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<p>CAPITAL RETURNS</p><p>Wall Street’s Wheel of Fortune</p><p>(illustration by David Foldvari)</p><p>CAPITAL</p><p>RETURNS</p><p>INVESTING THROUGH THE</p><p>CAPITAL CYCLE: A MONEY</p><p>MANAGER’S REPORTS 2002–15</p><p>Edited by</p><p>EDWARD CHANCELLOR</p><p>© Marathan Asset Management LLP 2016</p><p>© Intoduction Edward Chancellor 2016</p><p>All rights reserved. No reproduction, copy or transmission of this</p><p>publication may be made without written permission.</p><p>No portion of this publication may be reproduced, copied or transmitted</p><p>save with written permission or in accordance with the provisions of the</p><p>Copyright, Designs and Patents Act 1988, or under the terms of any licence</p><p>permitting limited copying issued by the Copyright Licensing Agency,</p><p>Saffron House, 6–10 Kirby Street, London EC1N 8TS.</p><p>Any person who does any unauthorized act in relation to this publication</p><p>may be liable to criminal prosecution and civil claims for damages.</p><p>The author has asserted his right to be identified as the author of this work</p><p>in accordance with the Copyright, Designs and Patents Act 1988.</p><p>First published 2016 by</p><p>PALGRAVE</p><p>Palgrave in the UK is an imprint of Macmillan Publishers Limited, registered</p><p>in England, company number 785998, of 4 Crinan Street, London N1 9XW</p><p>Palgrave Macmillan in the US is a division of St Martin’s Press LLC,</p><p>175 Fifth Avenue, New York, NY 10010.</p><p>Palgrave is the global imprint of the above companies and is represented</p><p>throughout the world.</p><p>Palgrave® and Macmillan® are registered trademarks in the United States,</p><p>the United Kingdom, Europe and other countries</p><p>This book is printed on paper suitable for recycling and made from fully</p><p>managed and sustained forest sources. Logging, pulping and manufacturing</p><p>processes are expected to conform to the environmental regulations of the</p><p>country of origin.</p><p>A catalogue record for this book is available from the British Library.</p><p>Library of Congress Catalogingin-Publication Data</p><p>Capital returns : investing through the capital cycle : a money manager’s reports</p><p>2002–15 / Edward Chancellor.</p><p>pages cm</p><p>1. Business cycles. 2. Marathon Asset Management. 3. Speculation. I. Chancellor,</p><p>Edward, 1962– editor. II. Marathon Asset Management.</p><p>HB3711.C353 2015</p><p>332.6—dc23 2015025955</p><p>ISBN 978-1-349-55541-3 ISBN 978-1-137-57165-6 (eBook)</p><p>DOI 10.1007/978-1-137-57165-6</p><p>CONTENTS</p><p>List of Charts, Illustrations and Tables viii</p><p>Foreword x</p><p>Preface xii</p><p>Introduction by Edward Chancellor 1</p><p>Part I Investment Philosophy</p><p>1 Capital Cycle Revolution 25</p><p>1.1 Evolution of cooperation (February 2004) 25</p><p>1.2 Cod philosophy (August 2004) 28</p><p>1.3 This time’s no different (May 2006) 31</p><p>1.4 Supercycle woes (May 2011) 33</p><p>1.5 No small beer (February 2010) 37</p><p>1.6 Oil peak (February 2012) 40</p><p>1.7 Major concerns (March 2014) 43</p><p>1.8 A capital cycle revolution (March 2014) 45</p><p>1.9 Growth paradox (September 2014) 48</p><p>2 Value in Growth 52</p><p>2.1 Warning labels (September 2002) 53</p><p>2.2 Long game (March 2003) 55</p><p>2.3 Double agents (June 2004) 58</p><p>2.4 Digital moats (August 2007) 60</p><p>2.5 Quality time (August 2011) 62</p><p>2.6 Escaping the semis’ cycle (February 2013) 65</p><p>2.7 Value in growth (August 2013) 68</p><p>2.8 Quality control (May 2014) 70</p><p>2.9 Under the radar (February 2015) 73</p><p>3 Management Matters 76</p><p>3.1 Food for thought (September 2003) 76</p><p>3.2 Cyclical missteps (August 2010) 80</p><p>CONTENTSvi</p><p>3.3 A capital allocator (September 2010) 82</p><p>3.4 Northern stars (March 2011) 85</p><p>3.5 Say on pay (February 2012) 88</p><p>3.6 Happy families (March 2012) 91</p><p>3.7 The wit and wisdom of Johann Rupert (June 2013) 95</p><p>3.8 A meeting of minds (June 2014) 99</p><p>3.9 Culture vulture (February 2015) 102</p><p>Part II Boom, Bust, Boom</p><p>4 Accidents in Waiting 107</p><p>4.1 Accidents in waiting: meetings with Anglo Irish</p><p>Bank (2002–06) 109</p><p>4.2 The builders’ bank (May 2004) 117</p><p>4.3 Insecuritization (November 2002) 120</p><p>4.4 Carry on private equity (December 2004) 122</p><p>4.5 Blowing bubbles (May 2006) 126</p><p>4.6 Pass the parcel (February 2007) 130</p><p>4.7 Property fiesta (February 2007) 132</p><p>4.8 Conduit Street (August 2007) 135</p><p>4.9 On the rocks (September 2007) 138</p><p>4.10 Seven deadly sins (November 2009) 141</p><p>5 The Living Dead 145</p><p>5.1 Right to buy (November 2008) 146</p><p>5.2 Spanish deconstruction (November 2010) 148</p><p>5.3 PIIGS can fly (November 2011) 151</p><p>5.4 Broken banks (September 2012) 154</p><p>5.5 Twilight zone (November 2012) 156</p><p>5.6 Capital punishment (March 2013) 158</p><p>5.7 Living dead (November 2013) 160</p><p>5.8 Relax, Mr. Piketty (August 2014) 163</p><p>6 China Syndrome 167</p><p>6.1 Oriental tricks (February 2003) 168</p><p>6.2 Dressed to impress (November 2003) 171</p><p>6.3 Game of loans (March 2005) 173</p><p>6.4 What lies beneath (February 2014) 176</p><p>6.5 Value traps (September 2014) 179</p><p>6.6 Devil take the hindmost (May 2015) 181</p><p>CONTENTS vii</p><p>7 Inside the Mind of Wall Street 184</p><p>7.1 A complaint (December 2003) 185</p><p>7.2 Private party (December 2005) 189</p><p>7.3 Christmas cheer (December 2008) 192</p><p>7.4 Former Greedspin boss flees China (December 2010) 195</p><p>7.5 Occupy Bundestag (December 2011) 197</p><p>7.6 Season’s greetings (December 2012) 200</p><p>7.7 Lunch with the GIR (December 2013) 203</p><p>Index 207</p><p>LIST OF CHARTS , I LLUSTRATIONS</p><p>AND TABLES</p><p>CHARTS</p><p>I.1 The capital cycle 4</p><p>I.2 Asset growth and investment returns 8</p><p>I.3 Investor overreaction and the capital cycle 14</p><p>1.1 Nominal changes in commodity prices (2001–10) 34</p><p>1.2 Mining capital spending in the MSCI World Index 34</p><p>1.3 Global M&A activity in metals & mining industry 35</p><p>1.4 Capital markets financing of metals & mining industry 35</p><p>1.5 Global market share of top four brewers 38</p><p>1.6 Brent crude oil price 40</p><p>1.7 The fade rate 46</p><p>1.8 Vestas Wind Systems: capex-to-depreciation ratio and</p><p>relative share price performance 47</p><p>1.9 Global M&A, IPO and S&P 500 buybacks 50</p><p>2.1 The semiconductor cycle 65</p><p>3.1 European capital allocation 80</p><p>3.2 Average holding period for equities by geographic region 90</p><p>3.3 Credit Suisse Family Index 92</p><p>4.1 Anglo Irish Bank: extracts from Marathon meeting notes 108</p><p>4.2 Anglo Irish Bank EPS growth and customer advances 118</p><p>5.1 Irish banks lending share 152</p><p>5.2 US GDP recoveries after recessions 161</p><p>6.1 China’s investment share of GDP 175</p><p>6.2 Bank of America and ICBC: loan growth and credit costs 180</p><p>ILLUSTRATIONS</p><p>Wall Street’s Wheel of Fortune (illustration by David Foldvari) ii</p><p>4.1 Northern Rock headquarters 139</p><p>7.1 A Churn’s-eye view of the World 185</p><p>ixL IST OF CHARTS , I L LUSTRAT IONS AND TABLES</p><p>TABLES</p><p>2.1 Amazon’s net profit margin 61</p><p>6.1 Performance of Chinese government-sponsored equity</p><p>issues (1993–2003) 168</p><p>FOREWORD</p><p>Marathon Asset Management LLP1 will shortly celebrate its 30th birthday.</p><p>Over three decades, our investment philosophy has evolved, but two simple</p><p>ideas about how capitalism works have always been paramount.</p><p>The first notion is that high returns tend to attract capital, just as low</p><p>returns repel it. The resulting ebb and flow of capital affects the competitive</p><p>environment of industries in often predictable ways – what we like to call</p><p>the capital cycle. Our job has been to analyze the dynamics of this cycle: to</p><p>see when it is working and when it is broken, and how we can profit from it</p><p>on behalf of our clients. The second guiding idea is that management skill in</p><p>allocating capital is vital over the long-term. Picking managers who allocate</p><p>capital in sensible ways is crucial to successful stock selection. The best man-</p><p>agers understand the capital cycle as it operates in their industries and don’t</p><p>lose their heads in the good times.</p><p>We found that the kind of opportunities created by capital cycle analysis</p><p>often have long gestation periods, as the timing of the pay-off was highly</p><p>uncertain. As a result, we discovered that our approach has worked best</p><p>when we invested in a relatively large number of stocks, holding onto them</p><p>for long periods of time. This rather goes against the grain of our industry</p><p>where the preference has been to hold concentrated portfolios, confirming a</p><p>fund manager’s conviction in his or her ideas, albeit for shorter and</p><p>the time served by troops in a particular trench, making it harder for the</p><p>soldiers to establish cooperative rules of (non-)engagement with the opponent.</p><p>Industries where managers can be seen to be extending the “shadow of the</p><p>future,” by signalling how they will respond to competitor behaviour, are thus</p><p>wholly welcome.</p><p>Biological evolution works by natural selection, and so it is with the evo-</p><p>lution of cooperation. Employment or anti-trust concerns blunt the efficacy</p><p>of this process, most notably via Chapter 11 bankruptcy protection. Again,</p><p>we have noted in the past how the imposition of exit barriers can lead to</p><p>“survival of the unfittest.” Likewise on a broader macroeconomic level, the</p><p>low interest rate policy of the Federal Reserve – replacing an investment/</p><p>tech bubble with a housing/credit bubble – has (so far) stymied many of the</p><p>natural evolutionary forces. But that’s another story ... .</p><p>A basic industry with few players, rational management, barriers to</p><p>entry, a lack of exit barriers and non-complex rules of engagement is the</p><p>perfect setting for companies to engage in cooperative behaviour. It is rela-</p><p>tively easy to identify those industries where these conditions exist cur-</p><p>rently (just look at existing returns on capital), and it is for this reason that</p><p>the really juicy investment returns are to be found in industries which are</p><p>evolving to this state. The joy from a capital cycle perspective is that most</p><p>investors are, for a variety of behavioural reasons, taken by surprise. Across</p><p>many competitive battlefronts, we are always looking out for the next out-</p><p>break of peace.</p><p>CAPITAL RETURNS28</p><p>1.2 COD PHILOSOPHY (AUGUST 2004)</p><p>The cod fishing industry provided a marvellous example of the capital cycle</p><p>in action until governments intervened</p><p>Thoughtful investment managers probably packed Capital: The Story of</p><p>Long-Term Investment Excellence by Charles Ellis for their beach reading</p><p>this year. Instead, our pick of the holiday reading this year is Cod by Mark</p><p>Kurlansky. In this wonderful book, Kurlansky describes the rise and fall of</p><p>the cod fishing and processing industry from the perspective of a social his-</p><p>torian and gastronome, and the book takes the form of a culinary travelogue</p><p>peppered with recipes. The recipes look appealing, but our advice is to read</p><p>the book from the perspective of the capital cycle; then the industry’s rise</p><p>and fall becomes even more interesting.</p><p>While there has always been plenty of cod in the sea, so to speak, the</p><p>identity of the trade’s beneficiaries has changed constantly. What follows</p><p>here is a précis of the book from an investor’s perspective, with apologies to</p><p>Mr Kurlansky for reinterpreting his fine work.</p><p>Cod is prized because it is high in protein and low in oils and fats. Fresh,</p><p>the meat flakes and falls from the bone, so it is easy to prepare. When it is</p><p>dried, the water evaporates and the residue is more than 80 per cent protein.</p><p>Almost the entire fish can be put to use: in Iceland, the organs are used as</p><p>fertilizer and even the bones are softened with milk and fed to children. The</p><p>fish is large and easily caught – so easily caught it is of little interest to sport</p><p>fishermen. Markets for the fish stretch from North America, throughout</p><p>Europe and to the Caribbean. In fishing, cod’s where the money is (or, at</p><p>least was).</p><p>In the early sixteenth century, cod was so prized that Portuguese fisher-</p><p>men sailed to Newfoundland to catch cod for the Basque market in Spain.