Book-review: Capital Returns, Ed Chancellore

A great read about industry cycles driven by investment activity (supply) rather than demand and a corresponding investment framework.

As in my previous book review I focus more on my learnings/insights/personal summary vs writing style etc. I liked the book very much! I read on my kindle and only had to read the funny ‘Annual Report drafts’ on a PC screen.

If you prefer to read the pdf version click here. (links may not work in pdf)


Capital returns makes very clear that high returns on capital more often than not attracts additional capital which usually leads to lower returns in the future, and that low returns results in capital leaving the industry which usually results in higher returns in later periods.

Specialized analysts tend to not see the forest for the trees. Ie, they treat a firm like an individual problem — because besides other reasons they posses specialized knowledge about the company — instead of looking at a greater sample size (base rates acc. to Mauboussin I believe)

The asset-growth anomaly describes a factor that explains higher returns for low-asset-growth industries and lower returns for high asset-growth industries.

Part I: Investment Philosophy

1 Capital Cycle Revolution

Evolution of cooperation. Cooperation can work. Economics students will remember the tit-for-tat strategy as a viable strategy in repeated games (of chickens). Likewise, it can work in some industries. In cars it usually does not work b/c of too much product specifications and extra features.

Cod philosophy is a great historic account of change. Cod was fished and eaten a lot for its desirable features (high protein, easy to fish, abundant). The fish was dryed and salted in small ports nearby the fishing grounds. When various technologic developments happend at once the structures changed dramatically:

  • steam boats needed much bigger capital outlays (pricing out many people), resulted in much higher volumes and were unable to dock in small ports (too big)
  • The sonar made the ships even more efficient
  • Refrigerators resulted in fish being processed within the ships, and yet more efficiency gains

This time’s no different refers to commodity cycles with high prices enticing a supply answer by miners (growth). And one never knows when the next economic slowdown will reduce demand.

Supercycle woes were coming in since higher returns on invested capital are attracting more capital.

No small beer describes how an M&A frenzy drowe industry consolidation and lead to higher margins, lower CapEx ratios, and ultimately to better reruns on capital.

Peak oil and major concerns tells the story of a prime example of high commodity prices being the best cure for high prices. The higher the price the higher managements willingness to invest in projects, and thus fixing their cost base on a higher level (per barrel). In such situations it can be reasonable to lower the Valuation on profits since a slightly lower oil price has an ever stronger negative effect on profits. The longer oil prices stay high and ROEs are at elevated levels, encouraging higher investments according to capital cycle theory, the bigger the risk of prices (and ROEs) coming down. Quality of recent projects coming on stream, we’re of lower quality vs legacy assets, they are technically more difficult to asses (lowering ROEs) and located in riskier locations (CoC+), thus making it harder to achieve ROEs>>CoC.

A capital cycle revolution introduces the fade rate (Holt/CS) during which periods companies will revert or are expected to revert to average returns on capital. The aim is to find good growth companies that resist the fade longer then implied by market prices (implied expectations) or God value companies that can improve their ROCs faster than implied. The mispricing is often the result of behavioral biases.

Good growth companies can be misprices due to durability of entry barriers, scale and scope of addressable market(s), management’s capital allocation skills, often investors are simply biased against good but ‘boring’ companies.

Candidates from the value universe can be better than implied due to reduced competition as weaker firms disappear, or a change to peaceful coexistence. Firms often leave the market at the lows, and throw in the towel improving ROCs for remaining competitors.

Growth paradox describes the fact that EPS grew less than GDP, due to Pro cyclical share net issuance, and private companies earning disproportionate profits w/o agent problems and short termism, and IPOs generally taking place at high prices.

2 Value in Growth

Warning labels aus against labeling anything value or growth.

Long game means if I want to invest for the long term that I must search for insights with a long shelf life that are consistent with my holding period and often relate to capital allocation decisions: advertising, marketing, R&D, CapEx, debt levels, share repurchases/issuance, M&A,… Next quarters earnings or margins are unimportant. Wall Street is highly skewed to short term insughts.

Double agents is about bribed middle men: common economics dictate that demand decreases with higher prices, except for some rare cases like luxury goods when higher prices induce higher demand. Purchaser’s agents or middle man can indeed demand more at higher prices, ie, when they earn a margin on costs, and thus result in higher margins and higher volumes.

