How To Invest

The Asia Report episode 5: The capital cycle and how it can boost your returns

Hello, everyone today we’re back for another episode of The Asia Report where I will be talking about the Capital Cycle. “Capital cycle” was coined by a very successful asset management firm called Marathon Asset Management, they’re based in the UK, they’ve been around for about three decades now. They’ve been implementing this framework for quite a while, and essentially what a capital cycle is, is that it simply dictates that capital is attracted to places where investors think that there’s a prospect of high return and it is repelled or leaves when investors think that there’s no returns to be made, and this inflow and outflow of capital is what also generates mean reversion ultimately in the end.

Let me just break that down a little bit. It’s a very simple idea but it’s extremely important to understand.

Investors have probably heard of this term called mean reversion again and again. We have seen it a couple of times, and I think the easiest illustration is to use the example with a bubble tea store. When you had your first bubble tea store, and the first person was making a lot of money, second person, third person and you see the long queues, you see the newspaper reports, and it led to an inflow of capital, in other words, investments from prospective investors and stall owners who wanted to ride onto the trend because they saw the chance to make profits.

The issue is that as more and more capital flows into the industry, what happens is that your supply increases. Your demand is probably still increasing at this point of time but at a point of time in the life cycle of the business, eventually this demand is outstripped by the increase in supply. Eventually, because there are too many stalls who are essentially doing the same thing and which lack competitive niche, returns in the industry go down.

Your return on equity in the business goes down, you have less customers, your profit margins are lower, and eventually people start to see this because they’re earning less or even losing money. Finally, capital leaves the industry, and industry starts to consolidate, stalls start to close down, and there’s a certain equilibrium which is finally reached. That’s when the cycle turns again. This is in essence the capital cycle.

I think most analysts are familiar with the property cycle, something that is quite prevalent now, conversation comes up a lot. Some investors are familiar with the credit cycle which is linked to the property cycle, but I think most people aren’t as familiar with the capital cycle.

One of the perils of being an investor is that up to I think 2007/2008, it was a badge of honour to say that you’re a value investor, you don’t care about the macroeconomic climate, you don’t care about the outlook, you just look at the bottoms up fundamentals of the business.

But this was a very dangerous approach to it because you saw a lot of very good value investors like Bill Miller, go in into the financial crisis buying housing companies or banks which was really a big favourite of value investors back then, see their investments getting evaporated because they had underestimated the impact that the macroeconomic climate had. Which was really very close to being a repeat of the great financial crisis of 1930s if Ben Bernanke had not intervened as forcefully as he did.

I think that you have to draw a distinction between macro forecasting which I look less favorably on to knowing where we are in a macroeconomic climate. I think it’s important to know when there’s risk-taking behavior, when there’s excessive leverage and exuberance in the system and to take a step back. I think that is necessary and it’s truly important helping you understand how to invest and seek a good business.

This applies to a lot of different businesses. In some businesses, they tend to be more cyclical in nature, and you can see the impact of capital leaving and entering in the industry more dramatically, I think the oil and gas industry is one such sector which is very obvious in the last couple of years. The property one is a much more slow-moving cycle. But understanding cycles is essential in understanding business just because you see it repeat itself again and again in many variations. One of the great things about the capital cycle, if you read a book which was published, it’s called Capital Returns which I highly recommend, is that one of its key tenets is that it’s much easier to forecast supply whereas demand, where people tend to focus their energy on and try to forecast, is essentially a lot harder. What I mean, let’s elaborate this, let’s say it’s a situation where there’s a shortage of supply in a certain material that you need to say build a car, you’re saying that, “Oh, as more cars come out, and demand of cars goes up, and so on and so forth the demand for this material will go up exponentially as time goes on.”

The problem is that, as long as people are always striving for the profit motive, they will find replacements, they will find ways to become more efficient in using the product. If you’re using rubber which is natural you might say, “Maybe we can find a synthetic rubber, maybe we can find alternatives.” The point is that demand is very hard to forecast.

Same thing when it comes to even property demand. Right now the government may have a set of immigration policies that could have dictated that it’s very favorable to immigration, but a new system, a new candidate may propose something else, as we can see in the case of the change in immigration policies and a shift against globalization when Donald Trump came in. The key point is, demand is hard to forecast. These are just two simple examples, they’re plain examples, the idea is quite clear.