</p><p>This was no easy trip, and Kurlansky notes that “European ambition was</p><p>simply too far ahead of technology, and until better ships and better naviga-</p><p>tion were developed, shipwrecks and disappearances were a regular part of</p><p>this new adventure.” It is probably a safe bet that the price of cod reflected</p><p>these trials, enough at least to fund industry development, as by the mid-</p><p>sixteenth century over 60 per cent of the fish eaten in Europe were cod, a</p><p>percentage that remained relatively unchanged for almost two centuries.</p><p>To prepare the fish for the long journey to market, cod was gutted, sun</p><p>dried and salted. Space was limited on small, sail-powered trawlers, and so</p><p>processing took place in port. Harbours with natural exposed rock slabs for</p><p>drying cod, located near the cod fields, as can be found on the Newfoundland,</p><p>New England and Icelandic coasts, became the natural pinch-point between</p><p>CAPITAL CYCLE REVOLUT ION 29</p><p>the abundance of fish in the sea and the households of Europe. The result</p><p>was a cod processing boom, and “men of no particular skill, and with very</p><p>little capital, made fortunes.” However, the pinch-point in the system, where</p><p>the excess profits were made, did not stay with the fishing ports for long, as</p><p>their harbours were too small to berth transatlantic cargo vessels. Instead,</p><p>the bottleneck naturally migrated to the nearest sizeable port with a central</p><p>market, which in New England was Boston.</p><p>Until the American Revolution, Britain’s trade monopoly with</p><p>Massachusetts required the colony to sell Boston salted cod to selected British</p><p>ports. But England had its own cod industry and a taste for fresh, not salted</p><p>fish. The market for New England cod remained in Continental Europe and</p><p>especially with the Basques in Spain and in Portugal. So the British authori-</p><p>ties turned a blind eye to the illegal trade, and New England entrepreneurs</p><p>sold salt cod directly to the Europeans in exchange for currency and mate-</p><p>rials, with lower quality scraps sold directly to the sugar plantations in the</p><p>Caribbean in exchange for molasses.</p><p>A three-way trade evolved: ships took New England salted cod to Europe,</p><p>African slaves to the Caribbean sugar plantations, and Caribbean molasses</p><p>to the newly established New England rum distilleries. By the eighteenth</p><p>century, the three-way trade, powered by cod, had lifted New England from</p><p>a distant colony of starving settlers to an international commercial power</p><p>with a fully-fledged “cod aristocracy.”</p><p>This phase lasted until technology caught up, or rather at least three</p><p>technologies working in combination. The first was developed in the 1920s</p><p>by Clarence Birdseye (who else?) who, after a series of home experiments</p><p>which included irritating his wife by keeping live pickerel in the bathtub,</p><p>successfully developed food-freezing. Second, came the introduction of</p><p>steam-powered trawlers, which were larger and more efficient than their</p><p>sail-powered forerunners and could in theory strip the ocean of its contents.</p><p>Third, was sonar, which for the first time could accurately locate shoals of</p><p>cod and by the 1930s had become standard issue on British vessels. Once</p><p>food-freezing technology was incorporated into the new steam-powered</p><p>trawlers, there was no need to dock in the old harbours to cure fish or pay</p><p>commission to the Boston market. Instead, Spanish vessels fished off the</p><p>Newfoundland coast and docked fresh fish in La Rochelle, France. The old</p><p>harbours and the Boston market went into decline.</p><p>However, the new equipment was expensive; certainly, “men of no capi-</p><p>tal” were barred from entering the industry, and those that remained bor-</p><p>rowed heavily to stay competitive. Each individual’s financial incentive was</p><p>to catch more fish to repay debts, and over-fishing became commonplace. As</p><p>CAPITAL RETURNS30</p><p>the price of fish declined, fishermen became caught in a “prisoner’s dilemma”</p><p>and opted to land more fish. “Cod wars” broke out over rights to fish, and the</p><p>industry went into crisis.</p><p>The first government to intervene in the cod wars was Iceland, which</p><p>asserted sovereignty over its coastal waters to a distance of one mile, then</p><p>four miles, then 50 miles and, in 1973, 200 miles. The effect was to national-</p><p>ize the waters for the purpose of supporting the local industry and force for-</p><p>eign vessels elsewhere. The governments of Canada, the US and the EU had</p><p>little choice but to follow suit, and soon the North Atlantic had been carved</p><p>up into four exclusive zones, with fish</p><p>quotas set to restore depleted stocks.</p><p>When viewed from the perspective of the capital cycle, the interven-</p><p>tion has been a disaster. Ordinarily capital would leave the industry, pro-</p><p>ductive capacity would shrink, and prices rise toward an economic rate of</p><p>return. Instead, government support financed, of course, by taxes has kept</p><p>industry capacity high and the price of fish low. Worse still, the quota sys-</p><p>tem is administratively complex, hard to enforce, and is often flouted. The</p><p>Canadian government, which is reported to have invested three dollars in</p><p>the industry for every dollar the fisheries earn, has set the high water mark</p><p>for bureaucratic inefficiency.</p><p>Over approximately 150 years, the cod fishing and processing industry</p><p>has evolved from one where excess profits were earned at the ports, then the</p><p>market, then the food processors, to one where it is the consumers of fish</p><p>that are the industry’s chief beneficiaries. The primary driver of the process</p><p>has been the decline in the cost of technology, which has removed the excess</p><p>profits earned at the pinch-points in the industrial process.</p><p>It is for this reason that Marathon research focuses on not just the mag-</p><p>nitude of a company’s profitability (the size of the pinch-point – what is the</p><p>capacity of Boston’s port?) but also its sustainability (why dock at Boston at</p><p>all?). The longer one owns shares, the more important sustainability becomes,</p><p>and so we focus on companies that control their own pinch-point. Is Nike’s</p><p>$1bn media budget high enough? Is Ethan Allen’s advertising spending suf-</p><p>ficient? Is Invensys’ research and development proprietary? And for firms</p><p>with less control of their destiny, we focus on the industry supply side for</p><p>signs of rising levels of competition. Is the Thai cement industry expanding</p><p>again? Is Shimano increasingly vulnerable to niche competitors?</p><p>The same capital cycle process that hollowed out the profits from the</p><p>cod industry can been seen throughout the economy: it has taken around 70</p><p>years from the introduction of the Bessemer Process to reach commoditiza-</p><p>tion in the integrated steel mill industry, mainly through competition from</p><p>asset-light mini mills. Department stores have been commoditized in 30</p><p>CAPITAL CYCLE REVOLUT ION 31</p><p>years by big box retailing. In semiconductors, excess profits are wrung out</p><p>in less than two years. The question for investors today is how long will the</p><p>same process take in media distribution, telecommunication, or online auc-</p><p>tions? Which of these businesses will end up being the twenty-first century</p><p>equivalent of the Newfoundland harbours or Boston fish market?</p><p>1.3 THIS TIME’S NO DIFFERENT (MAY 2006)</p><p>High commodity prices are eliciting a supply side response</p><p>These are tough times to be a signalman on the French railways, if recent</p><p>newspaper reports are to be believed. They are having to cope with unprec-</p><p>edented levels of theft of signalling copper cable, from wires overhead or</p><p>buried in the ground, as the recent rise in the price of copper attracts the</p><p>attention of the light-fingered. Seven tonnes of copper are reported to have</p><p>been stolen from one stretch of track alone. Meanwhile, in the UK, the Royal</p><p>Mint has warned people not to think about melting down their pennies,</p><p>which some believe are now worth more for their copper content than as</p><p>currency. These strange circumstances are a result of the general rise in com-</p><p>modity prices over the past few years. The price of copper has risen six-fold</p><p>since the end of 2001, and the prices of a number of other metals – including</p><p>iron ore, zinc, aluminium and, of course, gold – have also taken off.</p><p>Part of the reason for the boom is demand from emerging countries,</p><p>notably China and India, whose economies are growing rapidly with high</p><p>levels of construction and relatively inefficient production. A commodi-</p><p>ties “supercycle” is said to be under way.2 Supply has been constrained by</p><p>underinvestment in the mid- to late-1990s, when commodity prices were</p><p>lower. Commodity bulls say that this cycle will be different from previous</p><p>cycles since better investment discipline is supposedly keeping supply levels</p><p>in check. Moreover, there is a shortage of mining equipment (a common</p><p>complaint from mining companies these days). A recent brokerage report</p><p>claimed that rising extraction costs – costs are said to have risen by around</p><p>30 per cent over the past two years – would ensure ever rising commodity</p><p>prices, as the miners would continue to be able to charge ever higher prices.</p><p>Such is the circular logic of bull markets.</p><p>The rise in commodity prices has naturally attracted interest on Wall</p><p>Street. Commodities, asset allocation experts claim, should be considered a</p><p>vital part of every investment portfolio. Hedge funds are now commodities</p><p>2 The expression “commodity supercycle” surfaced in a Morgan Stanley report published</p><p>in March 2004, just as the commodity bull market was taking off.</p><p>CAPITAL RETURNS32</p><p>experts. Banks are planning to double the size of their commodities trad-</p><p>ing staff, and there are breathless reports of seven-figure, sign-on bonuses</p><p>for commodities traders (who were probably unemployable a few years ago).</p><p>Several investment banks have developed specialist commodity indices,</p><p>which no doubt they use to sell derivative products to clients. At Marathon,</p><p>we are bombarded with invitations to attend exotic conferences on special-</p><p>ist areas of commodities (which stand alongside invites to conferences on</p><p>wind power, solar power and carbon emissions). The increasing popularity</p><p>of commodity-related funds suggests that that well known trend-follower,</p><p>the retail investor, is getting in on the act.</p><p>A simple analysis of the economics suggests that the rapid rise in price</p><p>in a number of commodities is unsustainable. Take copper, for example. The</p><p>current cost of production is roughly $0.80–0.90 per pound, with the mar-</p><p>ginal cost of production somewhat above that, say $1.20 per pound. Yet the</p><p>current price is $3.60 per pound, three times the cost of production (five</p><p>years ago, copper traded for as little as 60 cents). It is hard not to see specula-</p><p>tion at work, as hedge funds and other non-industrial buyers push up prices,</p><p>hoping to get out before the price turns.</p><p>Commodity bulls attribute high prices to supply shortages, and argue</p><p>that higher prices are needed as an incentive to invest in production. All the</p><p>same, one can be sure that additional supply will be forthcoming at some</p><p>point.3 Indeed, mining companies have certainly responded to the pricing</p><p>situation in the way that one would expect: initially they were sceptical of</p><p>the price rises, but later they started investing heavily to bring on new sup-</p><p>ply. Mining exploration costs doubled between 2003 and 2005. Much of this</p><p>additional spending is a consequence of having to absorb higher production</p><p>costs, but not all of it. Indeed, some mining companies believe that there is</p><p>enough supply coming on stream in copper for there to be a sizeable market</p><p>surplus in a couple of years’ time. Supply bottlenecks do not last forever.</p><p>Demand is the other part of the equation. Chinese demand is indeed</p><p>growing very strongly, but it is very tricky to know just how far into the future</p><p>this can be extrapolated. What we can say is that countries generally become</p><p>more efficient in their use of raw materials as their economies develop, and</p><p>so we should not be surprised to see the same thing happening gradually in</p><p>China. Indeed, the Chinese government have spoken of their desire to move</p><p>more towards a service-based economy in the future. Attempts to slow down</p><p>the Chinese juggernaut could have the same impact on demand but rather</p><p>3 The World Steel Association estimates that global iron ore production doubled between</p><p>2002 and 2013.