Capital Returns 

Table of Contents

- [[Chapter 1: Capital Cycle Revolution]]
- [[Chapter 2: Value in Growth]]
- [[Chapter 3: Management Matters]]
- [[Chapter 4: Accidents in Waiting]]
- [[Chapter 5: The Living Dead]]
- [[Chapter 6: China Syndrome]]
- [[Chapter 7: Inside the Mind of Wall Street]]
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# Chapter 1: Capital Cycle Revolution

< [[Capital Returns: Table of Contents]]

1. An understanding of the capital cycle helps to identify and avoid speculative bubbles. 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. Four of the articles presented below highlight the dangers posed to shareholders over the last decade by ever rising levels of investment in the mining and the oil and gas sectors.

# Evolution of Cooperation February 2004

__Instability within an industry can create the conditions for improved future returns__

1. For contrarian investors, a history of poor returns in an industry can represent a potential opportunity, since cooperative behaviour is more likely to break out if companies are responding to the imperative of balance sheet repair. Just as Hyman Minsky, the US economist and author of Stabilizing an Unstable Economy, observed that financial stability is destabilizing since it leads to all kinds of excessive behaviour, so instability can, from a capital cycle standpoint, create conditions of stability. 
2. A basic industry with few players, rational management, barriers to entry, a lack of exit barriers and non-complex rules of engagement is the perfect setting for companies to engage in cooperative behaviour. It is relatively easy to identify those industries where these conditions exist currently (just look at existing returns on capital), and it is for this reason that the really juicy investment returns are to be found in industries which are evolving to this state. The joy from a capital cycle perspective is that most investors are, for a variety of behavioural reasons, taken by surprise.

# Cod Philosophy August 2004

__The cod fishing industry provided a marvellous example of the capital cycle in action until governments intervened.__

1. A basic industry with few players, rational management, barriers to entry, a lack of exit barriers and non-complex rules of engagement is the perfect setting for companies to engage in cooperative behaviour. It is relatively easy to identify those industries where these conditions exist currently (just look at existing returns on capital), and it is for this reason that the really juicy investment returns are to be found in industries which are evolving to this state. The joy from a capital cycle perspective is that most investors are, for a variety of behavioural reasons, taken by surprise.
2. The governments of Canada, the US and the EU had little choice but to follow suit, and soon the North Atlantic had been carved up into four exclusive zones, with fish quotas set to restore depleted stocks. When viewed from the perspective of the capital cycle, the intervention has been a disaster. Ordinarily capital would leave the industry, productive capacity would shrink, and prices rise toward an economic rate of return. Instead, government support financed, of course, by taxes has kept industry capacity high and the price of fish low. Worse still, the quota system is administratively complex, hard to enforce, and is often flouted. The Canadian government, which is reported to have invested three dollars in the industry for every dollar the fisheries earn, has set the high water mark for bureaucratic inefficiency.
3. Over approximately 150 years, the cod fishing and processing industry has evolved from one where excess profits were earned at the ports, then the market, then the food processors, to one where it is the consumers of fish that are the industry’s chief beneficiaries. The primary driver of the process has been the decline in the cost of technology, which has removed the excess profits earned at the pinch-points in the industrial process.
4. It is for this reason that Marathon research focuses on not just the magnitude of a company’s profitability (the size of the pinch-point – what is the capacity of Boston’s port?) but also its sustainability (why dock at Boston at all?). The longer one owns shares, the more important sustainability becomes, and so we focus on companies that control their own pinch-point. Is Nike’s $1bn media budget high enough? Is Ethan Allen’s advertising spending sufficient? Is Invensys’ research and development proprietary? And for firms with less control of their destiny, we focus on the industry supply side for signs of rising levels of competition. Is the Thai cement industry expanding again? Is Shimano increasingly vulnerable to niche competitors? The same capital cycle process that hollowed out the profits from the cod industry can been seen throughout the economy: it has taken around 70 years from the introduction of the Bessemer Process to reach commoditization in the integrated steel mill industry, mainly through competition from asset-light mini mills. Department stores have been commoditized in 30 years by big box retailing. In semiconductors, excess profits are wrung out in less than two years. The question for investors today is how long will the same process take in media distribution, telecommunication, or online auctions? Which of these businesses will end up being the twenty-first century equivalent of the Newfoundland harbours or Boston fish market?

# This time's no different May 2006

__High Commodity Prices are eliciting a supply side response__

1. Commodity bulls attribute high prices to supply shortages, and argue that higher prices are needed as an incentive to invest in production. All the same, one can be sure that additional supply will be forthcoming at some point.3 Indeed, mining companies have certainly responded to the pricing situation in the way that one would expect: initially they were sceptical of the price rises, but later they started investing heavily to bring on new supply. Mining exploration costs doubled between 2003 and 2005. Much of this additional spending is a consequence of having to absorb higher production costs, but not all of it. Indeed, some mining companies believe that there is enough supply coming on stream in copper for there to be a sizeable market surplus in a couple of years’ time. Supply bottlenecks do not last forever.
2. As the capital cycle plays out in commodities, it is perhaps worth highlighting the outcome of another recent minor bubble: namely, that of the container shipping industry. Here, too, a couple of years back we were promised a “supercycle,” as earlier underinvestment led to a shortage of new ships, and strong Chinese growth was producing annual double-digit increases in shipping demand. Indeed, we even spotted the odd specialist container shipping conference invite. Spurred on by these “once-in-a-generation” conditions, shipping companies indulged in an M&A boom in mid-2005. Shipyards working flat out were fully booked out for years to come. Predictably, this frenzy marked the peak of the cycle, and shipping rates (and shipping company share prices) have now fallen sharply, while supply continues to increase.4 A sign of things to come in the commodities world?

# Supercycle Woes May 2011

__The commodity industry is showing the classic signs of a capital cycle peak__

1. A cursory analysis of the capital cycle for the commodity industry – in particular the huge expansion of commodity capital expenditure in recent years, and the precarious nature of Chinese demand for raw materials – suggests that the much hyped commodity “supercycle” is entering a downturn.
2. The bad news is that commodity industry is showing signs of a classic capital cycle peak – higher returns on invested capital are attracting more capital and higher share prices, leading to more mergers and acquisitions and IPOs.
3. Thus, ever rising amounts of capital are coming into the sector at a time when commodity prices are well above marginal costs of production, even for the high cost producers. When this supercycle eventually turns, there is potentially a long way for commodity prices to fall before they reach replacement cost. This could pose a problem for benchmark-hugging investors, since the metals and mining sector – up more than three times from its 1999 low – is currently close to its all-time high as a share of the FTSE World Index.

# No Small Beer February 2010

__Consolidation has improved the pricing power of the global brewing industry__

__“Most people hate the taste of beer to begin with. It is, however, a prejudice that many have been able to overcome.” Sir Winston Churchill__

1. This encouraging process is continuing with, for example, the largest players in the UK market all having announced price rises of 4 per cent already in 2010. In emerging markets, pricing growth has been easier to achieve, in part due to the greater fragmentation of the retail channel and generally higher levels of inflation which have made it possible to hide price increases. Here, as well as volume growth, the story is one of increased “premiumization” – persuading consumers to trade up as they become wealthier. In Europe, premium lager accounts for nearly 25 per cent of the market (and 15 per cent in the US), but this figure is well below 5 per cent in most emerging market countries. A consolidated market is not a prerequisite for premiumization, but having high volumes in a market makes it more economic for a brewer to offer a wider range of products at different price points. On the supply side, there is an encouraging capital cycle angle as the consolidation process has seen a reduction in brewery capacity, particularly in Europe where the fragmented regional nature of the market meant that there had been persistent overcapacity to be exploited by retailers. Several markets have experienced quite meaningful capacity reduction.
2. Following the M&A splurge, which pushed debt levels to an average net debt/EBITDA across the sector of around 3 times, compared to a long-run average of 1.5 times, there has been a greater focus on balance sheet discipline, with less need to defend market share by attempting to grow volumes aggressively. So whereas historically, companies were spending around 2 times depreciation on capex, on average this has come down to below 1.5 times, or from nearly 10 per cent of sales to below 8 per cent. There has also been more of an emphasis on working capital, with several of the companies adopting explicit reduction targets. Taking all these things together – the emphasis on pricing, the focus on cost reduction and balance sheet efficiency – an improvement in both margins and return on capital was to be expected. As for valuation, the average free cash flow yields of 6–7 per cent imply growth rates of around GDP or a little less, which suggests that the stock market is underestimating the potential long-run benefit to be derived from market consolidation and improved discipline. In the light of an improving capital cycle among brewers, we find ourselves able, to paraphrase Sir Winston, to overcome our prejudice and begin increasing our exposure to beer.

