Insights

When investing in businesses with limited to no entry barriers, an important framework to pay attention to is the capital cycle theory – For a detailed discussion of the framework, please refer to Capital Account: A Money Manager Reports on a Turbulent Decade by Edward Chancellor. The diagram below summarizes the framework.

Capital Cycle Framework. In essence, the process goes as follows:

• High returns on capital earned by an industry with limited to no entry barriers attract new entrants. Entrepreneurs allocate an increasing amount of capital to such businesses driven by simple economics – the cost of setting up new capacities is much lower than the price markets are willing to pay for them as investors are optimistic in this part of the cycle. Stock prices set up peaks for the cycle.
• As new supplies come online, they progressively drive returns on capital lower as the demand-supply gap starts tilting towards excess supply. Stock prices underperform as investor expectations of continued strong cash flows and earnings fail to materialize.
• As returns on capital decline well below the cost of capital, it leads to consolidation, business exits, and bankruptcies. The length of time that this part of the cycle takes depends on the extent of excesses from the upcycle and the extent of exit barriers.
• As the oversupply clears itself and we move back to a favorable demand-supply gap, returns on capital rise above the cost of capital. Investors are positively surprised as cash flows and earnings outperform the depressed expectations. As a result, prices outperform.

Tools to decipher the capital cycle. There is no single process to determine the state of the capital cycle. It is easy to see and classify things in the past – hindsight is always twenty-twenty. It’s a different ballgame when we are trying to put our fingers on the current state of affairs.

The analyst has multiple tools at his disposal when trying to understand where we are in the cycle. We summarize some of the important ones that apply across businesses below.

• The Reinvestment Ratio – Capital expenditures divided by Depreciation. At its core, depreciation expense is a way to create a reserve for businesses to replenish their capital investments. Suppose a company isn’t spending enough on capital expenditures to offset the depreciation of its assets. In that case, chances are that the business is underinvesting and is in the process of self-liquidation. Note that it isn’t a foolproof ratio – you still need to understand the specific mechanics of the business and industry.We can use this ratio as an indicator of where we may be in the capital cycle. Periods of investor optimism and the upcycle are associated with the reinvestment ratio rising toward excessive highs. Troughs in the ratio are usually indicative of the industry being in the middle of the down cycle.The chart below shows the reinvestment ratio for metals, minerals, steel, and aluminum companies globally. Geek’s note: There is some survivorship bias in how we have put this together. We pulled up historical data for all companies having a market capitalization of US$2 billion or greater. Then, we took the total of all of their capital expenditures and D&A (depreciation and amortization) to calculate the ratio for the sector. As there would have been companies historically that were large but didn’t exist on the date of construction of the index (March 2022), there is a survivorship bias in here.

• Commodity prices over the long term. Another way to assess the positioning in the capital cycle is to look at the underlying commodity price in relation to its inflation-adjusted price over an extended history over three-plus decades. Take a relook at that chart of the Reinvestment Ratio above. Over the past 40 years, three capital cycles have occurred: 1980 to 1993, 1993 – 2003, and 2003-2020. We hypothesize that throughout the complete capital cycle, the return on capital earned by all businesses in the industry is likely to be closer to the cost of capital – take a relook at the capital cycle diagram if you want to understand this better. The return on capital earned by commodity producers is an outcome of the underlying commodity price, e.g., a higher oil price will lead to a higher return on capital for Oil Exploration & Production companies and vice versa. So if the returns on capital over the entire capital cycle for all businesses average close to the cost of capital and the return on capital earned by these businesses is driven mainly by underlying commodity prices, it follows that average commodity prices over the entire capital cycle represent the prices needed for the industry to earn the cost of capital, i.e., the long-term equilibrium price. By looking back at a historical record encompassing multiple capital cycles, we improve our chances of correctly arriving at that equilibrium price. The inflation adjustment is meant to adjust for the impact of inflation on the overall cost structure of the firms. The chart below shows inflation-adjusted prices for crude oil over the past five decades. Our estimate of the inflation-adjusted average price for crude oil is $72. When above it, the industry is likely over-earning, while when below, the sector is likely under-earning.

• Again, note that this isn’t a foolproof process either. It holds only if there haven’t been significant changes in the production processes, overall demand, or overall supply cost curve. For example, opening the Saskatchewan basin in Canada resulted in a much higher potash supply growth. The result – potash prices stayed below their historical mean levels for an extended period of nearly two decades.
• New project announcements. Another tool that the analyst has is the announcement of new projects. By keeping a running tally of all new projects under development, the analysts can develop a model for oncoming supply response. Of course, the time it takes for a supply source to come online from the date of its announcement is dependent on the commodity itself. For example, while it takes about two to three years for a new nitrogen supply to come online, potash mines take five-plus years to develop.

So, where in the capital cycle are we for commodities? The reinvestment ratio peaked in 2012/2013 at well above 2x, indicative of the peak phase of the upcycle. Between 2016 and 2020, the ratio declined and stayed towards the 1 – 1.2x zone, indicative of the industry being in a downcycle and having to optimize capacities. Not surprisingly, this period was associated with capacities shutting down and development projects being shelved across many of these industries. The last couple of years have seen a moderate uptick in the ratio, suggesting the recovery part of the cycle has taken hold.

Note that the reinvestment ratio is well below previous peaks, suggesting that we are not yet in the peak cycle. Similarly, while most commodity prices shot up materially between 2020 and 2022, most stopped near +1 standard deviation levels and did not spend much time near those levels. At the same time, financial market participants are unwilling to supply capital for most commodity projects driven by ESG constraints. The result is that we haven’t had a significant supply response.

It means that the commodity cycle may have some time to run, i.e., commodity prices will likely stay in the zone where businesses will earn returns well above the cost of capital. Note that this doesn’t mean that stock prices will outperform – that will depend on the prices investors pay in relation to those businesses’ excess returns on capital.

Over the next few months, we will present some sector and company analyses highlighting the process we utilize for evaluating such businesses. Studies presented in this series are relevant primarily to the Global Select Value Fund and similar strategies.