Now, supply on the other hand is much easier to forecast, because it’s much slower-moving in nature. Let’s come back to this whole idea of the bubble tea store, right. Let’s say you decided to open a bubble tea store, you would at least have to sign a lease of a year or two at the very least, you’d have to spend money on training your workers, paying for machinery, taking a bank loan, etc. It’s not something that can be switched on or off very quickly. You can actually tell when the supply is coming online, factories are being built, buildings are being constructed. This takes time, and this supply doesn’t get turned offline very easily.

I think in the case of property is probably the easiest to see, if you look at 2012 to 2013, you can actually see a dramatic jump in the future supply of housing, generally in Singapore, in both public housing and private housing, but this did not have an impact on their prices immediately because it took time for this existing supply of housing to be built and to be delivered to the owners and the landlords. And the moment it did, you started to see the rent market actually being impacted, because suddenly as a prospective tenant, you were actually able to find substitutes. Just going back to this idea again, you should always be looking at supply and not demand.

For those of you who are quite devout students of Ben Graham, some of you may actually remember the interview where a couple of senators actually interviewed him and Ben Graham was obviously a very famous man back then. They asked him, “Do you think the stock market is too high? What is it that actually causes stock market prices to go up and down around this magical intrinsic value which you’re talking about?” And he said that, “This is a great mystery of the profession, we don’t actually know what it is.” But I think 20, 30, 40 years later, I think one of the things which we know now that really drives revaluation both up and down is actually mean reversion.

What mean reversion really is, in the stock price, and as one of the central tenets of value investing is that even though the market can be too optimistic or too pessimistic, eventually it always converges upon the intrinsic value in the end. What really changes this intrinsic value is actually mean reversion, changes in the conditions of the industry which lead to improvement in the earning power of the business or, in some cases, deterioration of the earning power of the business.

If you look at construction companies, you can see that there are periods of time where they’re winning a lot of government contracts, maybe there’s a lot of government stimulus in and the earnings power of the business improves and you have a mean reversion to what the business is actually able to earn. And you have periods of time of under-capacity where the business is not earning so much, maybe due to a lack of government contracts, and you can see that even though the assets are the same, the machinery is the same, the know-how is the same, you see much lower earning power, much lower earnings which translate to less dividends and a much lower valuation. I think these are just some of the things which the capital cycle really talks about. You heard me allude to this whole idea of there being a property cycle which you’re probably familiar with, the credit cycle which is really interlinked to the property cycle, and then the capital cycle which is really more industry-specific and business-specific.

These three cycles are really I think one of the big components which are missing from the frameworks of a lot of investors. I just like to elaborate one more time that when I talk about understanding these cycles, there’s obviously an element of forecasting where we are in the cycle, but at the end of the day trying to forecast the future of the cycle is going to be very hard, but what is very knowable is knowing where we are in a particular cycle.

Are we in a situation where there’s a lot of supply coming in? Are we in a situation where there’s lot of capital flowing in and people are generally being very aggressive? Or are we in a period of time where capital is actually exiting the industry? Or is it just generally not very even being very interested in the industry? I just came back from Yangon in Myanmar recently. If you just went back a couple of years ago, just read the news articles and a lot of the stock offerings and analyst reports, you can see that Myanmar was actually a very big growth story, people were hyping up a lot, plenty of capital flowing in. Today, a very much different story, even excluding what’s happening with the human rights disasters and the Muslim minority and all these things that are happening in Myanmar, even if you excluded all that, there was a period of cooling off because people were realizing that Aung San Suu Kyi coming in did not actually translate to a lot of things which they thought would be happening straightaway, making Myanmar a very business-running nation.

You can actually see small cycles happening, country-wide cycles, industry cycles. Even for smaller things such as even employment in certain sectors. If you look at 10, 15 years ago, you can see that the whole idea of being a programmer, being an engineer was very hot. A lot of people decided to pursue this profession. Then when economy turned and the dotcom bubble ended, you had a situation where there was an oversupply of a certain profession, and that led to very poor pricing power especially with the shift in immigration policies.

You can see that cycles really dominate our lives, not only in investing but in business, in our own personal lives and getting a hang and understanding these cycles I think is essential in understanding the business and the macroeconomic climate better, which in turn should also improve your understanding when it comes to investing, especially when you’re looking at very cyclical businesses such as property and banking in particular in Singapore.

Read more: Learn how to take advantage of the capital cycle to invest in deep value stocks, property conglomerates, and more

Tay Jun Hao LLB

Tay Jun Hao is the fund manager of the Heritage Global Capital Fund at Swiss-Asia Financial Services Pte Ltd. Tay Jun Hao graduated with a Bachelor of Laws (Honours) degree from University College London.

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