Learnings from the Giants

Capital Cycle Investing: Figuring out the Fade Rate

Reading about how other successful investors have, over the years, threaded their path ends up uncovering some fresh insights. And even if many a times these insights are not as ‘ground breaking’ as others, these offer interesting perspectives to look at existing realities. They helps us by way of broadening our worldly understanding of the events around us.

For example, Graham’s way of looking at market fluctuations have added a new dimension to our understanding about market movements. No longer are we avoiding volatility. Rather, we are seeking to reduce the chances of permanent loss of capital. And volatility, in many ways, is a core driver of our overall returns.

Similarly, Buffett’s calling to sometimes pay up for certain kind of businesses has helped us to embrace entities with hard to replicate advantages. His concept of ‘circle of competence’ has ensured that losses due to one’s ignorance are minimized. And Munger’s system of multi-disciplinary thinking promises us of reaching places which otherwise was unthinkable.

Left upon us, harvesting such deep in-sights would have easily taken a lifetime of trial and errors. As Newton once said we are truly ‘standing on the shoulders of giants’.

 

Capital Cycle way of investing

Recently, I was reading ‘Capital Returns’ – an impressive collection of essays written by Marathon Asset Management over 2004-2014. In one of its chapters, they discusses their core investing framework. It goes like this:

Marathon looks to invest in two phases of an industry’s capital cycle. From what is misleadingly labelled the “growth” universe, we search for businesses whose high returns are believed to be more sustainable than most investors expect. Here, the good company manages to resist becoming a mediocre one. From the low return, or “value” universe, our aim is to find companies whose improvement potential is generally underestimated. In both cases, the rate at which a company reverts to mediocrity (or “fade rate”) is often miscalculated by stock market participants. Marathon’s own experience suggests that the resultant mispricing is often systematic for behavioural reasons.

This chart conveys the above para beautifully –

Capital Cycle approach to investing
Capital Cycle approach to investing

Notice that they do not get themselves tied with the conventional way of ‘growth vs value’ investing way of thinking. At times, they become growth investor without paying up for growth and at other times they turn into value seekers. At both the times their expectations are higher than that of the market which presumably is on the pessimistic side.

 

Expectations Investing Vs Capital Cycle Investing

One can draw parallels between this and ‘expectations investing’ which Michael Mauboussin has effort-fully explained us over the years. Essentially, he says that successful investing is about figuring out those situations where market’s expectations are pessimistic than what a rational mind would expect. And also avoiding those where expectations are going through the roof!

But at one place this theory diverges from mainstream investing. While expectations investing could be applied to every kind of company, capital cycle approach deals with more or less those areas where rules of capital cycle applies. That is to say that franchise companies where in excess returns do not converge to average rate of return over very long periods are more or less left out of the investing universe. Guys at Marathon refer to them as situations where in ‘capital cycle breaks or cease to operate’

In a way, this theory excludes those fertile hunting grounds based on which Buffett has built $450Bn worth Berkshire over more than half a century!

Another point at which this theory departures is that on number of stocks to be held within a portfolio. Marathon says that they are looking to bet on an industry which looks well placed to benefit from a cyclical upturn. Hence, while individual companies matter, but what they are more concerned is with their portfolio’s exposure to a particular sector.

Invariably, this means that although their ideas may be concentrated on few events unfolding at the industry level, their portfolios are diversified. Nothing wrong in this. Only problem is that the effort required to be spent on managing a portfolio goes up as the number of stocks in it goes up. Those nagging company specific issues does consume our limited ‘mind share’

What compounds the problem further is that there are limited number of sectors in an economy and each of these are not investible at all points in time. That means one needs to look at multiples countries and multiple sectors there in. This widens the landscape sufficiently. However, it also means that now one is dealing more often in unfamiliar terrain. And getting one well acquainted to each of these is not easy. Also, dealing with multiple currencies has its own set of challenges.

Ability (and conviction) to concentrate on a limited number of stocks is advantageous in multiple ways.

Despite all of the above differences, capital cycle approach is worth understanding and Marathon’s collection of essays are worth reading. Given the challenges they face, the efforts they undertake while investing in broader geographical markets and their experiences there in are worth meditating.

 

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