# Oil Peak February 2012

__In the energy markets, as elsewhere, “there is no cure for high prices like high prices”__

1. It is said that “there is no cure for high prices like high prices.” Thus, while the price of crude appears to be suspended at an elevated level, the very persistence of the oil price above $100 per barrel is encouraging developments which pose an increasing risk to energy investors. There has been a surge in natural gas supply in North America, where new technology and better drilling techniques have helped to boost the production and lower the cost of natural gas from conventional resources, as well as from shale gas. US shale gas reserves are estimated to be huge. Extraction techniques continue to improve and we are still at the very early stages of the fracking revolution, so potential reserves from shale gas are probably still underestimated, as was the case in the early days of the oil industry. These extra and cheaper sources of energy have brought down natural gas prices in the US and opened up a huge price differential between crude oil and gas. In the US, at least, these developments have resulted in a dramatic shift towards natural gas, away from oil and coal, as a primary source of energy. Those who argue that the surge in gas supply will only impact North America are ignoring the fact that not only is the US still the largest consumer of crude oil (and is currently a net importer) but also that significant investment is being undertaken to be able to export this cheap gas. We are seeing gas import plants in the United States being reengineered to enable exports and new gas export facilities planned. In addition, to capitalize on the lowest US natural gas prices in a decade, industries are starting to shift production to the US and are even moving physical assets. In the case of Methanex, the world’s largest methanol maker, there are plans to dismantle an idled Chilean factory and ship it to Louisiana to be reassembled. The high oil price is fuelling other significant changes in the energy markets. The transport industry is becoming much more fuel efficient (airlines are ordering new fuel efficient aircraft/engines, and new fuel efficient ships are being ordered despite low cargo rates and a glut of older vessels). And there’s the increasing use of non-oil fuel for transport. Just look around. In Thailand, natural gas is already outselling petrol because of new technology used by taxis, tractors, buses and now some cars; in the US and in the UK (where there are tax incentives for “green” vehicles), there’s increasing evidence of not just hybrid vehicles but now fully electric cars (from economy models such as the Smart to the sporty Tesla), and facilities are being built to recharge these vehicles on the move; businesses are developing natural gas powered trucks (manufactured by Navistar and Clean Energy Fuels Corp) and hydrogen cell cars (by Acal). In short, there is no shortage of investment directed towards reducing the use of expensive crude oil. 
2. Meanwhile, oil producing countries within OPEC have become somewhat complacent about the high oil price. Some are using the extra revenue generated by the high oil price to pour billions of dollars into social spending. Saudi Arabia now requires an oil price of $90 per barrel to cover its planned expenditure (other OPEC countries “need” even higher prices). But these high spending commitments require decent volumes as well as high prices. This makes any volume discipline to control prices more difficult, and so undermines the ability of OPEC to influence oil prices in the future. Recent meetings with several of the largest global oil companies have also revealed some worrying signs. Senior oil executives appear to be anchoring their expectations about the future oil price on current market levels. Total, for instance, has raised its projection for long-term oil prices, which it uses to justify exploration and acquisition spending, from around $20 per barrel a decade ago to a range of $80 to $100. The French oil major claims it is willing to spend $20bn a year based on this elevated oil forecast. Increased spending promises to boost Total’s annual oil production, something which the company believes will lead to a rerating (upwards) of its shares.7 Total is not alone. The whole industry is justifying rising levels of investment based on the inflated expectations of future oil prices. BP has raised the oil price it uses to test new projects from $16 per barrel in 2002 to above $60. Even the well managed Imperial Oil, with substantial low cost oil and gas assets in Canada (over 100 years of reserves at current production), is now using a forecast of $50–60 per barrel compared to $35–40 ten years ago. Petrobras is aiming to spend $225bn in the next five years and to more than double its already substantial production in the next decade. The Brazilian oil giant assumes the crude oil price will be $80–95 per barrel for the next five years. Its record breaking $70bn rights issue last year shows there’s no shortage of funding for new oil projects while the oil price remains elevated.8 On current earnings, oil company valuations do not looked stretched: cash flow is lowly rated and dividend yields are above average. But there is now a risk that oil companies’ new assumptions about a high oil price are fixing their costs at a high level. The more of their healthy cash flows these companies spend on high cost projects, the lower their current earnings and cash flows are likely to be valued. The operational leverage of oil company profits is rising, so their earnings are particularly vulnerable to a severe correction in the oil price. And the longer the high oil price persists, the greater the risk of a correction. With this in mind, a modest and stock- specific weighting in the energy sector within our global portfolios seems prudent. It should at some stage add significant value to performance, at least on a relative basis.

# Major Concerns March 2014

__Energy companies are suffering from the delayed consequences of their capital spending boom__

1. Why has the higher oil price and rising capex not produced faster earnings growth? The main issue is that the majors have had a real fight just to stand still. The yield of an oil and gas field steadily steadily falls over its lifetime, in the order of 5 per cent annually, so a material amount of capital expenditure is required just to offset the decline rate. Lately, the quality of oil exploration projects coming on stream has not matched that of the legacy assets. Newer fields are both harder to access technically, as well as being in riskier jurisdictions. An ever greater amount of capital has been required to deliver the same level of production, resulting in the inevitable decline in return on invested capital. This explains why net production growth has been so depressed over recent years – in aggregate, the oil majors’ production has declined by approximately 2 per cent a year over the last five years. 
2. Are there any grounds for optimism? By virtue of the capital cycle, an extended period of growing capital intensity and low returns should eventually lead to a supply side contraction, laying the foundations foundations for an inflection in returns on capital and more healthy stock returns. In this sense, a weak oil price could even be a blessing in disguise for investors – much as its rapid rise since 2003 has been somewhat of a curse, accompanied as it has been by an increased focus on production at the expense of capital discipline.

# A Capital Cycle Revolution March 2014

__A Scandinavian wind turbine maker experiences the ups and downs of the capital cycle__

1. 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.
2. Chart 1.7 illustrates the “fade rate” of corporate returns, an idea developed by Holt Value Associates (now part of Credit Suisse). Holt’s concept of the stock market-implied fade rate chimed well with our focus on competitive conditions within industries and the flow of capital into (and out of) high (and low) return industries. Using this framework, two purchase candidates are identifiable. Purchase Candidate A is a company capable of sustaining high returns beyond the market’s expectation (the upper dotted line) – that is, the company remains above average for longer than average. Candidate B is a company which can improve faster than the market generally expects (the lower dotted line).
3. Marathon’s experience suggests that the stock market is often poor at pricing superior fade characteristics. For Purchase Candidate A, mispricing stems from a number of sources. One is the underestimation of the durability of barriers to entry. Another is the underappreciation of the scale and scope of the addressable market. Management’s capital allocation skills are also often overlooked.
4. The conditions leading to Purchase Candidate B often stem from the market misjudging the beneficial effects of reduced competition as weaker firms disappear, either through consolidation or bankruptcy. Alternately, an unruly oligopoly may tire of excess competition and enjoy an outbreak of peaceful coexistence. 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. Management skill at dealing with problems may also be overlooked. This is especially true when a new leader is recruited externally, maximizing the possibility of change.

# Growth Paradox September 2014

__The Capital Cycle partly explains why corporate profitability lags GDP growth__

1. Investors who assume corporate earnings will increase in line with the economy should look at the historical data.
2. The first issue is that new share issuance exceeded stock buybacks over time, diluting the equity holder. For example, in a 2003 paper, Bernstein and Arnott estimated net share issuance to have been in the order of 2 per cent a year in the US market.13 One explanation for this phenomenon is the procyclical behaviour of management, specifically the tendency to buy back stock when confidence is high and valuations heady, only then to be forced to issue equity when circumstances are less favourable and share prices lower. The recent experience of the banking sector is a particularly savage example of management’s buy high and sell low tendency.
3. Mergers and acquisitions show the same pro-cyclicality, with activity typically reaching a crescendo in the later stages of bull markets. Deals struck at high valuations lead to shareholder value destruction. Finally, management issuance of share options to employees has also been a drag on shareholder returns. Today a “burn rate” of 1 per cent is not uncommon – and it was even higher prior to the mandatory expensing of options through the profit and loss account. 
4. The concept of the capital cycle provides a broader explanation as to why corporate profitability lags GDP. The primary driver of healthy corporate profitability is a favourable supply side – not high rates of demand growth. Hence, it is possible for there to be rapid growth in an industry which brings little or no benefit to investors. In fact, strong growth in demand is often the direct cause of value destruction as it encourages a flood of capital into the industry, eroding returns.
5. Thus procyclical management behaviour alongside the destructive power of the capital cycle largely explain why real earnings growth of the US stock market has not kept pace with broader economic growth. Evidence suggests that these problems intensify the higher the rate of GDP growth, with no correlation between long-term GDP growth and equity market return.
6. Investors should not expect earnings to grow in line with economy. Rather, they should look out for those rare examples of management who are prudent in their use of capital. The starting point for company analysis is not the outlook for end demand but rather the supply side. Our goal is to find investments in depressed industries at positive inflection points in the capital cycle and in sectors with benign and stable supply side fundamentals.