</p><p>CAPITAL CYCLE REVOLUT ION 33</p><p>more quickly. It also seems reasonable to expect that a prolonged period of</p><p>elevated commodity prices will have a negative impact on demand, just as</p><p>high oil</p><p>prices in the 1970s forced improved oil efficiency on industry. This</p><p>already appears to be happening in Germany, where demand for copper</p><p>pipes is said to have halved from 90,000 tonnes to 45,000 tonnes over the</p><p>past year, as the construction industry switches to cheaper PVC plastics.</p><p>As the capital cycle plays out in commodities, it is perhaps worth high-</p><p>lighting the outcome of another recent minor bubble: namely, that of the con-</p><p>tainer shipping industry. Here, too, a couple of years back we were promised</p><p>a “supercycle,” as earlier underinvestment led to a shortage of new ships, and</p><p>strong Chinese growth was producing annual double-digit increases in ship-</p><p>ping demand. Indeed, we even spotted the odd specialist container shipping</p><p>conference invite. Spurred on by these “once-in-a-generation” conditions,</p><p>shipping companies indulged in an M&A boom in mid-2005. Shipyards</p><p>working flat out were fully booked out for years to come. Predictably, this</p><p>frenzy marked the peak of the cycle, and shipping rates (and shipping</p><p>company share prices) have now fallen sharply, while supply continues to</p><p>increase.4 A sign of things to come in the commodities world?</p><p>1.4 SUPERCYCLE WOES (MAY 2011)</p><p>The commodity industry is showing the classic signs of a capital cycle peak</p><p>A cursory analysis of the capital cycle for the commodity industry – in par-</p><p>ticular the huge expansion of commodity capital expenditure in recent years,</p><p>and the precarious nature of Chinese demand for raw materials – suggests</p><p>that the much hyped commodity “supercycle” is entering a downturn.</p><p>This capital cycle started a few years back after the pick-up in commod-</p><p>ity prices led to a material improvement in the returns on equity for mining</p><p>companies. Initially, the miners’ response to improved conditions in their</p><p>industry appears to have been quite controlled – capital expenditure rela-</p><p>tive to cash flow somewhat declined in the early 2000s as commodity prices</p><p>began to rise. Nor was there a bubble in the stock market. Mining shares</p><p>performed well because their fundamentals had never been better.</p><p>The bad news is that commodity industry is showing signs of a classic</p><p>capital cycle peak – higher returns on invested capital are attracting more</p><p>4 According to Clarksons Research, dry bulk new building orders rose from 33m dead-</p><p>weight tonnes in 2004 to a peak of 164m tonnes in 2007, falling back to 31m in 2009. The</p><p>Baltic Dry Index, a composite measure of the cost of moving major raw materials by sea,</p><p>peaked at nearly $12,000 in May 2008. Six months later it had fallen 94 per cent to $663, and</p><p>by the end of 2014 it was only slightly higher at $782.</p><p>CAPITAL RETURNS34</p><p>capital and higher share prices, leading to more mergers and acquisitions</p><p>and IPOs. Total mining capex from 124 companies in the MSCI All Country</p><p>World Index is predicted to rise to a whopping $180bn in 2011 from less than</p><p>$30bn ten years ago – a six-fold increase (see Chart 1.2).</p><p>The impact of all this investment has come with a lag. After a delay of</p><p>several years, the surge in mining capex, however, has propelled production</p><p>volumes to new highs. Merrill Lynch estimates that between 2000 and 2014,</p><p>global nickel production will have climbed from around 1,000 metric tonnes</p><p>to around 2,000 (a rise of 100 per cent), copper from some 15,000 metric tonnes</p><p>to over 20,000 (33 per cent increase), aluminium from roughly 25,000 metric</p><p>tonnes to over 50,000 (100 per cent increase), and most impressively, global</p><p>iron production is set to rise from 1bn metric tonnes at the turn of the century</p><p>to around 2.25bn by 2014, an increase of 125 per cent in just over a decade.</p><p>–100%</p><p>0%</p><p>100%</p><p>200%</p><p>300%</p><p>400%</p><p>500%</p><p>600%</p><p>P</p><p>al</p><p>la</p><p>di</p><p>um</p><p>A</p><p>lu</p><p>m</p><p>in</p><p>iu</p><p>m</p><p>Z</p><p>in</p><p>c</p><p>S</p><p>te</p><p>el O</p><p>il</p><p>N</p><p>ic</p><p>ke</p><p>l</p><p>S</p><p>ilv</p><p>er</p><p>C</p><p>op</p><p>pe</p><p>r</p><p>C</p><p>ok</p><p>in</p><p>g</p><p>C</p><p>oa</p><p>l</p><p>Ir</p><p>on</p><p>O</p><p>re</p><p>ETF tradeable Not tradeable</p><p>Chart 1.1 Nominal changes in commodity prices (2001–10)</p><p>Source: Macquarie.</p><p>0</p><p>20</p><p>40</p><p>60</p><p>80</p><p>100</p><p>120</p><p>140</p><p>160</p><p>180</p><p>200</p><p>1994 1996 1998 2000 2002 2004 2006 2008 2010 2012e</p><p>U</p><p>S</p><p>$b</p><p>n</p><p>Chart 1.2 Mining capital spending in the MSCI World Index</p><p>Source: Factset, Bloomberg, Marathon.</p><p>CAPITAL CYCLE REVOLUT ION 35</p><p>This change in mining fortunes has not been lost on investment bankers</p><p>who, true to form, have brought ever more seductive commodity-themed</p><p>IPOs to market. Between 2005 and 2010, the number of metals & mining</p><p>flotations rose by climbed by 50 per cent. The bankers have also abetted their</p><p>mining clients in an M&A frenzy, as deals in the sector have become larger</p><p>and larger. Large numbers of IPOs and high M&A activity in any sector tend</p><p>to occur in the later stages of the capital cycle.</p><p>0</p><p>500</p><p>1,000</p><p>1,500</p><p>2,000</p><p>2,500</p><p>3,000</p><p>0</p><p>30</p><p>60</p><p>90</p><p>120</p><p>150</p><p>180</p><p>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013</p><p>Tr</p><p>an</p><p>sa</p><p>ct</p><p>io</p><p>n</p><p>V</p><p>ol</p><p>um</p><p>e</p><p>V</p><p>al</p><p>ue</p><p>(</p><p>U</p><p>S</p><p>$b</p><p>n)</p><p>$0–<$500 $500–$1,000 >$1,000–$5,000 >$5,000 Volume</p><p>Chart 1.3 Global M&A activity in metals & mining industry</p><p>Source: PricewaterhouseCoopers.</p><p>0</p><p>10</p><p>20</p><p>30</p><p>40</p><p>50</p><p>60</p><p>70</p><p>80</p><p>90</p><p>100</p><p>2005 2006 2007 2008 2009 2010</p><p>(US$bn)</p><p>Follow-on IPO Convertible</p><p>Chart 1.4 Capital markets financing of metals & mining industry</p><p>Source: Dealogic, Credit Suisse.</p><p>CAPITAL RETURNS36</p><p>Thus, ever rising amounts of capital are coming into the sector at a</p><p>time when commodity prices are well above marginal costs of production,</p><p>even for the high cost producers. When this supercycle eventually turns,</p><p>there is potentially a long way for commodity prices to fall before they</p><p>reach replacement cost. This could pose a problem for benchmark-hugging</p><p>investors, since the metals and mining sector – up more than three times</p><p>from its 1999 low – is currently close to its all-time high as a share of the</p><p>FTSE World Index.5</p><p>Many commentators enthuse about a “new paradigm” for commodi-</p><p>ties associated with China’s rise. Almost all of the demand growth for</p><p>commodities is due to China’s insatiable appetite for raw materials. The</p><p>Middle Kingdom now consumes around half the global production of</p><p>iron ore, nickel, copper and zinc. The commodity bulls, however, seem</p><p>to be overlooking some troubling signs. The most obvious of these is</p><p>the inexorable rise of Chinese fixed asset investment to around 50 per</p><p>cent of GDP – even in Japan, with its penchant for building roads to</p><p>nowhere, investment peaked at only 30 per cent of GDP. It is not sur-</p><p>prising that much of this capital is being wasted. The Chinese indus-</p><p>trial sector’s return on net operating assets is low and continues to trend</p><p>downwards. Low profitability doesn’t stop Chinese SOEs from investing,</p><p>however. In the power industry, for instance, capital expenditure is run-</p><p>ning at over 100 per cent of operating cash f low (cement and steel capex</p><p>relative to EBITDA is running at only marginally lower levels). To make</p><p>matters worse, all the above mentioned sectors are also over-indebted.</p><p>Optimists are hoping that Beijing will encourage industrial consolida-</p><p>tion and reduce capacity. But even if this does occur, a lower pace of</p><p>investment growth in these industries won’t be good news for overall</p><p>commodity demand.</p><p>Investors are ignoring signs of an over-heated Chinese economy and</p><p>are enamoured of a commodity sector that has attracted, and continues to</p><p>attract, large amounts of capital and where supply is inexorably increas-</p><p>ing. To our minds, all this is clear evidence that the current chapter in</p><p>the commodity story appears much closer to its conclusion, than the</p><p>beginning.</p><p>5 Between 1 January 2012 and 31 December 2014, the MSCI Metals & Mining Index</p><p>underperformed the MSCI World Index by 79 percentage points.</p><p>CAPITAL CYCLE REVOLUT ION 37</p><p>1.5 NO SMALL BEER (FEBRUARY 2010)</p><p>Consolidation has improved the pricing power of the global brewing</p><p>industry</p><p>“Most people hate the taste of beer to begin with. It is, however, a</p><p>prejudice that many have been able to overcome.”</p><p>Sir Winston Churchill</p><p>For a number of years, the only exposure of Marathon’s European portfolios</p><p>to beer</p><p>(and we are of course talking investment exposure here, as opposed to</p><p>any stock picking inspiration brought about by its consumption!) was a holding</p><p>in Heineken. Being a shareholder in the Dutch brewer between 2002, when we</p><p>made our initial purchase, and 2008 was not a particularly happy experience,</p><p>with the shares underperforming the wider European market by some 30 per</p><p>cent over the period, although some of this was recovered in 2009.</p><p>In part, Heineken’s underperformance was due to a series of poor and over-</p><p>priced acquisitions, with the company investing some $9.5bn over the decade to</p><p>2009, over which period its return on capital dropped from 20 per cent to below</p><p>10 per cent. This run culminated in the unfortunate acquisition of Scottish &</p><p>Newcastle’s UK brewing assets in 2008, just as the UK entered recession and the</p><p>currency turned against them. While some of the other brewers did not fare so</p><p>badly, the overall return on capital for the brewing sector declined steadily from</p><p>13 per cent in 2000 to 9 per cent in 2008. Given all this, it may come as a sur-</p><p>prise to some that we are overcoming our prejudice and have been increasing</p><p>our exposure to the brewing sector, now owning positions in three of the four</p><p>listed brewers – Heineken, Carlsberg and AB Inbev – in European portfolios,</p><p>and in the other – SABMiller – in UK-only portfolios.</p><p>The acquisition activity which has driven down returns sharply over the</p><p>past few years has been part of a wider industry consolidation. This began</p><p>in earnest in 2002, when the South African brewer SAB bought Miller of</p><p>the US, with other significant M&A activity including the merger between</p><p>the Brazilian AmBev and the Belgian Interbrew in 2004; the joint venture</p><p>between SABMiller and Molson Coors in the US in 2007; Heineken and</p><p>Carlsberg buying S&N in 2008; and then the huge ($60bn!) InBev acquisi-</p><p>tion of US market leader Anheuser-Busch in the same year. Most recently,</p><p>Heineken has bid $7.6bn for the Mexican brewer FEMSA, which is no.2 in its</p><p>home market and no.4 in Brazil.</p><p>Apart from providing endless fees to investment bankers and confusing</p><p>investors as various company names got shunted together to form new ones,</p><p>CAPITAL RETURNS38</p><p>this long phase of deal-making activity brought about the situation illus-</p><p>trated in Chart 1.5 below, in which the global beer market concentrated into</p><p>the hands of four major (and European listed) players, having around 50 per</p><p>cent share of global beer volumes between them.</p><p>This process has been more pronounced in some markets than others,</p><p>with certain markets becoming extraordinarily concentrated. For example</p><p>in the US, the world’s largest beer market by value, 80 per cent is now shared</p><p>between just two players, AB InBev and the Miller Coors joint venture, while</p><p>in the 5th largest market (the UK), the top three – Heineken, Molson Coors</p><p>and AB InBev – have 67 per cent of the market. There is a similar picture in</p><p>the 6th largest market where AB InBev alone has a 70 per cent market share,</p><p>while in the no.7 market of Russia, Carlsberg, AB InBev and Heineken have</p><p>70 per cent of the market between them.