Digital moats are often strengthened by earning low margins in the early days to maximize longterm profits via growth and limiting competition, thereby strongly limiting risks for the business.

Quality time means increasing one’s allocation to higher quality names, ie companies making use of the agency business model,

Escaping the semiscycle — which is a prime example of booms and busts with capacity entering inustry at peak ROCs driving it lower forward — were two niche players Analog Devices and Linear Technology and I believe I recently read both names in my last book (see here).

Value in growth is to be found if intrinsic value is higher than price, and this depends on a great many things. Labels such as value and growth AR enot useful.

Quality control.. Many quality companies have customers who do not primarily care for a low price when buying the product. It is often due to being embedded in  processes for businesses or it is a strong brand or an agency model: an agent sits between the business and the end-customer and cares for many things: safety, quality, reliability, availability, and making a profit (commission). The price is often merely a pass-through and only a small portion of the total bill.

  • Short term performance is driven by macroeconomic and company specific factors.
  • Benefits of investing in higher quality companies can only be observed over the long-term, in the short term it can appear dull and unrewarding.
  • We tend to be income statement focused and thus compare P/E ratios and growth rates. fcf yields, growth and capital returns really matter.

Under the radar companies often provide business to businesses services or sell goods and are thus less known to the public. Often they sell mission critical goods or services and thus customers are reluctant to switch providers to get a little price discount. Sometimes regulation prohibit changing suppliers, ie the fda having to rcertify a production process after changing a tiny part.

3 Management Matters

Food for thought arises from the fact, that many specialized analysts did not see the fall or Arhold coming. They often compared all the industry specific metrics against peers, but never questioned if the business might just be horrible compared to a Thai Cement business or Nordic paper mills, they obtain inside views, are often (too) close to management without ever questioning their incentive structure, and are likely to act in Herd behavior.

Cyclical missteps is the story of managers buying high and selling low. This relates to share repurchases/issuance (their own shares transactions sometimes show better and alarming timing), and M&A.

A capital allocator to be good, must understand his industry’s capital cycle to invest countercyclical. At Sampo, Björn Wahlroos proved to understand and drive the industry capital cycle, allocate capital in a countercyclical manner and dispassionately sold assets if others are willing to overpay.

Northern stars explains the success of many Scandinavian companies and their stocks. Good management plays a role as does low corporate taxes and unions that know good jobs will only persist if the company is financially sound and sussesful, and therefore are willing to let production be relocated to countries with lower wages (in contrast to Italy or France). Polulation in Scandinavia is tiny and thus foreign growth markets were early targeted.

Say on pay. Direct significant long-term share ownership by management is the best way to deal with the principle agent problem.

Happy families can bring stability to the ownership structure of a business, or focus on internal family fights and result in a disaster for performance. Risk can result if the founder was successful because of connections to politics which might ultimately revert, ie when (s)he exits the company or dies.

The wit and wisdom of Johann Rupert. If CEOs do not know how to effectively deploy capital it will weigh on our long-term returns.

A meeting of minds. Too often managers mistake a shortterm target — ie EPS or ROE — for strategy. Real strategy, wether military or commercial,  involves and assessment of the position one finds in, the threats one faces, how one plans to overcome them, and how opponents might in turn respond. Appearances can provide insights on character:

  • An industrial CEO waering expensive shoes, suits, might enjoy spending time with investment bankers instead of visiting factories and clients
  • Corporate travel policy can offer insights on cost discipline, or the lack thereof
  • CEOs that delegate presenting/talking about an underperforming segment do not take responsibility
  • CEOs bringing many IR officers to meatings, treat carefully
  • CEO, CFO, or IR people knowing many attendees of investor presentations by first name. This means they are interested in investors and know who can buy there share. Often they are promotional at the same time (from 4.1).

Culture vulture. Good cultures can be a strong intangible asset and bad ones can be a company’s undoing (ie AIG). 

  • Some companies thrive by spending more, some by reigning in costs (esp. when coupled with decentralized profit sharing schemes)
  • Looking at glassdoor reviews can provide valuable information.