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# Chapter 2: Value in Growth

< [[Capital Returns: Table of Contents]]

1. Capital cycle analysis, as it originally evolved at Marathon, looked to invest in companies from sectors where capital was being withdrawn and to avoid companies in industries where assets were increasing rapidly. The insight being that both profits and valuations should generally rise after capital has exited an industry and decline after capital has poured in. In other words, capital cycle analysis was all about the drivers of mean reversion. Yet the same mode of analysis can be used to identify companies which, for one reason or another, are able to repel competition. 
2. Companies with such strong competitive advantages, possessing what Warren Buffett calls a wide “moat,” are able to maintain profits, often for longer than the market expects. Mean reversion is suspended. From a capital cycle perspective, it can be observed that a lack of competition prevents the supply side from shifting in response to high profitability. Acquiring stocks in companies which defy mean reversion has been a particularly fruitful investment strategy for Marathon over the last decade. 
3. Somewhat confusingly, this style of investment is known generally as “growth” investing in fund management industry parlance, as distinct from “value” investing. Having acquired the “value” investor label from industry consultants before and during the dotcom bubble, Marathon was wary of being accused of style drift as it invested increasingly in stocks with higher valuations and better growth prospects. As the essays below point out, the “value/growth dichotomy” is false – at least, to a true value investor, whose aim is not to buy stocks which are “cheap” on accounting measures (P/E, price-to-book, etc.) and to avoid those which are expensive on the same basis, but rather to look for investments trading at low prices relative to the investor’s estimate of their intrinsic value. 

# Warning Labels (September 2002)

**Labelling fund managers as value or growth investors risk distorting the investment process**

1. Many great investors will interpret value according to their perceptions of value. The renowned “value” investor Bill Miller of Legg Mason has championed Amazon.com and AOL, while Warren Buffett, that great disciple of Ben Graham, has preferred growth franchises such as Coke and Disney. The latter, however, believes (or at least did believe) that these high-quality businesses were cheap (i.e., good value relative to the present value of their expected future returns) and still regarded himself as buying value. The fact is that one person’s growth stock is another’s value stock.
2. Our capital cycle process examines the effects of the creative and destructive forces of capitalism over time. A growth stock usually becomes a value stock after excess capital, lured in by large current profitability, brings about a decline in returns. When this becomes extreme, as was the case during the technology bubble, the resultant bust can turn growth stocks into value stocks almost overnight.
3. Our belief is that stocks should be viewed not as “growth” or “value” opportunities, but rather from the perspective of whether the market is efficiently valuing their future earning prospects.

# Long Game (March 2003) 

**Long Term investing works because there is less competition for really valuable bits of information**

1. There are many ways to describe investment approaches, indeed a consulting industry has emerged whose primary function is to do just that. However, there is one attribute that separates investors better than most, in our opinion, and that is portfolio turnover.
2. While the case for long-term investment has tended to centre around simple mathematical advantages such as reduced (frictional) costs and fewer decisions leading (hopefully) to fewer mistakes, the real advantage to this approach, in our opinion, comes from asking more valuable questions.
3. Information with a long shelf life is far more valuable than advance knowledge of next quarter’s earnings. We seek insights consistent with our holding period. These principally relate to capital allocation, which can be gleaned from examining the company’s advertising, marketing, research and development spending, capital expenditures, debt levels, share repurchase/issuance, mergers and acquisitions and so forth.
4. Even if one has developed the analytical skills to spot the winner, the psychological disposition necessary to own shares for prolonged periods is not easily come by. J.K. Galbraith observed that: “nothing is so admirable in politics as a short-term memory.” Why should politics have a monopoly on sloppy thinking? Which makes us think that long-term investing works not because it is more difficult, but because there is less competition out there for the really valuable bits of information.

# Double Agents (June 2004) 

**Conflicts of interest in the business world sometimes play to an investors advantage**

1. In a recent lecture given at the University of California, Charles T. Munger described a test he had performed at a number of US business schools.5 This test involved the Berkshire Hathaway vice-chairman asking the MBA students the following question: “You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” The business school students all nod in agreement. Munger then goes on: “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” Some students come up with the luxury good paradox, whereby higher prices indicate superior quality which, in turn, leads to greater sales.
2. Very few students identify Munger’s answer, namely that when the customer is not involved directly in the purchasing decision, then higher prices can be used to bribe the purchaser’s agent and can result in both higher profit margins and sales volumes. From an economist’s perspective, the customer experiences an agency problem. Agency creates the potential for supernormal profits for both agents and producers. Investors who understand the process can profit, too. It’s worth examining how the agency issue – hitherto something discussed mainly in relation to the dysfunctionality of the investment management industry – relates to a number of companies we own or may purchase at some stage in the future (price permitting, that is). 
3. Normal relations between provider, intermediary and consumer are distorted when the consumer lacks understanding and relies on a supposedly independent intermediary. In many cases the relationship between the intermediary and the product provider has developed to the point where these parties form a tacit alliance to exploit consumer ignorance.
4. An unholy alliance between producers and distributors exploiting customer ignorance is also prevalent in the healthcare sector.
5. Munger is right. Customers will often pay more when agents are involved. In each of the cases we’ve discussed, the business models – whether in plumbing, dentistry, hearing aids, or product testing – involved value being transferred from the person who pays to the agent, with the producer taking a large slice of the pie. Each of these models has evolved over time and appears reasonably robust, even as consumers become better informed in the Internet age. Just as agency problems in the fund management industry have shown remarkable persistence, we expect the superior profitability of companies that exploit agency to endure.

# Digital Moats (August 2007)

**Internet companies investing in their competitive positions can afford to ignore short-term profitability**

1. The basic corporate model of low margins in order to maximize long-term absolute profit is a well-trodden path, with Wal-Mart the most notable exponent. It is not surprising that some companies will have the good sense to apply this old model to the new medium of the Internet. This strategy dramatically reduces business risks (via reduced competition) while simultaneously raising long-term rewards (via likely growth). Internet technology will help these firms secure competitive advantage, and investors should benefit in the long run.

# Quality Time (August 2011) 

**Our portfolios have shifted towards higher quality companies with sustainable barriers to entry**

1. We are on the lookout for factors which might lead to improved returns on equity, in particular: (1) the emergence of oligopolies in industries hitherto characterized by low returns and excessive competition; (2) the evolution of business models with high and rising barriers to entry; and (3) management behaviour which encourages these trends.
2. Another class of business whose weight in our portfolios has expanded in recent years has been subscription-based service companies with annuity-like revenue streams. The common theme here is a longer-term commitment made by the customer, together with an element of inertia when it comes to renewals. These factors, in combination with the scale economies which often arise in the provision of subscription services, make for significant barriers to entry and high and sustainable returns. This is particularly true where the cost of the service is only a small proportion of the customer’s total spending.

# Escaping the semis cycle (February 2013) 

**Niche semiconductor businesses have escaped the ravages of the industry's capital cycle**

# Value in Growth (August 2013)

**Chinese internet firms market dominance justifies it's high valuation**

1. It should never be forgotten that, in its most basic form, investing is always and everywhere about price and value. Price is what you pay, says the Sage of Omaha, and value is what you get. By this definition, every serious investor must be a value investor. This is not to say that investors should restrict themselves to buying companies with low valuation multiples. The business of investment is ultimately about buying stocks at a discount to intrinsic value. So how do you calculate value?
2. One common response to the difficulty of forecasting is to turn to simple value proxies, such as the price-to-book ratio, price-to-earnings (PE) ratio, and free cash flow yield. Many “value” investors advocate buying a basket of stocks which are cheap by these measures. There’s nothing inherently dumb about this approach. Each of the measures is a very useful indicator of potential value, but there’s a danger of oversimplification. Traditional valuation measures say nothing about the specific context of an investment – for instance, a company’s business model, its industry structure, and management’s ability to allocate capital – which determines future cash flows.

# Quality Control (May 2014)

**Capital Cycle analysis helps to identify investments with high and sustainable returns**

1. Pricing power has arguably been the most enduring determinant of high returns for these investments. It has come from two main sources. The first is a concentrated market structure, closely associated with effective management of capacity through the demand cycle which encourages a rational approach to pricing. The second is “intrinsic” pricing power within the product or service itself. Intrinsic pricing power is created when price is not the most important factor in a customer’s purchase decision. Most often, this property is generated by the existence of an intangible asset. There are several classes of intangible assets, examples of which can be found among Marathon’s holdings. An obvious one is consumer brands.
2. Finally, there is another more technical reason why the virtues of a high return business are not always fully appreciated by investors. This is the tendency of investors to focus on the income statement. This fosters a fixation on price-earnings (P/E) valuation metrics and not price to free cash flow (P/FCF). Thus, all earnings growth is seen as equal, even though it is materially more value creative when return on capital and cash flow generation is higher. Faced with a choice between investing in two companies with the same earnings growth, we are prepared to pay materially more (in P/E terms) for the business with high returns on equity and superior cash flow generation.