</p><p>Aside from the sheer scale of the consolidation, the other encouraging</p><p>point is that each of the four major players has a different area of profitability</p><p>focus, with, as one might expect, the greatest proportion of profits coming</p><p>from areas in which they have the greatest market shares.</p><p>So what implications did this have for profitability? Global beer volumes</p><p>grew at a fairly steady 4 per cent between 2005 and 2010. All this growth</p><p>came from emerging markets, notably China (9 per cent growth p.a.) and</p><p>Brazil (5 per cent), which were becoming increasingly affluent and had lower</p><p>starting levels of per capita beer consumption. By contrast, Western markets</p><p>experienced pretty flat volume growth, or in some cases declining volumes.</p><p>So it was interesting to note that US and Western European markets have</p><p>registered some fairly decent price increases over the same period. While</p><p>there is undoubtedly an element of “cost push” in these figures – the larg-</p><p>est raw material cost is barley and the price of this rose by some 60 per cent</p><p>13.3%</p><p>49.2%</p><p>86.7%</p><p>50.8%</p><p>1998 2008</p><p>Share of top 4 global beer companies</p><p>Chart 1.5 Global market share of top four brewers (volume)</p><p>Source: Bernstein, Eurostat.</p><p>CAPITAL CYCLE REVOLUT ION 39</p><p>between 2005 and 2007 – it is also an indication of how the larger brewers</p><p>were able to use their greater scale to push back against the retailers, without</p><p>much fear of interference from a disruptive third party.</p><p>This encouraging process is continuing with, for example, the largest</p><p>players in the UK market all having announced price rises of 4 per cent</p><p>already in 2010. In emerging markets, pricing growth has been easier to</p><p>achieve, in part due to the greater fragmentation of the retail channel and</p><p>generally higher levels of inflation which have made it possible to hide price</p><p>increases. Here, as well as volume growth, the story is one of increased “pre-</p><p>miumization” – persuading consumers to trade up as they become wealthier.</p><p>In Europe, premium lager accounts for nearly 25 per cent of the market (and</p><p>15 per cent in the US), but this figure is well below 5 per cent in most emerg-</p><p>ing market countries. A consolidated market is not a prerequisite for pre-</p><p>miumization, but having high volumes in a market makes it more economic</p><p>for a brewer to offer a wider range of products at different price points.</p><p>On the supply side, there is an encouraging capital cycle angle as the</p><p>consolidation process has seen a reduction in brewery capacity, particularly</p><p>in Europe where the fragmented regional nature of the market meant that</p><p>there had been persistent overcapacity to be exploited by retailers. Several</p><p>markets have experienced quite meaningful capacity reduction. In the UK,</p><p>for example, 10 per cent of brewing capacity was taken out of the market</p><p>following Heineken’s acquisition of Scottish & Newcastle. Markets such as</p><p>Ireland, Finland and France experienced similar levels of capacity reduc-</p><p>tion, while a lesser amount of capacity was taken out of the Danish market.</p><p>Brewers have also worked hard to generate savings in areas such as procure-</p><p>ment, looking at the potential for greater cross-border supply to improve</p><p>utilization rates, as well as simplifying product ranges.</p><p>Following the M&A splurge, which pushed debt levels to an average net</p><p>debt/EBITDA across the sector of around 3 times, compared to a long-run</p><p>average of 1.5 times, there has been a greater focus on balance sheet disci-</p><p>pline, with less need to defend market share by attempting to grow volumes</p><p>aggressively. So whereas historically, companies were spending around 2</p><p>times depreciation on capex, on average this has come down to below 1.5</p><p>times, or from nearly 10 per cent of sales to below 8 per cent. There has also</p><p>been more of an emphasis on working capital, with several of the companies</p><p>adopting explicit reduction targets.</p><p>Taking all these things together – the emphasis on pricing, the focus on</p><p>cost reduction and balance sheet efficiency – an improvement in both mar-</p><p>gins and return on capital was to be expected. As for valuation, the average</p><p>free cash flow yields of 6–7 per cent imply growth rates of around GDP or a</p><p>CAPITAL RETURNS40</p><p>little less, which suggests that the stock market is underestimating the poten-</p><p>tial long-run benefit to be derived from market consolidation and improved</p><p>discipline. In the light of an improving capital cycle among brewers, we find</p><p>ourselves able, to paraphrase Sir Winston, to overcome our prejudice and</p><p>begin increasing our exposure to beer.6</p><p>1.6 OIL PEAK (FEBRUARY 2012)</p><p>In the energy markets, as elsewhere, “there is no cure for high prices like</p><p>high prices”</p><p>Following a relatively good stock market performance over the past 12</p><p>months for the energy sector (which is dominated by major oil companies),</p><p>and with the oil price approaching its all-time</p><p>high (Chart 1.6), it makes</p><p>sense to review our significant underweighting of the energy sector.</p><p>Various theories have been put forward to justify high oil prices and an</p><p>increased asset allocation to commodities, chief among which is the idea</p><p>of “peak oil.” Bullish forecasts suggest that increasing energy demand from</p><p>emerging markets, together with declining oil reserves and rising produc-</p><p>tion costs, will propel the price of crude oil to $200 a barrel or more. While</p><p>a high oil price, however, is perceived to be beneficial for oil company profits</p><p>6 From the time of writing to the end of 2014, all of the abovementioned beer companies</p><p>outperformed the MSCI Europe Index with the exception of Carlsberg, which has experi-</p><p>enced problems with its Russian operations.</p><p>0</p><p>20</p><p>40</p><p>60</p><p>80</p><p>100</p><p>120</p><p>140</p><p>160</p><p>(US$)</p><p>Mar-00 Apr-01 May-02 Jun-03 Jul-04 Aug-05 Sep-06 Oct-07 Nov-08 Dec-09 Jan-11 Feb-12</p><p>Chart 1.6 Brent crude oil price</p><p>Source: Bloomberg.</p><p>CAPITAL CYCLE REVOLUT ION 41</p><p>in the short run, there are trends developing which will severely undermine</p><p>both the oil price and energy shares during the coming years.</p><p>It is said that “there is no cure for high prices like high prices.” Thus,</p><p>while the price of crude appears to be suspended at an elevated level, the</p><p>very persistence of the oil price above $100 per barrel is encouraging devel-</p><p>opments which pose an increasing risk to energy investors. There has been</p><p>a surge in natural gas supply in North America, where new technology and</p><p>better drilling techniques have helped to boost the production and lower</p><p>the cost of natural gas from conventional resources, as well as from shale</p><p>gas. US shale gas reserves are estimated to be huge. Extraction techniques</p><p>continue to improve and we are still at the very early stages of the fracking</p><p>revolution, so potential reserves from shale gas are probably still underesti-</p><p>mated, as was the case in the early days of the oil industry. These extra and</p><p>cheaper sources of energy have brought down natural gas prices in the US</p><p>and opened up a huge price differential between crude oil and gas. In the</p><p>US, at least, these developments have resulted in a dramatic shift towards</p><p>natural gas, away from oil and coal, as a primary source of energy.</p><p>Those who argue that the surge in gas supply will only impact North</p><p>America are ignoring the fact that not only is the US still the largest con-</p><p>sumer of crude oil (and is currently a net importer) but also that significant</p><p>investment is being undertaken to be able to export this cheap gas. We are</p><p>seeing gas import plants in the United States being reengineered to enable</p><p>exports and new gas export facilities planned. In addition, to capitalize on</p><p>the lowest US natural gas prices in a decade, industries are starting to shift</p><p>production to the US and are even moving physical assets. In the case of</p><p>Methanex, the world’s largest methanol maker, there are plans to dismantle</p><p>an idled Chilean factory and ship it to Louisiana to be reassembled.</p><p>The high oil price is fuelling other significant changes in the energy mar-</p><p>kets. The transport industry is becoming much more fuel efficient (airlines</p><p>are ordering new fuel efficient aircraft/engines, and new fuel efficient ships</p><p>are being ordered despite low cargo rates and a glut of older vessels). And</p><p>there’s the increasing use of non-oil fuel for transport. Just look around. In</p><p>Thailand, natural gas is already outselling petrol because of new technology</p><p>used by taxis, tractors, buses and now some cars; in the US and in the UK</p><p>(where there are tax incentives for “green” vehicles), there’s increasing evi-</p><p>dence of not just hybrid vehicles but now fully electric cars (from economy</p><p>models such as the Smart to the sporty Tesla), and facilities are being built to</p><p>recharge these vehicles on the move; businesses are developing natural gas</p><p>powered trucks (manufactured by Navistar and Clean Energy Fuels Corp)</p><p>CAPITAL RETURNS42</p><p>and hydrogen cell cars (by Acal). In short, there is no shortage of investment</p><p>directed towards reducing the use of expensive crude oil.</p><p>Meanwhile, oil producing countries within OPEC have become some-</p><p>what complacent about the high oil price. Some are using the extra revenue</p><p>generated by the high oil price to pour billions of dollars into social spend-</p><p>ing. Saudi Arabia now requires an oil price of $90 per barrel to cover its</p><p>planned expenditure (other OPEC countries “need” even higher prices). But</p><p>these high spending commitments require decent volumes as well as high</p><p>prices. This makes any volume discipline to control prices more difficult,</p><p>and so undermines the ability of OPEC to influence oil prices in the future.</p><p>Recent meetings with several of the largest global oil companies have also</p><p>revealed some worrying signs. Senior oil executives appear to be anchoring</p><p>their expectations about the future oil price on current market levels. Total,</p><p>for instance, has raised its projection for long-term oil prices, which it uses</p><p>to justify exploration and acquisition spending, from around $20 per barrel a</p><p>decade ago to a range of $80 to $100. The French oil major claims it is willing</p><p>to spend $20bn a year based on this elevated oil forecast. Increased spending</p><p>promises to boost Total’s annual oil production, something which the com-</p><p>pany believes will lead to a rerating (upwards) of its shares.7</p><p>Total is not alone. The whole industry is justifying rising levels of invest-</p><p>ment based on the inflated expectations of future oil prices. BP has raised</p><p>the oil price it uses to test new projects from $16 per barrel in 2002 to above</p><p>$60. Even the well managed Imperial Oil, with substantial low cost oil and</p><p>gas assets in Canada (over 100 years of reserves at current production), is</p><p>now using a forecast of $50–60 per barrel compared to $35–40 ten years ago.</p><p>Petrobras is aiming to spend $225bn in the next five years and to more than</p><p>double its already substantial production in the next decade. The Brazilian</p><p>oil giant assumes the crude oil price will be $80–95 per barrel for the next five</p><p>years. Its record breaking $70bn rights issue last year shows there’s no short-</p><p>age of funding for new oil projects while the oil price remains elevated.8</p><p>7 From the date of this article to the end of 2014, Total SA’s share price declined by 9 per</p><p>cent in US dollars, underperforming the MSCI Europe Index by nearly 26 per cent.</p><p>8 In September 2010, Petrobras conducted the largest share sale in history, raising $73bn</p><p>on the Brazilian stock exchange – a capital cycle red flag if ever there was one. Not all this</p><p>money, however, found its way into increasing oil production. In March 2014, federal police</p><p>arrested Paulo Roberto Costa, former chief of refining at Petrobras, in a money launder-</p><p>ing investigation. Mr Costa, seeking leniency, confessed to far more than that, according to</p><p>The Economist. Construction companies that won contracts from his division diverted 3 per</p><p>cent of their value into slush funds for political parties, Mr. Costa claimed. Police identified</p><p>nearly $6bn of suspicious payments making petrolão (the “big oily”) Brazil’s biggest corrup-</p><p>tion scandal.