In common with many value investors, I spend most of my time analysing individual companies and very little time thinking about the economy or economic cycles.
I now realise that this is a mistake and that being aware of economic cycles, and the capital cycle in particular, could improve my investment returns.
The dangers of ignoring business cycles
A handful of my investments in recent years have been in the supermarket and commodity sectors and most of those investments have performed badly. An example would be Tesco, whose shares I recently sold.
It became obvious that there was a recurring pattern:
- I find a company with a good track record of growth and shares that are attractively priced
- The share price is attractive (i.e. low) because the company has recently run into what appear to be minor problems
- After a period of time, the minor problems become much worse and the company’s revenues, earnings, dividends and share price decline, sometimes dramatically
- It becomes clear that the company’s past growth will not be replicated in the future anytime soon and that the investment has become a value trap
Since I believe in the principle of continuous improvement I have spent a lot of time looking for some kind of signal or evidence that would have warned me that these investments had a high risk of becoming value traps.
Thanks to a bit of luck I think I have at last found something which could be the missing piece to this particular puzzle, and it’s called the capital cycle.
A brief introduction to the capital cycle
The economy is cyclical and that cycle is made up of other interacting cycles including the credit cycle, the sentiment cycle and the capital cycle, also known as the capital expenditure (capex) cycle.
I was reminded of the importance of the capital cycle by a presentation given by Edward Chancellor for the CFA UK earlier this year. The talk was based on his book Capital Returns, which is in turn based on a collection of letters from Marathon Asset Management to their clients.
As I watched the presentation online last Saturday it gradually dawned on me that the capital cycle could be just what I was looking for.
A short extract from the book should give you a good idea of what the capital cycle is all about:
“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.”
Or pictorially, from the same book:
So when a lot of capital is invested into an industry, either through increased capex or by the entrance of new competitors, the result is a lot of supply and a lot of competition, both of which tend to reduce returns on that invested capital.
But what does that have to do with my underperforming supermarket and commodity sector investments? I’ll try to explain using Tesco as an example.
Tesco is an example of the expansionary phase of the capital cycle
When I bought shares in Tesco in 2012 it had an impressive record of steady growth, which is exactly what I like to see:
Back in 2012, I didn’t look at capex at all; it was just not on my radar at all. However, about two years ago I did start looking at capex and, more specifically, the ratio between a company’s capex and its post-tax profits.
This ratio is an important metric for me now because many capital-intensive companies:
- Have higher fixed costs, which can make their profits and cash flows more volatile
- Have to invest large amounts in new capital assets in order to grow, which can be a drain on cash and often involves taking on debt
This is how Tesco’s capex and profits looked in the run-up to 2012:
Clearly, Tesco was investing more each year in capex than it made in post-tax profits. You can also see the impact of the financial crisis when capex was cut dramatically after 2009.
During that period Tesco:
- Made £17.0bn in post-tax profits
- Spent £28.9 billion on capital investments
This gave Tesco a ten-year capex ratio of 170% in 2012. I consider anything above 100% as “high” and Tesco was investing far more in capital assets relative to its profits than most other companies.
However, maintaining and opening supermarkets is a capital-intensive business and just having a high ratio of capex to profits doesn’t necessarily indicate whether Tesco was growing its capital assets or simply maintaining what it already had.
To understand that, we can look at the ratio between capex and depreciation.
The importance of the capex-to-depreciation ratio
In very simple terms, depreciation is the amount by which a capital asset loses value each year.
For example, imagine a company that buys a delivery truck for £10k and expects it to last 10 years, after which it will be worn out and worthless.
On the profit and loss statement expenses relate to the current financial year, so if the truck will be used for ten years it isn’t right to put the whole £10k down as an expense for the current year.
Instead, it would be better to account for the truck by recording the £10k as a capital expense on the balance sheet rather than a revenue expense on the P&L statement. The result would be a £10k capital asset rather than a £10k expense.
For the next ten years, the company would record a £1k depreciation expense, which would also reduce the value of the capital asset (i.e. the truck) by £1k until its value reached zero.
Since the value of the truck declines by £1k each year the company would do well to put aside £1k each year (and perhaps a little more) in order to buy a new truck when the old one wears out.
In some respects then, depreciation (and amortisation, which is the same thing but for intangible assets) can be seen as the ongoing replacement cost of a company’s capital assets.
If a company’s capital expenses are at about the same level as depreciation then the company is more or less replacing its existing capital assets, but not growing them.
For companies to grow they usually have to increase their capital assets and that means having capex significantly higher than depreciation, sometimes over many years.
In Tesco’s case, its capex and depreciation in the period up to 2012 look like this:
Tesco’s capex in the run-up to 2012 was much higher than its depreciation rate. Having looked at the relationship between capex and depreciation for a few dozen companies, I can say that Tesco’s capital investment rate in that period is really quite exceptional.
Every single year it made capital investments far beyond the existing rate of depreciation; in other words, it was expanding its capital assets rapidly and investing aggressively for growth.
Tesco’s total capital expenditure over that period came to £28.9bn compared to total depreciation of £9.6bn.
In other words, Tesco invested an additional £19.3bn in capital assets and was investing at more than three times the rate required to simply maintain its existing assets (primarily supermarkets, fittings and fixtures, IT, supply chain assets etc.).
In my opinion, this is a clear indicator that Tesco was expanding its capital assets massively, bringing on huge amounts of new supply which would – according to the capital cycle theory – almost inevitably have a detrimental impact on profitability (especially when measured as return on capital employed).