# Under the Radar (February 2015)

**Companies which provide indispensable services to their customers often prove to be excellent investments**

1. The typical growth stock starts out with high returns, rising turnover, and glorious prospects, only to stumble in later years. The trouble is that profitable and growing businesses tend to attract lots of competition, especially when they operate in exciting areas, such as technology. Investors who buy growth at high starting valuations generally end up disappointed. There is, however, a certain class of company which we have found is well worth paying a premium for. Our preferred growth stocks undertake apparently unglamorous activities that are essential to their customers – so essential, in fact, that customers pay little attention to what they’re being charged. 
2. When Marathon encounters such companies, the common refrain of managers is that their products (or services) constitute only a small part of the customers’ total cost and yet are of vital importance to them. It may be that a particular component is “mission critical” for an industrial process or a company’s workflow. For instance, customers may face a very high cost if they have to shut down a production line when a crucial component fails. Hence, reliability weighs more highly than price. The product may also be essential by virtue of its quality, safety or performance attributes.
3. While the high profitability of the companies under discussion may be below the radar of their customers, it has not escaped the attention of investors. In the past, when we encountered such wonderful businesses we were prone to assume that high valuations meant they were fairly priced, or even overpriced, in the stock market. A few years later, however, when we reengage with the same firms, we often find that their share prices have shot up. When we first met with Spirax-Sarco in 2005, for instance, it was valued at 17.5 times earnings and the shares were trading around £8. We demurred. Five years later, at our next meeting, the stock was trading above £18. Again, we concluded that it was fully valued. Since then, the share price has almost doubled again. The lesson seems to be that a full price is often justified for high quality, “under-the-radar” businesses.

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# Chapter 3: Management Matters

< [[Capital Returns: Table of Contents]]

1. Like many other investors, Marathon never tires of quoting Warren Buffett. One particular comment of the Sage of Omaha has become something of a mantra at the firm: namely, Buffett’s observation that “after ten years on the job, a CEO whose company retains earnings equal to 10 per cent of the net worth will have been responsible for the deployment of more than 60 per cent of all capital at work in the business.” What this means is that investors should pay particular attention to the capital allocation skills of management. As Marathon’s investment holding periods became more extended, in contrast to the fund management industry as a whole, the notion that a manager’s skill in capital allocation is decisive to the investment outcome has been reinforced. The study of management, via face-to-face meetings and general observation, has become one of the main elements of the daily job at Marathon.

# Food for Thought (September 2003)

**The failure of specialist analysts to anticipate a dutch corporate collapse comes as no surprise.**

1. To our mind, this research reveals specific flaws in the specialist analyst model, which largely derive from the relationship between research analysts and the companies they follow: 
    * Too close to management. By occasionally giving privileged information to particular analysts, the recipient may have felt (consciously or not) that he or she owed management a favour – what is known as “reciprocation tendency. And when things started to go wrong, the weird and wonderful effects of Stockholm syndrome – whereby the hostage becomes the mouthpiece for his captor – may have taken hold.
    * Too much information. Having more information doesn’t necessarily improve decision-making. We know from studies of horse racing that when handicappers receive more information about the horses and riders, they become proportionately more confident even though they are no more likely to pick the winner. Our racecourse punters apparently become more confident of their opinion after having placed their bet. The danger is that the analyst reaches a conclusion based on a single line of thought and then sticks with this view, come what may. 
    * Living in a cocoon. Specialist analysts operate in a cocoon, in which they are overexposed to company management and peer analysts and underexposed to what is going on in the rest of the world. Herding instincts may tend to reinforce similar opinions among peer analysts. Their thinking starts to reflect what Daniel Kahneman calls the “insider view.” 
    * Poor Incentives. Management has a huge influence over the capital allocation of a business. Decisions taken by senior executives are likely to be influenced by their incentives. Yet specialist research rarely addresses the key issue of incentives.
    * An even worse performance metric. Once analysts set the market’s EPS expectations for the next quarter and management beats the expected numbers, the share price can be expected to rise. We have previously discussed the futility of this game, vulnerable as it is to “Goodhart’s Law” (namely, that once a data point is widely used as a measuring stick, it ceases to be reliable).
   
# Cyclical Missteps (August 2010)

**A great mystery of the corporate world is the tendency of management to buy high and sell low.**

1. While boards acting on behalf of shareholders have generally mistimed their equity purchases and sales, insiders have done rather better when trading for their own account. 
2. Looking back over recent years, our overwhelming impression is that most companies mistimed the cycle and misjudged the crises. As a result, poor capital allocation decisions were made over that period. 

# A Capital Allocator (September 2010)

**The best managers understand their industry's capital cycle and invest in a countercyclical manner**

1. Warren Buffett has pointed out: _The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering - or sometimes, institutional politics._
2. Financial companies are probably the most challenging of all for CEOs to manage, as they require many more capital allocation decisions compared with, say, running a large food retailer or consumer products company.
3. The Sampo case study combines many of the key elements that we look for in management; namely, it has a chief executive who both understands and is able to drive the industry’s capital cycle (the Nordic P&C consolidation story), allocates capital in a countercyclical manner (selling equities prior to the GFC), is incentivized properly (large equity stake) and takes a dispassionate approach to selling assets when someone is prepared to overpay (Finnish bank divestment). The pity is that there are so few examples of Sampo-esque management elsewhere in Europe.

# Northern Stars (March 2011)

**The superior performance of Nordic stocks reflects the quality of management**

# Say on Pay (February 2012)

**Long term insider ownership is the best of all imperfect solutions to the principal-agent problem**

1. What is the optimal incentive scheme, then? The answer is it depends on the circumstances. Remuneration structures based on earnings per share (EPS) growth and total shareholder return (TSR) performance measures are increasingly commonplace. Yet they suffer from the problem identified long ago by the management guru, Peter Drucker, who observed that the search for the right performance measure is “not only likely to be as unproductive as the quest for the philosopher’s stone; it is certain to do harm and to misdirect.” This is particularly the case when pay is linked to EPS – a particular bête noire for Marathon over many years.
2. The earnings per share measure is prone to manipulation by unscrupulous executives; it takes no account of risk and encourages value destroying acquisitions and buybacks, especially when interest rates are low. It also encourages the quarterly EPS guessing game beloved by the sell-side. At times, it seems that meeting the EPS target has become the main strategic purpose of the company. This is regrettable. Corporate strategy should be about how best to allocate resources. If a turnaround requires a three-year investment phase, management may not pursue the optimal business plan if their compensation is linked to interim EPS results. While these inter-temporal issues can be partly resolved by phasing in performance rewards over a period of years, investor myopia and management’s own interest tend to lead to an exclusive focus on the calendar year EPS, which bears no relation to long-term value creation. 
3. Linking compensation to total shareholder return (TSR), the most common share price-based measure, is better than EPS, as it forces management to think about what drives shares prices over the medium term. Such schemes suffer from point-to-point measurement, which can be distorted if the stock price at either the start or end date is inflated by takeover speculation or by general overvaluation in the stock market. Then, there are questions over what time frame to measure the returns; also, whether the benchmark should be absolute or relative – both have their merits, neither is perfect. In the case of relative schemes, should the benchmark be provided by a peer group or by the broader market index? Sir Martin Sorrell, the head of advertising giant WPP, has become a very wealthy man thanks to his ability to outperform a small group of marketing service companies. Unfortunately, this wealth creation has not been shared with the company’s owners due to the under-performance of this sector over many years. 
4. For this reason, we normally prefer corporate incentives schemes to be benchmarked against the stock market index, in line with our own performance fees. Company managers might feel aggrieved that they have no control on performance relative to a broad index, which may be driven by moves in some heavily-weighted sector, such as mining or pharmaceuticals in the FTSE 100. Some companies have come to us seeking to switch from a relative TSR scheme to an absolute one – often after a period of relative outperformance which presumably management believes will end imminently. 
5. As regards the time frame over which performance should be measured, here one runs into the problem of investor myopia. Since the average holding period for European shares is down to 12 months (see Chart 3.2), the “average” investor has little interest in the performance of a company over a five-year period. We prefer longer measurement periods, with multiyear phasing in of benefits to encourage long-range strategic thinking. The views of high frequency traders and investors obsessed with quarterly EPS should be given a very low weight by management. Time frames may also need to vary by sector. In the capital goods and extractive industries, project terms may be well in excess of five years (for aero engines, product life cycles can be decades). 
6. Given that each measure has pros and cons, it is not surprising that remuneration consultants seek a compromise, bundling together a mixture of measures in the incentive scheme. But so-called “balanced” approaches, such as those which mix an EPS target with a return on capital overlay and a TSR override, are likely to confuse both management and investors and, even worse, can encourage sophisticated gaming strategies. 
7. Insider ownership has always seemed to us as the most direct way to deal with the principal-agent problem, which arises with the separation of corporate management from ownership. Our portfolios have tended to be skewed towards companies where successful entrepreneurs run their companies and retain sizeable shareholdings. Long-term share ownership is probably the best way of concentrating the minds of management on the true drivers of value. The manager’s instinct for wealth protection should guard against excessive risk-taking, the unfortunate counterexample of Lehman’s Dick Fuld notwithstanding.

