Capital returns: concentrate on the supply side

Capital returns is a must read for anyone serious about investing and business in general. The book exemplifies that capital investment drives investment returns and, therefore, investors should be concentrating on the supply side more than the demand side. Mean reversion is driven by investment; as capital enters an industry earning over the cost of capital, returns revert to normal.

The book is a hand-picked collection of investor letters by Marathon from the past decade. The letters cover specific events on the micro and macro level, emphasising the power of capital in shaping changes in competitive advantages for industries and businesses. The essays are mostly case study based and cover a wide range of situations including the GFC, Spanish property bubble, China and Ireland's banking crisis.

'Everything (including investment) should be made as simple as possible, but no simpler' 

Why try and predict the many different, fast moving variables attributable to future demand when we can analyse the slow-moving parts of the supply side? Entrants and exits into an industry happen a lot slower and less frequent than product launches or price moves. Capital expenditure and asset growth is easier to track and forecast than revenue growth. Consumer preferences and habits are fast moving and ever-evolving but the structure of industry's and companies are slow moving. The supply side is notably easier to analyse yet it's seemingly overlooked by the sell side and market commentators.

Human nature follows trends, scared to miss out on the excess returns neighbours may be earning. Managers are under the same herding bias when allocating shareholder capital. Good management capital allocation decisions are paramount to shareholder performance in the long run. Marathon look for counter-cyclical allocators, those that are able to scoop up assets at the bottom of the cycle or who raise at the top.

Management of one company I follow fits the criteria well: TGS NOPEC. Operating within an industry that is currently consolidating and seeing huge capital outflow the company has ramped up capex to buy cheap assets and gain market share. Tracking management's allocation decisions throughout the cycle can prepare one for making a move when the demand side is clearer.

Finally, one good question the book implies investors ask oneself is: how much capital would a serious competitor need to gain market share over X company? Not only how much would they need, but how would they need to allocate this capital to gain a similar competitive position over company X?

Notes from the book here

Disclosure: No position in TGS.