What a capital cycle value trap looks like when the trap snaps shut
In 2012 some investors (including Neil Woodford) were exiting Tesco, perhaps because of the rise of the German discounters and competition in general.
But Tesco’s share price looked attractive and so I (along with Warren Buffett) bought some of its shares on the assumption that any slowdown would be a minor bump in the road and that the past record of growth would return in due course.
Events may have unfolded differently if I’d looked at Tesco from a capital cycle point of view. Having seen the enormous investment in capital assets I might have chosen to sit and wait for Tesco to enter the downward phase of the cycle.
If I had waited then I would have seen Tesco’s profits, dividends and share price collapse and would have avoided investing in this most high profile of value traps (although thanks to a policy of broad diversification the hit to my personal portfolio and the UKVI model portfolio was just a percentage point or two):
I think the massive capital asset expansion that Tesco and the other supermarkets embarked on during the previous decade(s) played a major role in the sector’s recent downfall.
Having reached the peak of the capital cycle, this is how Tesco looks now from the point of view of its post-tax profits and capex:
As you can see, the collapse in profits has inevitably led to a massive decline in capex.
While I don’t have a crystal ball, this lower level of capex could easily last for many years given the huge expansion the company has gone through since the 1980s.
Looking at Tesco from yet another point of view, here’s how that lower level of capex compares to depreciation today:
As the chart shows, unlike profits or capex (or dividends for that matter), depreciation does not decline so quickly or easily.
Once a capital asset has been added to the balance sheet it will typically depreciate at a fairly steady rate over many years, assuming big chunks of it aren’t sold off to pay down debts (which is something Tesco has also been doing recently).
One way to think of capital assets is that they’re like baby birds which constantly need feeding. As they get bigger they demand more food, and if you don’t feed them they’ll shrink and perhaps even die.
The problem for Tesco is that now it has built up this massive base of capital assets those assets need feeding with massive amounts of cash, and if they’re not fed they will fall into disrepair and generate even lower rates of return.
This process of capital consolidation may have begun as the chart shows Tesco’s 2016 capex falling below depreciation. This means its remaining capital base has started to shrink in value, finally ending a very long period of expansion.
With hindsight, it’s obvious that avoiding Tesco was the best option, given its massive and prolonged capital investment (there were other problems too, but here I’m focusing on the capital cycle). But hindsight is for historians. What I want to know as an investor is:
Was there some way of knowing in advance that Tesco was very likely to become a capital cycle value trap?
Using the capex-to-depreciation ratio to avoid capital cycle value traps
What I’m after is a ratio or other metric which is going to alert me to companies that are rapidly expanding their capital bases.
Having crunched the numbers for most of my holdings over the past five years and in particular those that have run into problems, I have decided to settle on the capex-to-depreciation ratio as my metric of choice:
- Capex to depreciation ratio = capex / (depreciation + amortisation)
I’m interested in avoiding those companies where capex has been much higher than depreciation (and amortisation) over the last decade and so I’m looking to avoid companies where the capex to depreciation ratio is well above 100%.
But how high is “too high”?
There is no single correct answer, but from the research I’ve carried out, it seems that those companies where the capex to depreciation ratio is consistently above 200% are the ones that are much more likely to run into problems later on, caused in part by excess investment and excess supply.
So taking account of both capex in individual years and over the last decade as a whole, this is my new rule of thumb for avoiding capex cycle value traps.
New rule of thumb:
- Only invest in a company if its capex-to-depreciation ratio for the last ten years as a whole is below 200% and if the ratio is below 200% in more individual years than not during that period
Applying that rule of thumb to Tesco:
- Tesco’s overall capex-to-deprecation ratio for the period leading up to 2012 was 299%
- Tesco’s capex to depreciation ratio was over 200% in ten years out of ten in the run-up to 2012
Clearly, Tesco was flashing all sorts of warning signs in terms of its potential to be a capital cycle value trap.
There were many other warning signs too, which I’ve already covered in my post-sale review, but the company’s massive investment in capital assets is an important one.
Other examples of my investments which (with hindsight) had a high risk of becoming a capital cycle value trap were:
- BHP Billiton (purchased in 2011): In 2011 BHP had a ten-year capex-to-depreciation ratio of 241% and the ratio was above 200% in seven of those years
- Rio Tinto (purchased 2012): In 2012 Rio Tinto had a ten-year capex-to-depreciation ratio of 252% and the ratio was above 200% in seven of those years
- Wm Morisson (purchased 2013): In 2013 Morrison had a ten-year capex to depreciation rate of 207% and the ratio was above 200% in five of those years, so Morisson was a borderline case in terms of the capital cycle
I still hold each of those companies and so whether they will eventually turn out to be good or bad investments is currently unknown. However, so far they have each performed terribly.
Having bought the companies a few years ago, each has since moved from the expansionary phase of the capital cycle through to the consolidation phase and that has occurred alongside collapsing profits, dividends and share prices.
At the very least, waiting for the capital cycle to turn would have resulted in me either not investing at all or eventually investing at a significantly lower share price than the one I actually paid.
However, it’s not all doom and gloom.
The vast bulk of my current and previous investments easily make it past that capex/depreciation rule of thumb and have not had any noticeable capital cycle-related difficulties to date.
On that basis, I think this new rule of thumb is a reasonably good first stab at producing a capital cycle value trap warning signal.
Of course, if it turns out to be too restrictive, or too lax, I will adjust accordingly, but for now, I’m happy to add this ratio to my existing investment toolbox.
Finally, there’s a video interview at MoneyWeek between Merryn Somerset Webb and Edward Chancellor covering the capital cycle here.