# Happy Families (March 2012)

**Family control can cause problems for outside shareholders, but it can also provide as elegant solution to the agency problem.**

1. The evils which arise at joint-stock companies where management and ownership are separated are not of recent vintage. In the year of the American Revolution, Adam Smith observed what we now call principal-agent problem: _The directors of such companies ... being the managers rather of other people’s money rather than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which [they would] watch over their own ... Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. (Wealth of Nations, 1776)_
2. One potential solution to this problem is to invest in companies which remain under family control. Unfortunately, this is not without its pitfalls.
3. The problem for investors is to determine between the good and bad family stewards. Readers of a scientific bent may be aware of the Anna Karenina principle,9 in which a deficiency in just one of a number of factors dooms an endeavour to failure. What follows is a list of common family deficiencies, any one of which is liable to undermine a company’s success:
    * Lack of Family Unity
    * Loss of Business Acumen
    * Self Dealing
    * Poor Succession Planning
    * Politics of Rent Seeking

# The Wit and Wisdom of Johann Rupert (June 2013)

**The departing boss of Richmond is a true corporate star**

1. Marathon looks to invest with corporate managers who know how to allocate capital effectively. This requires certain character traits in the individual, such as suspicion of investments fads (and investment bankers), and a willingness to swim against the tide. One of our more successful decisions has been to invest alongside Johann Rupert, until recently the executive chairman and CEO of Richemont, the Swiss luxury goods group in which his family owns a controlling interest. As Mr. Rupert prepares to move on, we decided to look back over our meeting notes to remind us of the qualities which attracted us to this truly outstanding manager.
2. We have collected below a number of throwaway comments from Mr Rupert, who speaks with a distinctive distinctive South African accent, which illustrate to our mind why he has been such a successful steward of other people’s money.

## On management: 
    * “The danger sign is always when a manager does not understand the business that he or she is in.” 

# On relations with a dominant supplier 
   * “Don’t play cat and mouse games if you’re the mouse.” 
   * “I think if you want to be successful you need a very healthy dose of paranoia that every day there’s somebody out there who wants to eat your breakfast, and if you’re not alert they will do.” 
   * “Don’t postpone until tomorrow what you can delegate today.” 
   * “I learned many years ago – that from the day you’re born until you ride the hearse, things are never so bad that they can’t get worse.” 
   * “The real question is do companies redeploy free cash flow accretively, or do they waste it?” 

# On short-termism: 
    * “I raised a glass of champagne when Al Dunlap fell on his chainsaw.” 
    * “So anybody who’s going to ask, so what do you think the next year looks like, why don’t you just not ask the question because we’re not going to answer any. And it’s not because we’re coy or funny. We don’t know.” 
    * “I’m not going to tell you what I think our third quarter XYZ is going to be.” 

# On M&A and buybacks:      
    * “Ultimately, if any asset is wrongly priced, it is abused.” 
    * “If you pay an excessive multiple, deals will never make it.” 
    * “No, no, no, no. I didn’t lose a lot of money when I tried to sell the business. I lost the money when I bought the bloody thing. That’s when you park your money, it’s not when you try to find a bigger idiot than you to take it off your hands.” 

# On successfully exiting pay TV
    * “Never confuse luck with genius.” 
    * “Our job here is to create goodwill and not to pay other people for goodwill.” 
    * “[There are] three stages of [an] acquisition, which [are] euphoria and then disillusionment. And the next thing is looking for somebody to blame for buying the place.” 
    * “The grass is always greener on the other side of the fence. But you only find out when you climb over that the reason why it’s greener is because of all the cow dung hidden in the grass. And as soon as you start stepping in all this stuff then you wonder why you ever crossed the fence.” 
    * “You can discount us ever using equity for acquisitions. Equity is always the most expensive way to pay.” 

# On share-financed takeovers during the TMT bubble:
   *  “Like a child selling his dog for $1m, only he gets paid with two severed cat’s paws.” 
   * “If you talk up your share price, when the price comes down, the folks come looking for you.”
   * “We don’t talk about a load of rubbish that I also had a hand in buying.” 
   * “If you look at share buybacks, and at the prices at which companies bought their shares back, they inevitably bought the shares back at very close to the top of the market because that’s when they had a lot of cash. And boy, do they regret it when two years later all hell breaks loose.” 

# On investment bankers:  
    * “Recessions occur because the investment bankers provide capital at too low a cost which leads to overcapacity and a slump.” 
    * “When you really need firepower, the banks are not there and the funds are gone.” 

# On corporate governance: 
    * “So if you want a perfect governance score, get somebody you don’t know, whom you’ve never met, who knows nothing about your business because he’s never been involved, employ him and give him a nice bonus for sitting on a committee. Then you get all the boxes ticked [by the proxy voting services]. And guess what happens? After five years, chaos. There’s a direct, inverse correlation between the best corporate governance box-ticking and medium-term performance.” 

# On the luxury business: 
    * “The only way we know how to maintain a sustainable competitive advantage is to grow the brand equity ... . because that brand equity creates demand and will result in pricing power.” 
    * “I’m just a normal business person who thinks that the luxury business is a great business to be in to create shareholder value” 
    * [Quoting Coco Chanel] “Fashion fades, only style remains the same.” “Coco Chanel years ago said that money is money is money. It’s only the pockets that change. We’ve got to find those pockets.”
    * "Anniversaries, birthdays and girlfriends are always going to be there.” 
    * “If your business model, or your intellectual property, is in ones and zeros, you’re going to have issues. So luckily our intellectual property resides in atoms and it’s tough to wreck.” 
    * “Cartier sleeps in the vault.” 

# On brand integrity: 
    * “You cannot make Ferraris in Fiat factories.” 

# On China: 
    * “When the Chinese nouveau riche want to spend, they do not want to buy Chinese.” 
    * “In the East, authenticity, originality and history matters.” 
    * “I feel like I’m having a black-tie dinner on top of a volcano. That volcano is China ... . Personally I don’t think anything’s going to go wrong in China, that’s my view, but I know nothing and I mean it.”

# Meeting of Minds (June 2014)

** One can learn a lot from meeting with managers, providing the setting is right.**

1. The prime purpose of our company meetings is to assess the skill of managers at investing money on behalf of their shareholders. 
2. Meeting management is not a scientific process. Rather, it involves making judgements about individuals, an activity which is prone to error (witness the rate of divorce). We go into meetings looking for answers to questions such as: does the CEO think in a long-term strategic way about the business? Understand how the capital cycle operates in their industry? Seem intelligent, energetic and passionate about the business? And interact with colleagues and others in an encouraging way? Appear trustworthy and honest? Act in a shareholder-friendly way even down to the smallest detail?
3. When a management team compliments a competitor, this can be like gold dust to investors. Learning that DMGT, the UK media company, found it hard to compete with Rightmove, the property listings website, contributed to our decision to invest in the company.