</p><p>CAPITAL CYCLE REVOLUT ION 43</p><p>On current earnings, oil company valuations do not looked stretched:</p><p>cash flow is lowly rated and dividend yields are above average. But there is</p><p>now a risk that oil companies’ new assumptions about a high oil price are fix-</p><p>ing their costs at a high level. The more of their healthy cash flows these com-</p><p>panies spend on high cost projects, the lower their current earnings and cash</p><p>flows are likely to be valued. The operational leverage of oil company profits</p><p>is rising, so their earnings are particularly vulnerable to a severe correction in</p><p>the oil price. And the longer the high oil price persists, the greater the risk of</p><p>a correction. With this in mind, a modest and stock- specific weighting in the</p><p>energy sector within our global portfolios seems prudent. It should at some</p><p>stage add significant</p><p>value to performance, at least on a relative basis.9</p><p>1.7 MAJOR CONCERNS (MARCH 2014)</p><p>Energy companies are suffering from the delayed consequences of their</p><p>capital spending boom</p><p>Is now the time to increase exposure to the oil majors? Stocks of the largest</p><p>five global oil companies, which in aggregate account for over 40 per cent</p><p>of the MSCI World Oil and Gas Index, are trading at significant discounts</p><p>to the MSCI World price-earnings ratio and provide, on average, close to</p><p>double the dividend yield. These valuations may look attractive, but a closer</p><p>examination of the recent financial performance of the five oil majors reveals</p><p>a fairly worrying picture.</p><p>Over the period 2003 to 2012, as the Brent oil price increased by 16 per</p><p>cent a year, the net income of the oil majors grew by only 8 per cent a year.</p><p>Total growth in their earnings per share (EPS), including the effect of share</p><p>buybacks, was 10 per cent – lagging the S&P, which compounded earnings at</p><p>12 per cent over this same period. A surge in the Brent crude price between</p><p>2003 and 2007 (increasing at 33 per cent a year) resulted in the aggregate return</p><p>on equity for the oil majors rising to 27 per cent. As capital cycle theory would</p><p>suggest, this led to a dramatic rise in capital expenditure, which increased</p><p>from 1.2 times depreciation and amortization between 2003 and 2007 to 1.7</p><p>times between 2007 and 2012. Despite this rise in capex, net income has actu-</p><p>ally fallen slightly in aggregate, which explains the marked drop in returns on</p><p>9 By the end of 2014, the Brent Crude oil price had fallen to $57, a decline of over 50 per</p><p>cent from the date of this article (February 2012). Over the same period, the FTSE All-World</p><p>Oil & Gas Index fell by 16 per cent, underperforming the broad FTSE All-World Index by</p><p>over 48 per cent.</p><p>CAPITAL RETURNS44</p><p>equity for the large energy companies – from 27 per cent in 2007 to 17 per cent</p><p>in 2012, at a time when the oil price increased by nearly 20 per cent.</p><p>Why has the higher oil price and rising capex not produced faster earn-</p><p>ings growth? The main issue is that the majors have had a real fight just to</p><p>stand still. The yield of an oil and gas field steadily falls over its lifetime, in</p><p>the order of 5 per cent annually, so a material amount of capital expenditure</p><p>is required just to offset the decline rate. Lately, the quality of oil explora-</p><p>tion projects coming on stream has not matched that of the legacy assets.</p><p>Newer fields are both harder to access technically, as well as being in riskier</p><p>jurisdictions. An ever greater amount of capital has been required to deliver</p><p>the same level of production, resulting in the inevitable decline in return</p><p>on invested capital. This explains why net production growth has been so</p><p>depressed over recent years – in aggregate, the oil majors’ production has</p><p>declined by approximately 2 per cent a year over the last five years.</p><p>Of course, given the long-term nature of oil projects – the average time</p><p>lag to reach full productive capacity is around six years – the impact of recent</p><p>capex spending may yet be seen over the next five years, with an attendant rise</p><p>in earnings. However, an analysis of company guidance and analyst expecta-</p><p>tions for the next four years (2014–17) does not support this contention. The</p><p>ratio of capex-to-depreciation is expected to remain high, at 1.6 times, with a</p><p>forecast cash conversion rate of only 50 per cent, even lower than over the last</p><p>five years.10 Furthermore, production growth is expected to remain muted,</p><p>growing at around just 2 per cent a year. While this, in theory, is above the</p><p>growth rate of the last five years, reality has often fallen short of expectations.</p><p>So it is difficult to argue that the majors are “cheap” today. On cash</p><p>earnings, valuations are much higher than the low earnings multiple sug-</p><p>gests – indeed, if forecasts are correct, the majors are trading on a price to</p><p>free cash flow multiple of 22 times, a premium to the wider market. Yet the</p><p>earnings growth outlook for the sector is below that of the market, even</p><p>assuming a reasonably resilient oil price. And there is the very real possibil-</p><p>ity that the oil price falls in the medium term – witness the progress in the</p><p>way energy is both produced and used.</p><p>In addition, there are particular reasons why investors should demand a</p><p>discount on a cash flow multiple, before committing capital to the oil sector.</p><p>First, the sheer quantum of capex required on an annual basis means the</p><p>investor is forced to place a large degree of faith in the management team to</p><p>allocate capital correctly. This has been a problem historically, given the bias</p><p>10 The cash conversion rate measures the extent to which reported profits convert into</p><p>free cash flow.</p><p>CAPITAL CYCLE REVOLUT ION 45</p><p>of management to focus on growth over returns, particularly in periods of</p><p>strong oil price appreciation. Second, oil fields are captive assets. The risk of</p><p>government intervention and profit claw-backs is higher than average, and</p><p>the risk is increasing as the mix of the industry’s asset base shifts towards</p><p>less politically stable regions.</p><p>Are there any grounds for optimism? By virtue of the capital cycle, an</p><p>extended period of growing capital intensity and low returns should even-</p><p>tually lead to a supply side contraction, laying the foundations for an inflec-</p><p>tion in returns on capital and more healthy stock returns. In this sense, a</p><p>weak oil price could even be a blessing in disguise for investors – much</p><p>as its rapid rise since 2003 has been somewhat of a curse, accompanied as</p><p>it has been by an increased focus on production at the expense of capital</p><p>discipline.</p><p>1.8 A CAPITAL CYCLE REVOLUTION (MARCH 2014)</p><p>A Scandinavian wind turbine maker experiences the ups and downs of the</p><p>capital cycle</p><p>Marathon looks to invest in two phases of an industry’s capital cycle. From</p><p>what is misleadingly labelled the “growth” universe, we search for businesses</p><p>whose high returns are believed to be more sustainable than most investors</p><p>expect. Here, the good company manages to resist becoming a mediocre one.</p><p>From the low return, or “value” universe, our aim is to find companies whose</p><p>improvement potential is generally underestimated. In both cases, the rate at</p><p>which a company reverts to mediocrity (or “fade rate”) is often miscalculated</p><p>by stock market participants. Marathon’s own experience suggests that the</p><p>resultant mispricing is often systematic for behavioural reasons.</p><p>Chart 1.7 illustrates the “fade rate” of corporate returns, an idea developed</p><p>by Holt Value Associates (now part of Credit Suisse). Holt’s concept of the stock</p><p>market-implied fade rate chimed well with our focus on competitive conditions</p><p>within industries and the flow of capital into (and out of) high (and low) return</p><p>industries. Using this framework, two purchase candidates are identifiable.</p><p>Purchase Candidate A is a company capable of sustaining high returns beyond</p><p>the market’s expectation (the upper dotted line) – that is, the company remains</p><p>above average for longer than average. Candidate B is a company which can</p><p>improve faster than the market generally expects (the lower dotted line).</p><p>Marathon’s experience suggests that the stock market is often poor at</p><p>pricing superior fade characteristics. For Purchase Candidate A, mispricing</p><p>stems from a number of sources. One is the underestimation of the durabil-</p><p>ity of barriers to entry. Another is the underappreciation of the scale and</p><p>CAPITAL RETURNS46</p><p>scope of the addressable market. Management’s capital allocation skills are</p><p>also often overlooked. A recent meeting with the CEO of Bunzl, the lead-</p><p>ing specialist business-to-business distributor, was instructive in this regard.</p><p>While sell-side analysts covering the stock have made reasonably accurate</p><p>forecasts of returns from the core business, they have consistently failed to</p><p>give management credit for adding value via bolt-on acquisitions, despite 20</p><p>years or so of supporting</p><p>evidence. Investors also appear to be biased against</p><p>“boring” high return companies, such as Bunzl, which do not offer the pros-</p><p>pect of immediate high share price appreciation.</p><p>The conditions leading to Purchase Candidate B often stem from the</p><p>market misjudging the beneficial effects of reduced competition as weaker</p><p>firms disappear, either through consolidation or bankruptcy. Alternately, an</p><p>unruly oligopoly may tire of excess competition and enjoy an outbreak of</p><p>peaceful coexistence. The turn in the capital cycle often occurs during peri-</p><p>ods of maximum pessimism, as the weakest competitor throws in the towel at</p><p>a point of extreme stress. When the pain of losses coincides with a depressed</p><p>share price, investors can find wonderful opportunities, particularly if they</p><p>are willing to take a multiyear view and put up with short-term volatility.</p><p>Management skill at dealing with problems may also be overlooked. This</p><p>is especially true when a new leader is recruited externally, maximizing the</p><p>possibility of change. The turnaround achieved at Fiat by Sergio Marchionne</p><p>Time</p><p>Growth universe</p><p>Value universe</p><p>Market</p><p>assumed fade</p><p>rate Average</p><p>market</p><p>sector</p><p>CFROI</p><p>C</p><p>F</p><p>R</p><p>O</p><p>I</p><p>Marathon purchase</p><p>candidate</p><p>Marathon purchase</p><p>candidate</p><p>Market</p><p>assumed fade</p><p>rate</p><p>Chart 1.7 The fade rate</p><p>Source: Marathon, Credit Suisse HOLT.</p><p>CAPITAL CYCLE REVOLUT ION 47</p><p>in recent years is one outstanding example.11 Highly competent managers</p><p>are often attracted by the challenge of turning around a troubled company,</p><p>not least because of the financial rewards. This factor was evident in a recent</p><p>meeting with Rupert Soames, who is shortly to take on the role of CEO at</p><p>Serco, the embattled UK outsourcing company.</p><p>A recent example from Marathon’s European portfolio illustrates the</p><p>perils and opportunities faced by investors in low return companies. In the</p><p>case of Vestas Wind Systems, Marathon’s initial investment took place in</p><p>2003, when the company was suffering from a temporarily weak US market</p><p>due to change in tax incentives. Partly in response, Vestas acquired a local</p><p>rival. Subsequently, demand for wind turbines recovered and Vestas’ share</p><p>price multiplied by around 40 times from its trough to the 2008 peak.</p><p>The good news didn’t last. With the advent of the financial crisis, wind</p><p>farm projects around the world were quickly shelved at just the point when</p><p>the new wind turbine capacity came on stream. Although we had reduced</p><p>clients’ holdings by a quarter at near-peak levels (see Chart 1.8 below), the</p><p>residual holding then suffered an ignominious “Return to Go” with a 96 per</p><p>cent decline in value.