In one of the interviews Edward Chancellor gave recently, he made the comment below, which I think was probably the most practical investing lesson that can be used going forward:
Ed: And this interesting point is that people, I don’t quite know why, but they love to think about and project demand into the future. They love it, I suppose, because… well, they like projecting demand because demand is unknowable. And because it’s unknowable, then you can have any fantasy you want about it at all, optimistic or pessimistic.
But given the nature of mankind, those would tend to be optimistic. So a huge amount of work goes into forecasting demand. As our mutual friend Russell Napier says, analysts spend 90% of their time thinking about and forecasting demand, and 10% of their time thinking about supply.
Now, the interesting thing about supply is that supply actually can be forecasted because in most industries, it takes quite a while for the supply to come on stream. You can see how much assets have grown inside an industry, or inside any particular business. You can see it through any number of measures.
Through IPO issues, through secondary share issues, through companies taking on more debt, through companies going through a boom, such as the mining companies or the US homebuilders, who have had a surge in profitability, and have reinvested those profits.
You can measure it technically through looking at things, like current capital spending to depreciation ratios. Or you can look at it, for instance, the rate of reported profitability of a company to its cash flow, the so called cash conversion rate. And if a company is generating large profits, but not generating any cash flow, it’s probably in a negative phase of the capital cycle.
So the point, to go back to what you were saying, is that investors, if they knew the right way to approach, would be thinking 90% about supply, and then fantasising 10% about the completely, or not quite completely, but more or less completely unknowable demand side.
In his introduction to the book Capital Returns he gives several recent examples where a focus on supply instead of rosy demand projections would have allowed one to better grasp the risk one was taking investing in particular stages of those industry cycles, including the telecoms in the late 1990s, shipping in the 2001-2007 period, and the homebuilding industry that peaked in 2006. The below excerpt on the homebuilding boom is a good example showing the capital cycle and the importance of focusing on industry supply:
Rising house prices after 2002 prompted another capital cycle in the US homebuilding industry. By the time the US housing bubble peaked in 2006, the excess stock of new homes was roughly equal to five times the annual production required to satisfy demand from new household formation. Spain and Ireland, whose real estate markets had even more pronounced upswings, ended up with excess housing stocks equivalent to roughly 15 times the average annual supply of the pre-boom period. Whilst under way, housing booms are invariably justified by references to rosy demographic projections. In the case of Spain, it turned out that recent immigration had largely been a function of the property boom. After the bubble burst and the Spanish economy entered a depression, foreigners left the country by the hundreds of thousands.
Several well-known “value” investors who ignored capital cycle dynamics were blindsided by the housing bust. In the years before US home prices peaked in 2006, homebuilders had grown their assets rapidly. After the bubble burst, these assets were written down. As a result, investors who bought US homebuilders’ stocks towards the end of the building boom when they were trading around book value – towards their historical lows – ended up with very heavy losses [5]. From a capital cycle perspective, it’s interesting to note that although UK and Australia experienced similar house price “bubbles,” strict building regulations prevented a supply response. Largely as a consequence, both the British and Australian real estate markets recovered rapidly after the financial crisis [6].
[5] For instance, the large US homebuilder KB Home experienced a 28 per cent compound annual growth in assets between 2001 and 2006. By summer of 2006, its shares were trading at 1.2 times book. From that point, KB’s book value declined by 85 per cent, and its shares, already well below their peak, fell a further 75 per cent
[6] The fact that UK housing supply didn’t respond to the British housing bubble is reflected in the superior performance of UK homebuilding stocks relative to their US counterparts over the last decade