Part II: Boom, Bust, Boom

4 Accidents in Waiting

Accidents in waiting: meetings with Anglo Irish Bank and written notes thereof tell an interesting story. Anglo Irish’ business model is lending to property owners at rather high interest rates. The interest payments seem rather secure if the tenant (ie Mc Donald) is solvent, but the principal repayment is much more risky and depends on the property market in, say 10yrs. The ‘competitive advantage’ ;was to approval loans quickly.

The builders’ bank was involved in speculative finance (borrowers can only serve interest payments with their current Cashflows), but not in hedge finance (interest and principal repayments covered by CFs), and not yet in ponzi finance (not even interest covered), acc. to Minsky. Such a business model tend to work well in falling interest environments.

Insecuritization. Securitization resulted in much too cheap capital, delaying the normalization of returns on capital for affected companies and industries. Ie, airlines, bought discounted aircrafts, put them into SPVs receiving cash, these SPVs issued tranched certificates secured by lease payments and the senior ones by the asset. Airlines could immediately book a profit when buying an airplane. Some mortgage brokers in the US played a similar game. Many sub-prime mortgages were easily sold on from brokers without a big discount. This was, because they were repackaged and securities, and the final buyers were money that didn’t care for the mortgages’ underlying economics.

Carry on private equity. European PE deals experienced a strong upcycle in the early 2000 resulting in ever higher multiples and leverage, driven by low interest rates, and historically low credit defaults (rear view mirror argument). Further, privat firms escape the heavy burden of regulation, managers compensation and restructuring measures are easier to implement. Though, many new principal agent problems arise. Record amounts of PE money raised was planned to be invested within three years after raising funds (fund targets), and skillful investment bankers drove prices higher via auctions. PE careers were the most favorite route for MBAs, a reliable contra indicator. IBs often have the upper hand over credit officers generating big fees today: Banks advising on a sale and offering credit to the acquirer is a big warning sign.

Blowing bubbles. Several indicators signaled speculation and a émarket peak.

Pass the parcel was a game Svenska Handelsbanken was not participating in. It had a policy to only enter into loan agreements if it is willing to keep them on the book. It came through the 1990 banking crisis unscathed. Others were playing the parcel game, by securitizing loans and sell them off.

Property fiesta is about the Spanish property bubble. Property firms share prices rocketed, and more were IPO’ed. Interest rates were artificially low thanks to the EUR. In a country where it is difficult to pay with a 50 or 200 Euro note, it was believed that a quarter rof all 500 Euro bills were fluctuating within Spain, mostly within the property sector that has murky relations with local politicians.

Conduit Street tells the story of banks, particularly banks in the competitive or over banked German market often relying on cheap funding through explicit and then implicit state guarantees (EU ended it). IKB is one of the highlighted cases. As many other banks it used domestically unregulated off balance sheet special purposes vehicles (conduits). Since management was incentivized on annual ROE targets these were perfect means using little capital. And, management held little equity stakes skewing incentives negatively.

On the rocks tells the story of Northern Rock, which went under due to boring short and lending long, to the risk of a credit crunch. Northern Rock’s young CEO was atypical and appeared a bit too clever.

  • Innovation in capital markets and the pursuit of fee-driven approaches (…) shift risk to those least capable of evaluating it.

Seven deadly sins tells the story of Svenska Handelsbanken sailing through the GFC. Svenska has many other good features, ie the employee profit sharing scheme which receives a share of the extra profits above a peer roe average limited by the level of dividends paid and only is disburse dto employees at the age of 60. No matter if one worked as CEO or security guard. I like that and remember my banking apprenticeship at a bank where even the cooks where employed at the bank instead of being outsourced, and, of course, participated at carnival and xmas parties etc.

  1. Imprudent asset liabily mismatch, ie borrowig short and lending long.
  2. Supporting asset liability mismatches, ie duration btw loan and asset or FX
  3. Lending to bad customers that won’t pay. Instead lending to good or even rich clients, on the basis of good long relationships.
  4. Reaching for growth in unfamiliar areas, ie FX lending in CEE, with ‘low’ interest rates but considerable exchange, and thus default risk. Instead, Svenska was easily hiring good branch managers in mature western markets who often brought their best clients and colleagues with them, since they had enough of their old employers’ centralizing tendencies.
  5. Off balance sheet lending. The other rule is onyl to accept risks when prepare to hold on its BS until maturity, ie no securitization and origination business.
  6. No ponzi schemes. Things can look less risky than they are simply because all the willing lenders act in happy groupthink and provide the credit creating the good conditions rather themselves. Good players often lose market share in frothy times.
  7. Relying on the rearview mirror too much, ie VAR models with limited historical data. Another approach is to use historical scenarios that were truly worst case scenarios or at least rather close.