</p><p>Vestas had become a victim of the alternative energy capital cycle. Its</p><p>capex-to-depreciation had risen from just over 1 times in 2005 to nearly 5</p><p>11 Sergio Marchionne was appointed Chief Executive of Fiat SpA in mid-2004. Since</p><p>that date, Marchionne has revitalized Fiat’s car operations and spun off the company’s</p><p>agricultural equipment division (Case New Holland). An investment in Fiat at the time of</p><p>Marchionne’s appointment was worth 183 per cent more by the end of 2014 (based on the</p><p>combination of FCA and CNH’s share prices, excluding dividends).</p><p>Chart 1.8 Vestas Wind Systems: capex-to-depreciation ratio and relative share</p><p>price performance</p><p>Source: Capital IQ, FactSet.</p><p>0</p><p>500</p><p>1,000</p><p>1,500</p><p>2,000</p><p>2,500</p><p>3,000</p><p>0</p><p>1</p><p>2</p><p>3</p><p>4</p><p>5</p><p>98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13</p><p>Capex-to-depreciation (LHS) Share price relative to MSCI Europe (RHS)</p><p>CAPITAL RETURNS48</p><p>times in 2008, contributing to excess capacity in the wind turbine sector.</p><p>With the benefit of hindsight, it would have made sense to dispose of our</p><p>entire holding after the crisis struck, as the share price subsequently endured</p><p>four more years of under-performance. This would have saved us having to</p><p>answer awkward questions from consultants and clients about why our posi-</p><p>tion had been maintained!</p><p>Nevertheless, continued contact with the company provided the oppor-</p><p>tunity to buy more shares at a later date, an option which might have been</p><p>lost had we washed our hands of the embarrassing position. Following a</p><p>meeting with the impressive new Swedish chairman in early 2013, Marathon</p><p>bought more shares, increasing the holding by 90 per cent and becoming</p><p>the company’s largest shareholder. New management has since been able</p><p>to implement significant restructuring at a time when investor fears about</p><p>weak industry demand have proved too pessimistic. Capex has been slashed</p><p>to 0.4 times depreciation in 2013, boosting cash flow and helping to repair</p><p>the weak balance sheet. The subsequent 360 per cent share price rise has</p><p>partly spared our blushes from failing to sell more at the peak.</p><p>The example of Vestas shows how a company can morph from being a</p><p>“value” buying opportunity to being an expensive “growth” stock and then</p><p>cheap value again in the course of a few years. Investors can take advantage</p><p>of Mr. Market’s shifting moods. Our Vestas experience also demonstrates</p><p>the benefits of well-timed contrarian purchases, notwithstanding the valid</p><p>questions the case raises about selling discipline.</p><p>1.9 GROWTH PARADOX (SEPTEMBER 2014)</p><p>The capital cycle partly explains why corporate profitability lags GDP</p><p>growth</p><p>Investors who assume corporate earnings will increase in line with the econ-</p><p>omy should look at the historical data. Since 1960, US earnings have com-</p><p>pounded by 2 per cent a year in real terms, while the US economy has grown</p><p>by 3.1 per cent. With an average dividend pay-out of 45 per cent, companies</p><p>effectively ploughed back the majority of earnings into the business only to</p><p>trail growth in the wider economy. Even more puzzling, corporate profits as a</p><p>share of GDP actually increased significantly during the period, rising from 6</p><p>per cent in 1960 to over 10 per cent by 2013. What has gone wrong?12</p><p>12 This example comes from the US market. The problem is even more pronounced glob-</p><p>ally. The real growth in dividends on a global basis has only been 0.6 per cent in the period</p><p>1900–2013 (Credit Suisse Global Investment Returns Sourcebook, 2014).</p><p>CAPITAL CYCLE REVOLUT ION 49</p><p>The first issue is that new share issuance exceeded stock buybacks over</p><p>time, diluting the equity holder. For example, in a 2003 paper, Bernstein and</p><p>Arnott estimated net share issuance to have been in the order of 2 per cent a</p><p>year in the US market.13 One explanation for this phenomenon is the procy-</p><p>clical behaviour of management, specifically the tendency to buy back stock</p><p>when confidence is high and valuations heady, only then to be forced to issue</p><p>equity when circumstances are less favourable and share prices lower. The</p><p>recent experience of the banking sector is a particularly savage example of</p><p>management’s buy high and sell low tendency.</p><p>Mergers and acquisitions show the same pro-cyclicality, with activ-</p><p>ity typically reaching a crescendo in the later stages of bull markets. Deals</p><p>struck at high valuations lead to shareholder value destruction. Finally,</p><p>management issuance of share options to employees has also been a drag on</p><p>shareholder returns. Today a “burn rate” of 1 per cent is not uncommon –</p><p>and it was even higher prior to the mandatory expensing of options through</p><p>the profit and loss account.14</p><p>Another explanation for surprisingly low earnings growth is that a dis-</p><p>proportionate portion of new profits are generated by unlisted companies.15</p><p>This is partly because private firms, less encumbered by agency problems</p><p>and the pressure of meeting near-term earnings expectations, tend to invest</p><p>more than public companies. Additionally, new business models and tech-</p><p>nology are often developed by unlisted companies and only reach the public</p><p>market once they are relatively mature and past the high growth phase. For</p><p>investors in public equity, this poses two problems. First, new businesses and</p><p>technologies have a disruptive impact on the returns of publicly listed com-</p><p>panies. Secondly, as with buybacks and M&A</p><p>activity, the level of IPO activ-</p><p>ity is strongly procyclical (see Chart 1.9). This means valuations at the time</p><p>of listing are typically elevated, effectively causing dilution of earnings per</p><p>share at the aggregate level. To make matters worse, the subsequent inflow of</p><p>capital following a stock market debut often directly contributes to an even-</p><p>tual deterioration in returns, especially when multiple companies are listing</p><p>from the same industry (a classic example being the rash of telecoms IPOs in</p><p>the late 1990s which were raising capital to invest in fibre optic networks).16</p><p>13 William Bernstein and Robert Arnott, “Earnings Growth: The Two Percent Dilution,”</p><p>Financial Analysts Journal, 2003.</p><p>14 Prior to 2006, FASB accounting rules did not require the expensing of stock options.</p><p>15 See John Asker et al., “Comparing the investment behavior of public and private firms,”</p><p>National Bureau of Economic Research, 2011.</p><p>16 See Jay Ritter, “Initial Public Offerings: Updated Statistics” (2013) for a comprehensive</p><p>statistical study showing that IPOs on average under-perform the wider market in the first</p><p>three years.</p><p>CAPITAL RETURNS50</p><p>The concept of the capital cycle provides a broader explanation as to why</p><p>corporate profitability lags GDP. The primary driver of healthy corporate</p><p>profitability is a favourable supply side – not high rates of demand growth.</p><p>Hence, it is possible for there to be rapid growth in an industry which brings</p><p>little or no benefit to investors. In fact, strong growth in demand is often the</p><p>direct cause of value destruction as it encourages a flood of capital into the</p><p>industry, eroding returns.</p><p>It is not hard to think of examples. Technological advancement in digital</p><p>semiconductors has revolutionized technology and economic productivity.</p><p>Yet the experience of investors in the semiconductor industry has been a</p><p>depressing one. A fragmented supply side allied with high capital intensity</p><p>and low product differentiation has led to long-term destruction of eco-</p><p>nomic value. It is only very recently, with an improvement in the supply side</p><p>via consolidation, that the outlook has improved. The airlines have revolu-</p><p>tionized travel over the last 60 years, with attendant economic benefits, but</p><p>again a poor supply side has led to a very bumpy ride for investors.17 Even the</p><p>17 The capital cycle for the airline industry has been so poor – largely owing to the fact</p><p>that supply has generally not diminished during times of industry losses and bankruptcy –</p><p>that the aggregate profits of US airlines between 1960 and 2000 would have been sufficient to</p><p>pay for the delivery of just two 747 jumbo jets. Over the last decade, however, the capital cycle</p><p>has turned positive as the industry consolidated (following mergers between US Airways</p><p>and American, Delta and Northwest Airlines, United and Continental, and Southwest and</p><p>Airtran Airways.) After this bout of mergers, US airline stocks performed strongly. There</p><p>are signs, however, that the industry is once again losing capital discipline. Southwest and</p><p>0</p><p>100</p><p>200</p><p>300</p><p>400</p><p>500</p><p>600</p><p>700</p><p>0</p><p>20</p><p>40</p><p>60</p><p>80</p><p>100</p><p>120</p><p>140</p><p>99 00 01 02 03 04 05 06 07 08 09 10 11 12 13</p><p>Global M&A volumes (LHS, indexed to 100) Global IPO volumes (LHS, indexed to 100)</p><p>S&P 500 Buyback (RHS, $bn)</p><p>Chart 1.9 Global M&A, IPO and S&P 500 buybacks</p><p>Source: Citi, Dealogic.</p><p>CAPITAL CYCLE REVOLUT ION 51</p><p>most bullish tech analyst would not have predicted how widespread mobile</p><p>phones have become, and yet such foresight would not have helped long-</p><p>suffering shareholders in Nokia, Motorola or Blackberry-maker RIM.</p><p>Thus procyclical management behaviour alongside the destructive power</p><p>of the capital cycle largely explain why real earnings growth of the US stock</p><p>market has not kept pace with broader economic growth. Evidence suggests</p><p>that these problems intensify the higher the rate of GDP growth, with no</p><p>correlation between long-term GDP growth and equity market return. The</p><p>Chinese stock market is perhaps the most obvious example of this – despite</p><p>stellar GDP growth since 1993, the real return from Chinese equities has</p><p>been negative, declining by 3 per cent per year.</p><p>Investors should not expect earnings to grow in line with economy.</p><p>Rather, they should look out for those rare examples of management who</p><p>are prudent in their use of capital. The starting point for company analysis is</p><p>not the outlook for end demand but rather the supply side. Our goal is to find</p><p>investments in depressed industries at positive inflection points in the capi-</p><p>tal cycle and in sectors with benign and stable supply side fundamentals.</p><p>several other US airlines are currently committed to growing “available seat miles” by 10 per</p><p>cent annually, or around four times faster than underlying economic growth.</p><p>2</p><p>VALUE IN GROWTH</p><p>Capital cycle analysis, as it originally evolved at Marathon, looked to invest</p><p>in companies from sectors where capital was being withdrawn and to avoid</p><p>companies in industries where assets were increasing rapidly. The insight being</p><p>that both profits and valuations should generally rise after capital has exited an</p><p>industry and decline after capital has poured in. In other words, capital cycle</p><p>analysis was all about the drivers of mean reversion. Yet the same mode of anal-</p><p>ysis can be used to identify companies which, for one reason or another, are able</p><p>to repel competition.</p><p>Companies with such strong competitive advantages, possessing what</p><p>Warren Buffett calls a wide “moat,” are able to maintain profits, often for</p><p>longer than the market expects. Mean reversion is suspended. From a capital</p><p>cycle perspective, it can be observed that a lack of competition prevents the</p><p>supply side from shifting in response to high profitability. Acquiring stocks</p><p>in companies which defy mean reversion has been a particularly fruitful</p><p>investment strategy for Marathon over the last decade.</p><p>Somewhat confusingly, this style of investment is known generally as</p><p>“growth” investing in fund management industry parlance, as distinct from</p><p>“value” investing. Having acquired the “value” investor label from industry</p><p>consultants before and during the dotcom bubble, Marathon was wary of</p><p>being accused of style drift as it invested increasingly in stocks with higher</p><p>valuations and better growth prospects. As the essays below point out, the</p><p>“value/growth dichotomy” is false – at least, to a true value investor, whose</p><p>aim is not to buy stocks which are “cheap” on accounting measures (P/E,</p><p>price-to-book, etc.) and to avoid those which are expensive on the same</p><p>basis, but rather to look for investments trading at low prices relative to the</p><p>investor’s estimate of their intrinsic value.