# Culture Vulture (February 2015)

**Marathon's focus on management forces us to think about corporate culture.**

1. Corporate culture is constituted by a set of shared assumptions and values that guide the actions of employees, and encourage workers to act collectively towards a specific goal. Cultures both reflect the values, and are a prime responsibility, of management. Yet strong cultures can persist long after the careers of those who put them in place. Still, sceptics might ask, why should investors bother with something so ineffable, so intangible? Well, the evidence suggests that culture pays. 
2. Perhaps the best-known study of the subject is Corporate Culture and Performance by John Kotter and James Heskett. This work examines the relationship between corporate culture and company performance in over 200 firms during the 1980s. The authors asked employees their opinions of attitudes to customers and shareholders at competitor firms. Shares in companies exhibiting strong and positive cultures outperformed rivals by more than 800 per cent during the study period. Other studies which measure corporate culture according to how employees regard their own workplace have found a similar link between esprit de corps and stock market returns. 
3. The point is that a strong corporate culture constitutes an intangible asset, potentially as valuable as a high-profile brand or network of customer relationships. As Warren Buffett says of Berkshire Hathaway’s family of businesses: _If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength ... . On a daily basis, the effects are imperceptible; cumulatively, though, their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.”_
4. If a beneficial culture is a valuable intangible asset, and a corrosive one an existential threat, it becomes important to ask: how can an outside investor tell the difference? As with so much of investment, the process is one of piecing together incomplete and obscure pieces of evidence, gathered over time through meetings and research. 
5. Some quantitative measures can be helpful: staff loyalty and inside share ownership are liable to be higher at firms in which employees believe in what they are doing. Corporate incentive schemes say a lot about the firm’s culture. Is management being greedy? What performance metrics are valued – growth for its own sake or customer satisfaction? What do employees think? Opinions can be unearthed through websites such as glassdoor.com (a sort of TripAdvisor for companies). We are constantly looking out for signs of management extravagance and vanity. Danger signs include expensive executive travel (a corporate jet is liable to elicit groans), too numerous pictures of the CEO in the annual report, and dandyish attire.
6. Yet even if a strong culture is instilled in a company, it can take many years for its full effects to play out. That may be beyond Wall Street’s limited investment horizon. Long-term investors, however, would be wise to take heed.
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# Chapter 4: Accidents in Waiting

< [[Capital Returns: Table of Contents]]

* The looming financial crisis also can be understood from a capital cycle perspective. During the boom years, the banks were rapidly growing their assets (loans) and competition was increasing – as evidenced by the appearance of a shadow banking system and the decline in bank lending spreads. This outward shift in the supply side for the finance industry impacted eventually on the industry’s profitability. Viewed in this way, there is nothing particularly special about the banking sector. Capital cycle analysis could also applied usefully to the housing markets in the pre-crisis world. High and rising house prices in some countries elicited an enormous supply response, notably in Spain and Ireland. Those economies which experienced the most extreme capital cycle – in terms of increased stocks of credit and housing – later suffered from the most severe hangovers.

# Accidents in Waiting: Meetings with Anglo Irish Bank (2002-06)

**In the years before the crisis, our meetings with British and Irish bank management teams created a strong sense of foreboding**

* In his book Behavioural Investing, James Montier devotes an entire chapter to the topic entitled “Why Waste Your Time Listening to Company Management?” Montier argues that meetings can overload fund managers with information and are likely to confirm pre-conceptions, especially overly optimistic ones. Fund managers may also become too impressed with authority figures. Admittedly, there’s a danger that the naïve will be gulled into dreadful mistakes. On the other hand, exposure to a truly terrible manager can help investors steer clear of the rocks. Marathon’s own experience of avoiding some of the worst banking disasters of the credit bubble suggests that meetings can have considerable value. We keep notes of our meetings. Below are some pre-crisis observations of a banking accident waiting to happen.

# The Builders Bank (May 2004)

**%A pre-crisis look at the Anglo Irish can of worms**

*Time Is a great story teller*

# Insecuritisation (November 2002)

**Securitisatuon has flooded certain sectors with too much cheap capital**

* Marathon’s investment methodology is based on the tendency for returns on capital for any particular company, or industry, to trend towards a normal level over time. Depending on how quickly this evolution takes place, relative to the market’s expectations, an investment opportunity may arise. For this process to work, however, poor and failing businesses must be deprived of cheap funding. Yet the securitization process now supplies capital at an abnormally low cost to inherently risky activities, delaying the normalisation of profits and storing up losses for the future. This has capital cycle implications. Shareholder returns in industries funded with easy money from securitizations are likely to oscillate around the low marginal cost of funding.

# Carry on Private Equity (December 2004)

**The buyout boom has entered a bubble phase**

# Blowing Bubbles (May 2006)

**Several indicators of speculative activity suggest a market peak has been reached**

# Pass the Parcel (February 2007)

**The securitized debt markets are responsible for the private equity mania**

* For the banks engaging in this pass-the-parcel game, there is always the risk of being caught at the point when the credit market turns. Furthermore, it may be that the banks have not been as clever as they claim in getting rid of potentially toxic credit risks. Once offloaded, the securitized debt may end up back at the same bank’s proprietary trading desk. A recent FSA survey of banks found that only 50 per cent of respondents were able to provide an indication of where they believed the debt had been distributed to. Andy Hornby, chief executive of HBOS, has said that the matter of where leveraged lending risk ends up is one of the biggest issues currently facing UK banks.
* For private equity players, the attitude of making hay while the sun shines seems wholly appropriate, although a scenario of rising defaults is unlikely to leave them unscathed. From the standpoint of an investor in listed equities, however, it appears sensible to maintain a cautious stance towards the European financial sector. Bank assets continue to reach new highs despite the widespread adoption of originate-then-distribute banking practices. Passing on risk, however, may prove easier than passing on blame.

# Property Fiesta (February 2007)

**Over the past few years the Spanish have gone property mad.**

*A tree that grows crooked will never straighten it's trunk* Spanish Proverb

# Conduit Street (August 2007)

**The fragmented nature of the German banking system makes it especially accident prone**

# On the Rocks (September 2007)

**Northern Rock's fickle funding source made the UK bank vulnerable to a credit crunch**

1. While there are some individual instances worthy of attention, our overall sense is that underweighting of the financial sector is the correct position to maintain at this point in time. A number of commentators have drawn the distinction between liquidity risk (lack of wholesale funding) and solvency or the credit quality of the underlying collateral (whether the mortgage is ever repaid). The current crisis is limited to liquidity risk, so the argument goes, and one has nothing to fear regarding the asset side of banks’ balance sheets. Yet the correlation between ever more abundant liquidity and asset price appreciation over the past decade suggests to us that asset prices are vulnerable in the absence of generous support from lenders. From this perspective, it is better to wait for the rise in non-performing loans and asset write-downs, before raising our exposure.

# Seven Deadly Sins (of banking) (November 2009)

**How a Swedish bank sailed through the financial crisis unscathed**

1. First deadly sin: Imprudent asset-liability mismatches on the balance sheet.
2. Second deadly sin: Supporting asset-liability mismatches by clients.
3. Third deadly sin: Lending to “Can’t Pay, Won’t Pay” types.
4. Fourth deadly sin: Reaching for growth in unfamiliar areas.
5. Fifth deadly sin: Engaging in off-balance sheet lending.
6. Sixth deadly sin: Getting sucked into virtuous/vicious cycle dynamics.
7. Seventh deadly sin: Relying on the rearview mirror.

* There are many other ways in which Handelsbanken is different from its peers. In its dialogue with investors, bank representatives refuse to engage in the game of trying to estimate this year’s profit number. They have no other choice, since divisional budgets were abolished in 1972. If managers have budget targets, so the thinking goes, it becomes more difficult to stay out of the market when pricing is unfavourable. 
* Management incentives are also unusual. The bank funds an employee profit-sharing scheme called the Oktogonen Foundation, which receives allocations when the group’s return on equity exceeds the weighted average of a group of other Nordic and British banks. If this criterion is satisfied, and it usually is, except at the peak of the cycle, one-third of the extra profits can be allocated to Oktogonen subject to a limit of 15 per cent of the dividend to shareholders. If the Handelsbanken lowers the dividend paid out to its shareholders, no allocation is made to the profit-sharing foundation. 
* The foundation channels a large part of its resources into Handelsbanken stock and currently holds 11 per cent of the bank’s equity. All employees receive an equal part of the allocated amount (without the traditional skew towards the upper echelons), and the scheme includes all staff in the Nordic countries and, since 2004, in Great Britain. Disbursements are only made once a member of staff has reached the age of 60. Employees who have been working for Handelsbanken since 1973 have around $600,000 – which turns out to be roughly half the value of a Nobel prize – due to them at retirement, regardless of whether they have worked as the CEO or as a security guard. The system undoubtedly contributes to the bank’s tribal culture and aligns employee interests with shareholders. 
* Ultimately, Handelsbanken is a wonderful example of a bank with a strong culture and management team that allocates capital in an intelligent way, with the right incentives and a long-term approach. All of these qualities appeal to Marathon’s investment philosophy. The valuation remains attractive, trading at 1.4 times book value, a P/E of 14 times and a dividend yield of 3 per cent. If only more banks were built this way.
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# Chapter 5: The Living Dead

< [[Capital Returns: Table of Contents]]

1. Capital cycle analysis is strongly influenced by J.A. Schumpeter’s notion of creative destruction, namely that competition and innovation produce a constantly evolving economy and spur improvements in productivity. From this perspective, an economic recession serves a useful function as – to use a rather hackneyed image – the forest fire burns away the dead wood and weaker trees, allowing healthy young plants to grow and prosper.
2. The decline in equity prices following the global financial crisis presented a variety of investment opportunities. Some of the best appeared in industries where capital was rapidly withdrawn after the bust and consolidation took place. The experience of Ireland’s banking sector described below is a good example of the capital cycle moving into a benign phase. It has not been all good news, unfortunately. Several of the pieces in this chapter comment on how European policymakers have prevented various industries – in particular the employment-heavy auto sector and the politically sensitive Continental banking sector – from consolidating. As a result, the operation of the capital cycle has been arrested. This is bad news for investors as the problems of excess capacity and weak profitability have not been addressed. It also augurs ill for the eurozone economy, which appears doomed to low productivity and weak economic growth. These problems have been exacerbated by the post-crisis policy of ultra-low interest rates which, by lowering funding costs, have allowed weak businesses – the corporate zombies – to continue limping along.