5 The Living Dead

Schumpeter’s notion of create destruction play or should play a strong role in economic cycles. Politicians often don#t allow it to work its magic, and thus capital cycles might just not happen as we envisioned.

Right to buy was in 2008 as many indicators suggested that the market was in buying territory.

Spanish deconstruction lists some untimely corporate acquisitions at the cycle peak often funded by cheap accessible debt.

PIIGS can fly. Some Irish businesses thought about being listed in Ireland might depress their public market valuation and relisting elsewhere might help. Between many bad businesses in Ireland they found a ferry operator they wanted to buy.

Broken banks as the current and future situation in Europe. In  essence,  the  capital  cycle  is  not  working  in  the  banking  sector  in  Europe, because the creative destruction that is required is politically unac-ceptable.

Twilight zone. Buying depressed European businesses at fractions of replacement value might not work out well if there is no path to better ROEs. Then, looking at businesses with healthy ROEs already that are sold off with the overall negative sentiment might be a better alternative.

Capital punishment

Living dead. Lower interest rates warrant higher P/E multiples but we must not forget why interest rates are low in the Foret place, namely low growth, high leverage, the GFC,…, and thus lower PE ratios are warranted. Western markets might experience a lost decade. Low return firms love on helped by artificial low interest rates.

Relax, Mr. Piketty. Low interest rates entice investors into higher yielding riskier investments (Marks’ uses the carrot and the stick analogy when the cat climbs higher in the tree). These various modest yield pick-up often destroys accumulated wealth in the next crisis.

6 China Syndrome

Oriental tricks. Chinese IPO candidates often reach their highest margins and returns of capital around the time of IPO. Afterwards they decline. Many IPO candidates had questionable corporate structures, special vehicles for the IPO with some assets staying with the former company, etc.

Dressed to impress. Many Chinese IPOed companies use their cash to buy assets, ie land, from local governments, or for other questionable growth, like lengthening the receivables terms for their clients, telecoms.

Game of loans in China means the state’s economic growth model mostly relies on the optionality of loan repayment, and political decisions which goal to pursue via which SOE or privately listed entity. Growth is achieved via ever higher input factors not better capital efficiency. This is true für the overall economy and for specific businesses which dilute shareholders since listed companies cannot rely on loan forgiveness.

What lies beneath refers to the difference between ppearance and reality in China. IPO prospectuses touting high ROEs (appearance) often fail to highlight the role of high leverage needed to propel low returns on assets. Artificially low funding costs bring the risk of falling profits if interest rates normalize.

Value traps is likely the right classification for the big Chinese banks, who’s high ROEs would appear modest if adjusted for likes too low credit costs provisioning and leverage ratios too high. Further, systemic risks appeared elevated in China.

Devil take the hindmost. State media is sometimes propelling stock market frenzies, margin loans were allowed being responsible for large trading volumes, and brokerage business is rocketing. Mainland China prices are even more elevated than HK equivalents, but that must not mean that the HK listings are anywhere cheap.

7 Inside the Mind of Wall Street

The very business of investment banking is to provide capital to whatever sector is hot, currently. Thus, the effects can be very detrimental to longterm investors.

A complaint is a funny fictional read about a business complaining about the analyst’s questions about incentives, governance, unprofitable growth, etc.

Private party tells the story of investment banks bringing very much too high leverage financing to PE shops, and even bring the deals, since they generate big fees and sell off the debt (passing the hot potato).

Christmas cheer tells a story of PE shops earnings outsized fees for nothing (or even worse, that is horrible performance). And a proposal aka Christmas letter to the current FED chair and former GS colleague to use his connection to build the next fee gushing PE scam utilizing all these US government dollars to build infrastructure.

Former Greedspin boss flees China reminds us of China frauds.

Occupy Bundestag mentions German corporate lobbyism.

Season’s greetings entertains the reader with a great Annual Report draft, in which the ‘deleted’ words are the most important.

Lunch with the GIR paints the picture of a guy we should not do business with.

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