activity. Decisions are made based on the basis of supply forecasts. Basically, capital cycle approach prevents the investors from getting into the traps of growth, value and demand and keeps them realistic by working on supply.
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The Capital Cycle approach has been explained in detail in the book ‘Capital Returns: Investing through the Capital Cycle: A Money Manager’s Reports 2002-2015’ by Edward Chancellor. A short extract from the book will give you a better idea into the capital cycle approach.
“High current profitability often leads to overconfidence among managers, who confuse benign industry conditions with their own skill – a mistake encouraged by the media, which is constantly looking for corporate heroes and villains. Both investors and managers are engaged in making demand projections. Such forecasts have a wide margin of error and are prone to systematic biases. In good times, the demand forecasts tend to be too optimistic and in bad times overly pessimistic.
Thus, the high growth and demand forecasts are to the extremes and do not come true in most of the cases. This is because the circumstances change and the current scenario cannot be extrapolated into the future at most occasions.
High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow – perhaps they are equally hubristic, or maybe they just don’t want to lose market share. Besides, CEO pay is often set in relation to a company’s earnings or market capitalisation, thus incentivising managers to grow their firm’s assets. When a company announces with great fanfare a large increase in capacity, its share price often rises. Growth investors like growth! Momentum investors like momentum!
Investment bankers lubricate the wheels of the capital cycle, helping to grow capacity during the boom and consolidate industries in the bust. Their analysts are happiest covering fast-growing sectors (higher stock turnover equals more commissions.) Bankers earn fees by arranging secondary issues and IPOs, which raise money to fund capital spending. Neither the M&A banker nor the brokerage analysts have much interest in long-term outcomes. As the investment bankers’ incentives are skewed to short-term payoffs (bonuses), it’s inevitable that their time horizon should also be myopic. It’s not just a question of incentives. Both analysts and investors are given to extrapolating current trends. In a cyclical world, they think linearly.
In this way, capital cycle approach helps to keep the market grounded. The supply aspect is not ignored and the demand aspect is not unnecessarily highlighted. This makes the approach quite practical.
The Macro example also shows the lag between a rise in capital spending and its impact on supply, which is characteristic of the capital cycle. The delay between investment and new production means that supply changes are lumpy (i.e., the supply curve is not smooth, as portrayed in the economics textbooks) and prone to overshooting. In fact, the market instability created by lags between changes in supply and production has long been recognised by economists (it is known as the “cobweb effect”).
The capital cycle turns down as excess capacity becomes apparent and past demand forecasts are shown to have been overly optimistic. As profits collapse, management teams are changed, capital expenditure is slashed, and the industry starts to consolidate. The reduction in investment and contraction in industry supply paves the way for a recovery of profits.”
Therefore, it is critical for an investor to be aware of the capital cycle. The investors invest in a company with good track record in terms of growth and share prices. After a certain period of time, the company starts facing minor problems which grow bigger and affect the growth, profits and share price negatively. This explains that the past growth and record of a company cannot be extrapolated into the future, which can be attributed to the capital cycle.
If the investor is unaware of it, he may keep blaming himself for not being able to see what was coming. The truth is that every company and stock undergoes cyclical changes in terms of economy. Every new entrant in the industry gives optimistic hopes to the investors, with time the competition causes the company to decline and the company underperforms. At the time of decline in business, the investors become pessimistic, but soon the supply side improves and the returns increase, causing the shares to outperform.
Thus, it is necessary to understand the capital cycle and accept it, to be able to get absorbed into the normal cycle of investing and business.