From Capital Returns (the excerpt below was from a Marathon letter in March 2014):
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.
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).
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. A recent meeting with the CEO of Bunzl, the leading specialist business-to-business distributor, was instructive in this regard. While sell-side analysts covering the stock have made reasonably accurate forecasts of returns from the core business, they have consistently failed to give management credit for adding value via bolt-on acquisitions, despite 20 years or so of supporting evidence. Investors also appear to be biased against “boring” high return companies, such as Bunzl, which do not offer the prospect of immediate high share price appreciation.
Chart 1.7 The fade rate
Source: Marathon, Credit Suisse HOLT.
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. The turnaround achieved at Fiat by Sergio Marchionne in recent years is one outstanding example. Highly competent managers are often attracted by the challenge of turning around a troubled company, not least because of the financial rewards.