# Right to Buy (November 2008)

**Now that signs of speculative excess have been dispelled, the markets look attractive again.**

1. Markets are now restrained by fear and conservatism. Tight liquidity is producing great pricing anomalies. Although the macroeconomic outlook is bleak, this is clearly discounted in equity prices and there would have to be a significant shock to jolt markets further. There have not been such compelling valuations for equities in a generation. From such a low base, it is difficult to believe that investors will not make good returns over any reasonable investment time frame.

# Spanish Deconstruction (November 2010)

**Now that the empire-building of Spanish construction firms are over, investment opportunities are appearing.**

# PIIGS Can Fly (November 2011)

**In the wake of the financial crisis, the capital cycle has entered a positive phase for certain Irish businesses.**

1. The situation at Irish Continental Group (ICG) is similar from a capital cycle perspective. This firm operates as Irish Ferries between Holyhead–Dublin and Pembroke–Rosslare, the shortest sea routes between Ireland and the UK.

# Broken Banks (September 2012)

**The necessary cleansing process for the European Banking Sector is being thwarted by politicians.**

1. European banks are trading at a discount to tangible book, making them considerably cheaper than their US counterparts. Yet from a capital cycle perspective, the investment case for European banks is not clear-cut.
2. One of the lessons from (bitter) experience of investing in banks in the US and UK is that when something as fundamental as the ultimate share count remains uncertain, the investment outcome is unpredictable.
3. In essence, the capital cycle is not working in the banking sector in Europe, because the creative destruction that is required is politically unacceptable. Under the cover that the banks face liquidity problems and not a solvency crisis, eurozone governments are propping up their banks and are likely to continue doing so for years to come. For investors in banks with stronger balance sheets, returns are likely to be restrained by weak lending growth and excessive competition. Schizophrenic policymakers, who on the one hand exhort banks to lend more and on the other hand restrict lending capacity via onerous capital and liquidity requirements, make matters even worse. The threat of abrupt deleveraging in Europe has been replaced by the prospect of many years of slow and painful adjustment.

# Twilight Zone (November 2012)

**Low interest rates are slowing the process of creative destruction **

1. From a capital cycle perspective, the above situations only become attractive when stock market valuations fall to a fraction of replacement cost and a path opens up for dealing with the excess capacity. While the first condition is close to being met in many European sectors, the prospects for the second appears dim. In previous downturns, capacity adjustment has come as a result of interest rates rising to choke off inflation, leading to widespread bankruptcies and industry consolidation. In the early 1990s, for example, our portfolios benefited from UK investments which survived the shake-out and prospered in the subsequent recovery, among them homebuilders (Taylor Woodrow), conglomerates (Trafalgar House) and advertisers (WPP). 
2. With interest rates low and set to remain so, and banks prepared to prop up weak businesses for fear of crystallising losses, monetary policy looks very unlikely to precipitate a major reallocation of resources. Indeed, it appears designed to head-off such a denouement. Under such circumstances, supply side restructuring via industry consolidation also looks like a long-shot, especially as many European industries are already quite consolidated and face anti-trust barriers.
3. While the outlook from a shareholder perspective looks grim for those sectors discussed above suffering from excess capacity, the situation facing many businesses with higher returns on equity is much more promising, particularly as their valuations are tarnished by excessive Euro-pessimism. Our European portfolios have undergone a gradual shift towards higher return on equity businesses over the last ten years or so. Although valuations are at a premium to less profitable businesses, their potential to deliver shareholder value appears far more promising.

# Capital Punishment (March 2013)

**The Capital Cycle ceases to function properly when politicians protect underperforming industries.**

1. The credit boom created excess capacity in a wide array of global industries. If the capital cycle had been operating smoothly, the subsequent collapse in share prices and demand ought to have led to consolidation and capital withdrawal. This has not always been the case, despite notable exceptions in certain industries (e.g., US homebuilders). Errors of capital cycle analysis can lead to mistaken share purchases. Still, they help us adapt and evolve our investment discipline. With hindsight, our capital cycle approach has failed at times when we have underestimated the impact on industries of political and legal interference, disruptive technologies and globalisation. 
2. To this list of external factors, one can add the self-inflicted wounds of mismanagement. The most common problem is the failure of capital to exit industries with unacceptably poor returns. In the latest cycle, the forces of creative destruction have been moderated by aggressive monetary easing and low interest rates. This has allowed weak firms to continue in business, servicing what are likely to prove unsustainable debt levels. This situation contrasts with the end of previous economic cycles when interest rates have risen to stave off inflationary pressures leading to mass bankruptcy. The effect has been exacerbated in a number of territories (notably Europe) by forbearance on the part of banks whose appetite for further write-downs is already constrained in an environment of rising regulatory capital requirements. 
3. Matters tend to get worse when politicians enter the picture. Jobs in manufacturing, unlike financial services, hold a particular allure for the political classes in many developed economies. Lack of growth and overcapacity in mature industries would ordinarily require restructuring and consolidation, particularly as off-shoring is more prevalent in more basic, labour-intensive industries. Nostalgia for a past golden age of “honest” jobs and the politicians’ hunger for votes fuel protectionist instincts. Nowhere is this more apparent than in Europe, where nationalistic urges are irresistible.
4. New technologies often interfere with the smooth operation of the capital cycle. The Internet has wreaked havoc on many industries, including music, regional newspapers, book retailing and travel agencies. Marathon has suffered in a number of cases where the benefits of supply side consolidation in distressed sectors was insufficient to offset a secular decline in demand.5 Fortunately, the capital cycle approach is well attuned to identifying superior Internet business models which can sustain high returns of capital.6 An understanding of the power of network and scale effects that protect companies from the chill winds of competition has led to successful investments in a number of Internet businesses including Amazon, Priceline and Rightmove. (Although, to date Amazon has proven better at destroying profits in other businesses than in generating any for itself.) 
5. In recent years, capital cycle analysis has been more useful at picking stocks in companies which can maintain high returns than in finding opportunities among bombed-out industries recovering (or not) after a supply side restructuring. For the former, the investment case rests on whether competing capital can enter the sector and boost supply, eventually driving down industry returns. What we have seen in a number of cases is that dominant businesses often become more powerful when they have well managed, proprietary assets. Examples here include Nestlé, Unilever, and McDonald’s. It has helped that the durable cash flows generated by such businesses have the bond-like characteristics investors crave in the current environment of low interest rates. 
6. In short, the great strength of the capital cycle approach lies in its adaptability. The basic insight doesn’t change. Namely, both high and low returns are likely to revert to the mean as valuation influences corporate behaviour and brings about shifts in the supply side. In Marathon’s early years, our discipline was focused on finding stocks where the supply conditions were changing. More recently, the emphasis has shifted to identifying sectors and companies where the forces of competition are blunted and the process of mean reversion is drawn out.

# Living Dead (November 2013)

**Extraordinary monetary policy should be seen as a negative rather than a positive by investors**

1. As 2013 draws to a close, the MSCI World Index is up over 20 per cent year-to-date and 130 per cent since March 2009. One oft-cited contributing factor to the equity market’s strength is the unprecedented monetary loosening undertaken since the financial crisis struck. When it comes to quantitative easing, the markets are being moved by two sets of beliefs. Firstly, there’s the view that monetary policy is going to stimulate the economy, which should help corporate profits. Secondly, low interest rates make equities look relatively more attractive than cash and fixed income. The trouble is that there is not much empirical nor theoretical support for either of these views.
2. While seemingly supportive of the economy in the short-term, artificially low interest rates distort incentives and hence outcomes in the economy. So-called “zombie” firms are allowed to live on, while a low cost of funding means lower hurdle rates for new investment. Over time, if capital is not flowing freely to its most productive use, aggregate returns on capital and economic growth will decline.
3. If the argument that quantitative easing benefits the economy is without much foundation, what about the notion that lower interest rates support higher equity valuations? In a world where debt yields little, equities at first glance appear relatively more attractive. In finance theory, a lower risk-free rate implies a lower cost of capital (unless the equity risk premium rises to offset this). And a lower cost of capital means a higher market P/E is justified. But it’s naïve to forget the reason why interest rates are so low in the first place, namely a weak economy, high leverage and the memory of a near catastrophic financial collapse in the rearview mirror. These factors might be expected to increase investors’ cost of equity assumptions warranting a lower P/E multiple.
4. Overall, the continuation of extraordinary monetary policies should be a negative signal for equity holders. It implies that the real economy remains challenged and unable to withstand normal monetary conditions. This, in turn, suggests it is unlikely that the economy will be able to grow fast enough to reduce aggregate leverage to a more sustainable level. Furthermore, the increasing leverage of the public sector raises the risk of another debt crisis – this time a sovereign one – at some future stage. Finally, the longer interest rates remain suppressed, the greater the risk of distorted economic outcomes as falling hurdle rates for investment impact on aggregate returns on capital. The danger is clear – we face a lost decade of growth, this time in the Western world.

