Capital cycle analysis — the study of how overinvestment in sectors can lead to oversupply and eventually a correction — is a vital topic in investment selection and may provide a useful way to talk about why returns across sectors vary over time.
Unlike, say, interest rates, the over- and underinvestment in capital equipment by companies in a given industry is easy to understand. And it's an essential aspect of investment selection. Companies don't operate in a vacuum, and factors such as capacity can be the difference between winners and losers.
Energy is only the latest example of the impact capital cycle can have on a sector. The dynamic has played out in other industries, including real estate, utilities, mining and manufacturing.
Even the best company in a struggling industry may face additional headwinds due to the behavior of its peers. Case in point: Oil.
Technology advancements that allowed for cost-effective fracking also led to increased capital flowing into the sector and an eventual supply glut.
Additional business spending can support greater sales for industries where product appetite is still expanding. But when the tide turns, excess capacity can amplify negative effects.
ADDITIONAL CHECK
We use capital cycle analysis as an additional check when examining opportunities to determine whether a company could benefit from a return to rationality in the industry in which it operates.
Metrics such as reported capital expenditures versus depreciation rates provide a starting point to assess areas that are seeing a flood of investment versus those where capacity is likely to be constrained in the future.
Even the best company can experience headwinds due to the behavior of its peers
However, the data require context. Its usefulness varies among sectors and at the industry level. This type of analysis is best for companies that operate in highly commoditized businesses, such as raw materials, semiconductors and manufacturing. Businesses with differentiated products, limited competition or where brand loyalty is strong tend to be less effected by capacity.
Advisers also should take a longer view of industry trends when forecasting supply imbalances. If excess investment has been building for years, a quarter or two of reduced corporate spending is unlikely to result in future pricing power.
Given our value focus, we tend to prefer sectors and industries where market interest has ebbed and stocks have sold off, capacity is declining due to low capital investment and product demand is nearing the low end compared to historical averages. Our process has led us to names in late-stage cyclical areas that have long been out of favor with investors.
For example, metals and mining companies are trading at their lowest levels relative to the S&P 500 in nearly 10 years. Capital investments in the space also have been depressed, and, for the majority of the past three years, have lagged the industry's rate of depreciation and amortization.
Poor returns for the group and a lack of investment could set the stage for additional tailwinds for effectively managed businesses.
FUTURE PRESSURES
Using capital cycle analysis can also highlight areas that may face pressures in the future. For example, airlines have been investing in their businesses almost twice as fast as capacity has been removed through depreciation. At the same time, stock performance of the group is at a 20-year high based on relative performance to the S&P 500. To us, the dynamic is setting the stage for potential pain when pricing pressure emerges.
The same dynamic is playing out in the luxury cruise market. Other areas for additional examination are oil and gas consumables, energy equipment, machinery and engineering and construction.
Different stages of the capital cycle can lead to oversupply, but additional business spending can support greater sales when demand is expanding. Similarly, if an industry has yet to reach a trough in demand, reduced investment can point to eventual pricing power, but challenges may remain in the near term.
