• “Marathon Asset Management will shortly celebrate its 30th birthday. Over three decades, our investment philosophy has evolved, but two simple ideas about how capitalism works have always been paramount. The first notion is that high returns tend to attract capital, just as low returns repel it. The resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways - what we like to call the capital cycle. Our job has been to analyze the dynamics of this cycle: to see when it is working and when it is broken, and how we can profit from it on behalf of our clients. The second guiding idea is that management skill in allocating capital is vital over the long term. Picking managers who allocate capital in sensible ways is crucial to successful stock selection. The best managers understand the capital cycle as it operates in their industries and don't lose their heads in the good times.” - intro

The Capital Cycle

• “Typically, capital is attracted into high-return businesses and leaves when returns fall below the cost of capital. This process is not static, but cyclical - there is constant flux. The inflow of capital leads to new investment, which over time increases capacity in the sector and eventually pushes down returns. Conversely, when returns are low, capital exits and capacity is reduced; over time, then, profitability recovers. From the perspective of the wider economy, this cycle resembles Schumpeter's process of "creative destruction" - as the function of the bust, which follows the boom, is to clear away the misallocation of capital that has occurred during the upswing.” → cyclicality in real estate asset types ie Zeckendorf’s Montreal office delays
• “Here's how the capital cycle works. Imagine a widget manufacturer - let's call it Macro Industries. The firm is doing well; so well, that its returns exceed Macro's cost of capital. The firm's CEO, William Blewist-Hard, has recently featured on the front cover of Fortune magazine. His stock options are in the money, and his wife no longer complains about being married to a boring industrialist. Of the nine investment bank analysts who cover Macro's stock, seven have buy recommendations and two have holds… Macro's strategy department anticipates strong demand growth for its products, especially in emerging markets where widget consumption per capita is less than one-tenth the level found in the advanced economies. After discussions with the board, Macro's CEO announces his plans to increase manufacturing capacity by 50 percent over the next three years in order to meet growing demand… Macro's shares rise on the announcement. Growth investors have lately been buying the stock, excited by the prospect of rising earnings. Five years later, Bloomberg reports that Macro Industries' chief executive has resigned after longstanding disagreements over corporate strategy with a group of activist shareholders. The activists, led by hedge fund Fantastic Investment, want Macro to shutter underperforming operations. Macro's profits have collapsed, and its share price is down 46 percent over the last twelve months. Analysts say that Macro's problems stem from over-expansion - in particular, its $2.5b new plant in Durham, North Carolina, was delayed and over budget. The widget market is currently in the doldrums, suffering from excess supply. Macro's long-established competitors have also increased capacity in recent years, while a number of new low-cost producers have also entered the industry, including Dynamic Widget, whose own shares have disappointed since its IPO last year. The market for widgets is suffering from the recent slowdown in emerging markets. China, the world's largest consumer of widgets, has vastly expanded domestic widget production over the last decade and has lately become a net exporter. Macro is reportedly considering a merger with its largest rival.” - the ups and downs of a capital cycle (As supply surpasses demand, goodbye pricing power)
• “The ups and downs of this fictional widget manufacturer describes a typical capital cycle. 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… In good times, the demand forecasts tend to be too optimistic and in bad times overly pessimistic. High profitability loosens capital discipline in an industry. When returns are high, companies are inclined to boost capital spending. Competitors are likely to follow… 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!” - the incentives are misaligned - “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 sexy 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.”

Avoid Competition Like the Plague

• “From the investment perspective, the key point is that returns are driven by changes on the supply side. A firm's profitability comes under threat when the competitive conditions are deteriorating. The negative phase of the capital cycle is characterized by industry fragmentation and increasing supply. The aim of capital cycle analysis is to spot these developments in advance of the market. New entrants noisily trumpet their arrival in an industry. A rash of IPOs concentrated in a hot sector is a red flag; secondary share issuances another, as are increases in debt.” → Basically, as Sam Zell would say, avoid competition like the plague (he got his start in student housing for college towns)

  

• The big winner cities of Covid, like Austin and PHX, are now suddenly oversupplied and seeing significant drops in rental rates! Inversely, markets like Springfield MA and Rochester NY saw no supply increases and thus their rental rates are increasing now 5-8% (RealPage analytics)

• Zell: “Frankly, there’s no substitute for limited competition. You can be a genius, but if there’s a lot of competition, it won’t matter. I’ve spent my career trying to avoid its destructive consequences. Competition skews people’s assessments; as buyers get competitive, the demand for assets inflates pricing, often beyond reason” → aka euphoria or the winner’s curse

• “All too often, high returns attract capital, breeding excessive competition and overinvestment. In recent years, for instance, there has been an epic burst of capital spending in the field of resource extraction.” - the winners of today become the losers of tomorrow - they share the story of the boom and bust of the cod market, which was hyped up ever since the 16th century because of its high protein contents and presence in the Boston harbor, but over time they overinvested and suffered from lower prices as technology (food freezing and better fish trawlers) allowed other areas to catch cod, thus increasing supply

The Grave Dancer

• Sam Zell is really the embodiment of these ideas, as he was labeled the grave dancer because of his ability to spot supply-demand imbalances and show up to the scene right when investment has tanked or prices have fallen → “The turn in the capital cycle often occurs during periods of maximum pessimism, as the weakest competitor throws in the towel at a point of extreme stress. When the pain of losses coincides with a depressed share price, investors can find wonderful opportunities, particularly if they are willing to take a multiyear view and put up with short-term volatility.” (You must adopt is zig when others zag mentality and avoid the allure of FOMO)
• We’ve noticed in the past this is why cash is king, because people like Buffett can be patient and get great deals in the middle of economic disasters

Telecoms & the Dotcom Bust

• “During the tech boom, many telecom companies operated on the mistaken assumption that Internet traffic was doubling every 100 days. This forecast was used to justify enormous capital spending by the likes of WorldCom, Global Crossing, and a host of long-forgotten "alternative carriers"... After the bubble burst, the misallocation of capital was revealed and, for several years afterwards, telecom networks were plagued with massive excess capacity (known as "dark fiber," as much of the networks' expensively laid fiber optic cable remained unlit.)” - Telecom capital cycle where Google came in later to buy this excess capacity for cheap