# Relax, Mr Piketty (August 2014 )

**Ultra-low rates are enticing investors  into risky assets with the prospect of future losses.**

1. Thomas Piketty in his unlikely bestseller, Capital in the Twenty-First Century, opines that the growing gap between rich and poor should be closed through the imposition of a global wealth tax. The likelihood of such a coordinated assault on the rich must be slim. Nevertheless, Mr. Piketty can take heart from the recent behaviour of many investors. Their hunger for yield and accompanying disregard for safety is set to reduce wealth disparities far more effectively than any new taxes. As J.K. Galbraith posited in The Age of Uncertainty: “The privileged have regularly invited their own destruction with their greed.”
2. Mr. Piketty can rest easy. In an age when risk-free assets yield little or nothing, the determination of the wealthy to earn somewhat more will, in due course, do more to restore equality than his proposed taxes. A free market solution to a political problem – who says capitalism is failing?

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# Chapter 6: China Syndrome

< [[Capital Returns: Table of Contents]]

# Oriental Tricks (February 2003)

**Earnings manipulation around Chinese IPO's has become the norm.**

1. The part played by the foreign investment community in facilitating these scandalous Chinese IPOs is regrettable. Until our industry starts paying more attention to the protection of our clients’ capital, the emergence of one billion consumers is unlikely to deliver a positive investment return.

# Dressed to Impress (November 2003)

**Investors transfixed by China's growth prospects are buying flaky businesses**

# Game of Loans (March 2005)

**Despite strong economic growth, Chinese equities have delivered appalling returns.**

# What lies beneath (February 2014)

**The prospectus of a Chinese asset management company reveals troubling exposures**

1. Even the ugliest of assets purchased at the right price can make for a great investment.

# Value Traps (September 2014)

**Chinese banks are highly leveraged and poorly positioned in the Capital Cycle**

* In the textbook example of a capital cycle, new capital is attracted into sectors with outsized profits. Eventually, this influx of capital causes capacity to overshoot, which hurts industry profitability and shareholder returns. This process is most marked in commodity businesses, whose products are undifferentiated. The opportunity to make really good investments tends to occur only after a turn in the cycle; that is, when capital begins to exit. 
* Given that credit is a commodity, capital cycle analysis is as relevant for banks as it is for any other commodity business. There are, however, some differences. Because credit has no physical constraints, its increase is limited only by the amount of equity a bank can accumulate and the amount of leverage it can assume. This makes it easier for management to get carried away in the upward phase of the cycle. When the banking cycle turns, there needs to be a catch-up charge for the unrecognised sins of the past – that is, a spike in credit costs. Capacity also needs to exit through deleveraging; this comes in the form of shrinking balance sheets and mergers.

# Devil Take the Hindmost (May 2015)

**Chinese equities are showing every sign of speculative excess.**


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# Chapter 7: Inside the Mind of Wall Street

< [[Capital Returns: Table of Contents]]

# A Complaint

**A satirical take on promotional corporate management**

* First your team questioned the very idea that we should grow. This is very demotivating for my team, as you can imagine. That growth is good in itself should be self-evident. Your analysts, however, appeared to be suggesting that we shrink our operations back to a profitable core and, by buying back shares, maximize the return on capital employed.
* Shrinking the business, as Marathon suggests, would represent a failure of management imagination. Our bankers at Greedspin, who currently have a host of acquisition ideas, have never suggested downsizing. Growth is also essential if we are to achieve our career goals. Bigger companies are able to reward top talent and we need to get onto a level playing field. Buying back shares would reduce liquidity and make the investor’s job more difficult. Surely you can see that. We are very proud of the fact that 10 per cent of General Chocolate’s stock is now traded each month. Yet still we think we can increase this level by improving the news flow. We are currently considering offering a new “instant guidance” service for shareholders that will be automatically triggered with every percentage point movement in the cocoa price.
* Even in the non-controversial area of cost control, there was no meeting of minds. Your colleagues suggested that we should raise costs in areas such as marketing and research. Yet such an action would have a negative impact on our quarterly earnings per share, hardly something we could present to our institutional shareholders. While the front cover of our annual report does indeed state that people are “our most important asset” we must weigh this against the productivity-enhancing redundancy program that specifically targets non-customer facing, non-measurable, up-front expenses with uncertain and distant pay-offs. This cost-focussed strategy improves visibility and is immediately EPS accretive.
* I am informed by our bankers, who employ hundreds of analysts, that the main job of an analyst is to understand the growth prospects of the business in order to forecast accurately the earnings numbers over the coming months.

# Private Party (December 2005)

**Marathon's fictional banker, Stanley Churn, is excited by fee prospects in the private equity world**

* The fund management industry still doesn’t “geddit.” The new leverage paradigm has passed most of these guys by and they’re still using ridiculous cost of capital metrics and debt structures left over from the past. Don’t they understand what little you need to do to enhance earnings per share? Just add debt! And the buy-side fools so confuse value and price, that when we say “20 per cent premium,” they scream “deal!” Their pockets are ripe for picking!
* My message to you is straightforward. We must act quickly to grasp a once-in-a-lifetime fee generation opportunity in the private equity industry – an opportunity which I believe is greater even than that available in my old field of investment banking.
* The fund management industry still doesn’t “geddit.” The new leverage paradigm has passed most of these guys by and they’re still using ridiculous cost of capital metrics and debt structures left over from the past. Don’t they understand what little you need to do to enhance earnings per share? Just add debt! And the buy-side fools so confuse value and price, that when we say “20 per cent premium,” they scream “deal!” Their pockets are ripe for picking!
* Managements can see where their bread is buttered. The real money is on the private side of the fence, and they’re fed up with all the pesky regulation on the public side. We just need to bring them on board and reload their incentives. With the C-Suite in our pockets, we can get the pre-deal earnings disappointments and all the board recommendations we need. The principal-agent conflict isn’t our problem – it’s our solution.

# Christmas Cheer (December 2008)

**Stanley Churn envisages a profitable future for Wall Street in the aftermath of the Lehman Bust**

# Former Greedspin boss flees China (December 2010)

**Stanley Churn's private thoughts on the Chinese economy are revealed**

# Occupy Bundestag (December 2011)

**Returning to Greedspin, our irrepressible banker is full of fee-generating ideas**

* Today the outlook appears bleak not just for Greedspin but for the very future of capitalism. However, if anything on Wall Street is certain – if history has taught us anything – it’s that challenges mean new fee opportunities.

# Season's Greetings (December 2012)

**Stanley Churn, now head of Greedspin, is out of sorts in the era of 'Citizen Banker'.**

* Now the only league tables we head are toxic ones: LIBOR-rigging, money laundering, insurance misselling, “unauthorized” trading losses ... . Behaviour which was once just part of the game – if not the game itself – is now viewed with horror by the sanctimonious prigs who regulate us. Yes, the same people who were the cops when the “crimes” were committed! How shocking it must have been to discover LIBOR submissions were phoney as they prepared to nationalize half the sector!

# Lunch with the GIR (Global Investment Review published by Marathon)(December 2013)

**The Greedspin banker talks about his career, his never-ending bullishness and a bizarre recreational interest**

1. With his new young wife, Susie, his Beijing-born former PA, he then moved to China to set up a new investment bank, Churn-Woo International. After a year, he was forced to flee following embarrassing leaks in the media revealed a wide gap between his own sceptical views on the Chinese economy and the firm’s marketing literature. The episode caught the eye of Greedspin’s then-Chairman, Ronnie Fix, who welcomed him back to his alma mater as special adviser. Redemption was complete when Mr. Fix was forced to resign after the LIBOR-rigging scandal and Churn was appointed Chairman of his old firm.
2. 

Thanks & Regards, 
Vimal & Sons