</p><p>VALUE IN GROWTH 53</p><p>2.1 WARNING LABELS (SEPTEMBER 2002)</p><p>Labelling fund managers as “value” or “growth” investors risks</p><p>distorting the investment process</p><p>Marathon has often been pigeon-holed as a value manager, a description</p><p>that we resist because it oversimplifies and misrepresents our investment</p><p>approach. The traditional definition of a value manager is one who invests</p><p>solely in companies with low valuations as measured by price-to-book, PE,</p><p>price-to-sales or price-to-cash flow. The value approach is associated with</p><p>Benjamin Graham, who sought unloved stocks with low stock price mul-</p><p>tiples which could deliver more than was generally expected – what was</p><p>termed “cigar-butt” investing in the sense that the object had been discarded</p><p>as worthless but nevertheless could provide one last puff. A growth manager</p><p>is one who invests at the other end of the spectrum in companies with high</p><p>stock price multiples.</p><p>Companies in the Marathon portfolio have tended to have below average</p><p>multiples, but this is not because we have been engaged in seeking “cigar-</p><p>butts.” In fact, the stocks in our European portfolios have relatively strong</p><p>earnings growth. Part of the reason for this apparent contradiction is that</p><p>we have found that smaller companies with above average growth</p><p>prospects</p><p>are often cheap.</p><p>While smaller companies have, in the recent past, tended to have low</p><p>valuations, large-cap stocks have attracted unjustifiably high valuations.</p><p>The growth of very large fund managers is largely to blame. In Europe,</p><p>the MSCI Europe Index consists of 540 stocks of which only 88 have a</p><p>market capitalization above $10bn. Liquidity reasons (that is, the amount</p><p>of time it takes to trade in and out of a stock) preclude fund managers</p><p>with vast assets under management from investing in stocks with market</p><p>valuations below this threshold. The trouble is that the largest cap stocks</p><p>are concentrated in certain sectors and underrepresented in others. Since</p><p>three-quarters of industrial stocks have a market cap of less than $10bn,</p><p>industrials are essentially “screened out” by the large-cap managers. By</p><p>contrast, 85 per cent of the healthcare stocks have market caps above</p><p>$10bn. As a result, pharma stocks attract disproportionate attention from</p><p>institutional investors.</p><p>The issue with style labelling is somewhat deeper, however. Similar to</p><p>the recent obsessions with tracking error, indexation and understanding</p><p>the “new economy,” it risks grossly distorting the investment process and</p><p>requires/encourages managers to use inappropriate tools and measurement</p><p>systems to construct portfolios. Many great investors will interpret value</p><p>CAPITAL RETURNS54</p><p>according to their perceptions of value. The renowned “value” investor Bill</p><p>Miller of Legg Mason has championed Amazon.com and AOL, while Warren</p><p>Buffett, that great disciple of Ben Graham, has preferred growth franchises</p><p>such as Coke and Disney. The latter, however, believes (or at least did believe)</p><p>that these high-quality businesses were cheap (i.e., good value relative to the</p><p>present value of their expected future returns) and still regarded himself as</p><p>buying value.</p><p>The fact is that one person’s growth stock is another’s value stock.</p><p>Recently, the investment data company Lipper has reported that Citigroup,</p><p>AIG and IBM are among the top 15 mutual fund holdings in both the large</p><p>company “value” and “growth” categories. This brings us to our next point,</p><p>which perhaps best explains why Marathon should never be labelled as a</p><p>pure value investor. Our capital cycle process examines the effects of the cre-</p><p>ative and destructive forces of capitalism over time. A growth stock usually</p><p>becomes a value stock after excess capital, lured in by large current profit-</p><p>ability, brings about a decline in returns. When this becomes extreme, as was</p><p>the case during the technology bubble, the resultant bust can turn growth</p><p>stocks into value stocks almost overnight.</p><p>The telecoms sector provides a good demonstration of this. Energis, the</p><p>UK alternative telecoms carrier, was bid up to a value of 10 times invested</p><p>capital during the “New Economy” boom of the late 1990s due to the per-</p><p>ceived growth potential for broadband and data networks. After an exces-</p><p>sive amount of money had been invested in the sector, Energis’s shares were</p><p>sold down to a tiny fraction of capital invested. They continue to languish.</p><p>The lesson here recently is not only the slim dividing line between value and</p><p>growth but also the danger of “value traps,” since Energis (like Worldcom)</p><p>never turned out to be cheap however much the stock fell.1</p><p>Marathon’s portfolio strategy in Europe and elsewhere is now shifting</p><p>from the deep value biases, maintained over the last five years, to more of a</p><p>relative valuation orientation, as stocks that were previously overvalued on</p><p>their perceived growth potential have slumped. At the same time, yesterday’s</p><p>deep value sectors – such as basic materials, paper, chemicals and certain</p><p>capital goods – now do not appear such good buys from an intrinsic value</p><p>viewpoint. Our thinking is best illustrated by two recent portfolio trades.</p><p>Assa Abloy is a world-leading lock company, owner of well known brands</p><p>such as Yale, VingCard and Vachette. It has grown sales at 25 per cent per</p><p>annum for the last ten years and compounded earnings by 38 per cent a year</p><p>1 Energis was placed in administration in July 2002. It was subsequently turned around</p><p>and sold to Cable & Wireless in 2005.</p><p>VALUE IN GROWTH 55</p><p>over the same period, helped in part by acquisitions. Its shares have fallen</p><p>by 56 per cent as growth stocks have derated. Having been bid up to 4 times</p><p>sales, Assa Abloy’s stock now trades at less than 1.5 times sales, a discount</p><p>to our estimate of intrinsic value. We are buyers. On the other hand, we are</p><p>disposing of Stora Enso, a Finnish paper company that we have long owned,</p><p>but whose corporate strategy we have issues with. No longer a deep value</p><p>stock, Stora Enso remains cheaper than Assa Abloy on every single valuation</p><p>metric other than the one which matters but which can’t be screened on a</p><p>quantitative basis – namely, intrinsic value.2</p><p>Investment style labelling is another convenient box-ticking, quantita-</p><p>tive oriented procedure beloved of consultants. Investors who adhere to one</p><p>particular style are likely to end up in trouble, sooner or later. Our belief is</p><p>that stocks should be viewed not as “growth” or “value” opportunities, but</p><p>rather from the perspective of whether the market is efficiently valuing their</p><p>future earning prospects.</p><p>2.2 LONG GAME (MARCH 2003)</p><p>Long-term investing works because there is less competition for really</p><p>valuable bits of information</p><p>There are many ways to describe investment approaches, indeed a consulting</p><p>industry has emerged whose primary function is to do just that. However,</p><p>there is one attribute that separates investors better than most, in our opin-</p><p>ion, and that is portfolio turnover. Marathon’s portfolios have an average</p><p>holding period of around five years, a figure which in all likelihood will rise</p><p>in the coming years as the quality of the companies in the portfolio (as mea-</p><p>sured by normalized returns on capital and growth potential) has risen, post</p><p>bubble.3 We can therefore perhaps be expected to argue vigorously in favour</p><p>of low turnover investment strategies.</p><p>While the case for long-term investment has tended to centre around</p><p>simple mathematical advantages such as reduced (frictional) costs and fewer</p><p>decisions leading (hopefully) to fewer mistakes, the real advantage to this</p><p>approach, in our opinion, comes from asking more valuable questions.</p><p>The short-term investor asks questions in the hope of gleaning clues to</p><p>near-term outcomes: relating typically to operating margins, earnings per</p><p>2 From the date of writing (September 2002) to the end of 2014, Assa Abloy’s share price</p><p>rose by 452 per cent in US dollars, comfortably outperforming Stora Enso, which was up by</p><p>0.7 per cent over the same period.</p><p>3 Marathon’s holding period in its main EAFE product has subsequently risen to 7.5</p><p>years.</p><p>CAPITAL RETURNS56</p><p>share and revenue trends over the next quarter, for example. Such infor-</p><p>mation is relevant for the briefest period and only has value if it is correct,</p><p>incremental, and overwhelms other pieces of information. Even when accu-</p><p>rate, the value of the information is likely to be modest, say, a few percentage</p><p>points in performance. In order to build a viable, economically important</p><p>track record, the short-term investor may need to perform this trick many</p><p>thousands of times in a career and/or employ large amounts of financial</p><p>leverage to exploit marginal opportunities.</p><p>And let’s face it, the competition for such investment snippets is ferocious.</p><p>This competition is fed by the investment banks. Wall Street relies heav-</p><p>ily on promoting client myopia to earn its crust. Why else would Salomon</p><p>Smith Barney produce a research report which begins “We are focusing on</p><p>the three month sales momentum model this month”; or Deutsche Bank</p><p>publish a “Weekly Autos” review? Can there really be much of value to say</p><p>about industry developments over such limited time frames? Of course not.</p><p>Even so, we would hate to discourage such research as, from time</p><p>to time,</p><p>what the short-term guys are selling can turn out to be wonderful long-term</p><p>investments.</p><p>The operative word here is “quick.” The longer one owns the shares, how-</p><p>ever, the more important the firm’s underlying economics will be to perform-</p><p>ance results. Long-term investors therefore seek answers with shelf life. What</p><p>is relevant today may need to be relevant in ten years’ time if the investor is</p><p>to continue owning the shares. Information with a long shelf life is far more</p><p>valuable than advance knowledge of next quarter’s earnings. We seek insights</p><p>consistent with our holding period. These principally relate to capital alloca-</p><p>tion, which can be gleaned from examining the company’s advertising, mar-</p><p>keting, research and development spending, capital expenditures, debt levels,</p><p>share repurchase/issuance, mergers and acquisitions and so forth.</p><p>Take marketing, for instance, which can be vital to long-term value crea-</p><p>tion, yet is often ignored. An understanding of the economics of line exten-</p><p>sions and an advertising strategy would have proved useful to investors in</p><p>consumer products companies. Colgate Palmolive introduced its first line</p><p>extension – a blue minty gel – in the early 1980s, and supported this new</p><p>product with a hefty advertising spend. This was Colgate’s first new tooth-</p><p>paste in a generation, and line extensions, which had been used successfully</p><p>in other household goods, were novel to the toothpaste market. By advertis-</p><p>ing heavily, the firm hoped to change the buying habits of a generation of</p><p>shoppers who would subconsciously think of Colgate as they approached the</p><p>toothpaste section of a supermarket, and when they got there, would find a</p><p>product which was new, superior and, because of advertising spend, trusted.</p><p>VALUE IN GROWTH 57</p><p>We did not attend any Colgate meetings in the early 1980s, but if they</p><p>were anything like their equivalents today the questions might have been</p><p>along the lines of: what does the rise in advertising spend mean for mar-</p><p>gins next quarter (an almost worthless piece of information)? Or, how will</p><p>the increase in depreciation from the new product line for minty gel affect</p><p>earnings (yawn)? Brokerage reports following the meeting may have been</p><p>like one which crossed our desks this morning, entitled “Thinking Outside</p><p>the Box, but near term outlook remains dreary,” recommendation: under-</p><p>perform. Few investors would have understood, and even fewer would have</p><p>cared, about the transformation that was taking place.</p><p>Even today, Colgate presentations do not mention the company’s adver-</p><p>tising spend, which remains in excess of market share in all countries except</p><p>Mexico, where market share is around 90 per cent. And this is despite 20</p><p>years of the firm demonstrating that line extensions and advertising support</p><p>are powerful competitive weapons. “Most people don’t think it is impor-</p><p>tant,” confessed the firm’s investor relations spokeswoman. Even though we</p><p>don’t own the shares, Marathon is the only fund manager to have sought and</p><p>gained a meeting with Colgate’s director of advertising and marketing.4</p><p>In the two decades since its first line extension, Colgate’s share price has</p><p>risen 25 fold, handsomely beating the market. This shows how important</p><p>it is for long-term investors to understand a firm’s marketing strategy. Yet,</p><p>given the annual 100 per cent turnover in Colgate shares, very few of the</p><p>firm’s shareholders have benefited fully from its success. And since Colgate’s</p><p>investment returns didn’t outperform the S&P 500 in any meaningful way</p><p>for a full ten years after the introduction of its first line extension, investors</p><p>with short time horizons wouldn’t have cared about such matters.</p><p>Why did so few Colgate investors stay the course? There are a range of</p><p>psychological forces stacked up against the long-term investor. In particular,</p><p>there is strong social pressure from peers, colleagues and clients to boost</p><p>near-term performance. Even if one has developed the analytical skills to</p><p>spot the winner, the psychological disposition necessary to own shares for</p><p>prolonged periods is not easily come by. J.K. Galbraith observed that: “noth-</p><p>ing is so admirable in politics as a short-term memory.” Why should politics</p><p>have a monopoly on sloppy thinking? Which makes us think that long-term</p><p>investing works not because it is more difficult, but because there is less</p><p>competition out there for the really valuable bits of information.</p><p>4 At the time, Marathon believed that the share price was too expensive for Colgate to be</p><p>buying back so much stock. Since March 2003, Colgate has modestly outperformed the S&P</p><p>500 Index.</p><p>CAPITAL RETURNS58</p><p>2.3 DOUBLE AGENTS (JUNE 2004)</p><p>Conflicts of interest in the business world sometimes play to an investor’s</p><p>advantage</p><p>In a recent lecture given at the University of California, Charles T. Munger</p><p>described a test he had performed at a number of US business schools.5 This</p><p>test involved the Berkshire Hathaway vice-chairman asking the MBA stu-</p><p>dents the following question: “You have studied supply and demand curves.</p><p>You have learned that when you raise the price, ordinarily the volume you</p><p>can sell goes down, and when you reduce the price, the volume you can</p><p>sell goes up. Is that right? That’s what you’ve learned?” The business school</p><p>students all nod in agreement. Munger then goes on: “Now tell me several</p><p>instances when, if you want the physical volume to go up, the correct answer</p><p>is to increase the price?” Some students come up with the luxury good para-</p><p>dox, whereby higher prices indicate superior quality which, in turn, leads to</p><p>greater sales.</p><p>Very few students identify Munger’s answer, namely that when the cus-</p><p>tomer is not involved directly in the purchasing decision, then higher prices</p><p>can be used to bribe the purchaser’s agent and can result in both higher profit</p><p>margins and sales volumes. From an economist’s perspective, the customer</p><p>experiences an agency problem. Agency creates the potential for supernor-</p><p>mal profits for both agents and producers. Investors who understand the</p><p>process can profit, too. It’s worth examining how the agency issue – hitherto</p><p>something discussed mainly in relation to the dysfunctionality of the invest-</p><p>ment management industry – relates to a number of companies we own or</p><p>may purchase at some stage in the future (price permitting, that is).</p><p>Normal relations between provider, intermediary and consumer are</p><p>distorted when the consumer lacks understanding and relies on a suppos-</p><p>edly independent intermediary. In many cases the relationship between the</p><p>intermediary and the product provider has developed to the point where</p><p>these parties form a tacit alliance to exploit consumer ignorance. We came</p><p>across this phenomenon with Geberit, the Swiss sanitary systems manufac-</p><p>turer. The company sells its product to plumbers via wholesalers who then</p><p>install them in the end-customer’s home or commercial building. Geberit</p><p>has a push-pull marketing strategy whereby plumbers are educated to “pull”</p><p>the product through the wholesale channel, and company sales representa-</p><p>tives “push” the product to wholesalers. When we asked senior manage-</p><p>ment about pricing pressure, we were told that plumbers welcomed price</p><p>5 See www.tilsonfunds.com/MungerUCSBspeech.pdf</p><p>VALUE IN GROWTH 59</p><p>increases, since they were paid on a percentage commission basis for the</p><p>system installation.</p><p>This model encourages innovation – in Geberit’s case, it might be a new</p><p>pre-wall installation system (don’t ask) – as the plumber-agent finds it easier</p><p>to persuade customers to pay up for novelty. This had led to frantic product</p><p>development at Geberit, where around a third of the company’s sales derive</p><p>from products introduced over the last three years. The somewhat unholy</p><p>alliance between Geberit and plumbers has produced a deep profit pool,</p><p>from which Geberit takes a healthy share (it enjoys margins of over 15 per</p><p>cent at the group operating profit level). The company’s high market</p><p>shorter</p><p>periods of time.</p><p>While we have sometimes struggled to explain our stance to consult-</p><p>ants and other professionals in the financial services arena, it has always</p><p>proved easier when it came to our clients. The latter – pension funds, state</p><p>funds, foundations and endowments, predominantly in the United States –</p><p>are often staffed by individuals with experience of working in non-financial</p><p>businesses. A common refrain from them when explaining our process is</p><p>“that’s just common sense.” Fortunately for us, these ideas about how the</p><p>capital cycle operates and how management allocates capital are not widely</p><p>followed by our own competitors in the investment industry. This throws</p><p>1 Trading under the name of Marathon-London in the United States.</p><p>xiFOREWORD</p><p>up investment opportunities for us around the world. While we have made</p><p>innumerable errors over the years, our overall record in terms of relative</p><p>performance has been favourable.</p><p>Furthermore, the investment approach has fared well under conditions</p><p>of extreme stress and market madness. The Asian Crisis of the late 1990s and</p><p>the technology, media and telecoms (TMT) bubble of the turn of the mil-</p><p>lennium were documented in our last collection of essays, Capital Account.2</p><p>Since 2004, the principal stress test was the long run up to, and calamitous</p><p>aftermath of, the Global Financial Crisis (GFC). The challenges this posed</p><p>for fund managers is the main story of this book. We were responsible for</p><p>numerous howlers – catching “falling knives” from the detritus of both the</p><p>TMT bubble and the GFC, as well as numerous errors of judgment when it</p><p>came to picking management teams. Our hall of shame includes the likes</p><p>of Bear Stearns, Bradford & Bingley, Blockbuster, MBIA, HMV etc., etc.</p><p>Nevertheless, overall performance has been gratifying, giving us confidence</p><p>in the robustness of the investment philosophy.</p><p>This good fortune is matched by our success in persuading Edward</p><p>Chancellor to reprise his role as editor of this volume of essays taken from</p><p>the period 2002–15, as well as to write an insightful introduction. We thank</p><p>him, along with Marathon’s employees, past and present, for their role in</p><p>building this firm and creating this book.</p><p>Neil Ostrer, Founding Member</p><p>William Arah, Founding Member</p><p>June 2015</p><p>2 Edward Chancellor (ed.), Capital Account: A Money Manager’s Reports on a</p><p>Turbulent Decade 1993–2003 (2004).</p><p>PREFACE</p><p>Capital Returns appears just over a decade after the publication of Marathon’s</p><p>previous publication, Capital Account, which I also had a hand in editing.</p><p>This new work is arranged along the same lines as its predecessor. The pieces</p><p>here have been selected from the firm’s Global Investment Review, which</p><p>appears eight times a year and typically contains six essays of around 1,500</p><p>words in length. The review, or GIR as it is known in-house, is written to</p><p>inform Marathon clients of the firm’s investment approach and to provide</p><p>real-time insights into developments in the investment world.</p><p>The essays collected in the current volume have been chosen because they</p><p>exemplify Marathon’s capital cycle investment philosophy, which Marathon</p><p>believes to be of some interest to the wider investing public (and perhaps even</p><p>the odd economist if any can bring himself or herself to read a book devoid</p><p>of equations and mathematical models). The process of selection inevitably</p><p>leads to what is known in the investment world as “survivorship bias”: those</p><p>essays which haven’t survived the test of time, or have turned out to be plain</p><p>wrong, have been jettisoned, while the better investment calls have largely</p><p>avoided the cull. The result is to make Marathon appear more clairvoyant</p><p>than is actually the case – one could quickly put together a far larger volume</p><p>of duff pieces! My intention has not been to flatter the authors’ prescience,</p><p>but rather to find interesting examples of capital cycle analysis, as applied by</p><p>Marathon’s analysts over the past decade.</p><p>As before, I have been given a free hand in editing and have employed</p><p>the same technique as formerly. Namely, I have edited the text to make it</p><p>read more fluently than when it first appeared. Editing a text long after it</p><p>has been written necessarily involves some hindsight bias. This diminishes</p><p>to some extent the integrity of Capital Returns as original source material.</p><p>My aim, however, has been to draw out the capital cycle analysis as clearly as</p><p>possible without changing the meaning of the original piece.</p><p>The authors of the essays in this collection are (in alphabetical order):</p><p>Charles Carter, David Cull, Mike Godfrey, Jeremy Hosking, Nick Longhurst,</p><p>Jules Mort, Michael Nickson, Neil Ostrer, James Seddon, Nick Sleep, Mike</p><p>xiiiPREFACE</p><p>Taylor, Simon Todd and Qais Zakaria. I have received even more help putting</p><p>together Capital Returns than with the earlier volume. Simon Todd valiantly</p><p>started out the selection process, which in many ways is the most arduous</p><p>aspect of the job (there were over 600 essays from which to pick). Quentin</p><p>Carruthers undertook the initial sub-editing. William MacLeod has assisted</p><p>with many of the footnotes. Nicola Riley has helped on the administrative</p><p>side, printing off numerous drafts and sending me countless files. Bridget</p><p>Hui kindly checked the proofs. As with Capital Account, the present volume</p><p>is largely the product of my friend and former colleague Charles Carter. It</p><p>has been a pleasure working with him again.</p><p>Edward Chancellor</p><p>June 2015</p><p>INTRODUCT ION</p><p>This book contains a collection of reports written by investment professionals</p><p>at Marathon Asset Management. What makes these reports stand out, in my</p><p>opinion, is an analytical focus on the ebb and flow of capital. Typically, capital</p><p>is attracted into high-return businesses and leaves when returns fall below the</p><p>cost of capital. This process is not static, but cyclical – there is constant flux. The</p><p>inflow of capital leads to new investment, which over time increases capacity in</p><p>the sector and eventually pushes down returns. Conversely, when returns are</p><p>low, capital exits and capacity is reduced; over time, then, profitability recovers.</p><p>From the perspective of the wider economy, this cycle resembles Schumpeter’s</p><p>process of “creative destruction” – as the function of the bust, which follows the</p><p>boom, is to clear away the misallocation of capital that has occurred during the</p><p>upswing.</p><p>The key to the “capital cycle” approach – the term Marathon uses to</p><p>describe its investment analysis – is to understand how changes in the</p><p>amount of capital employed within an industry are likely to impact upon</p><p>future returns. Or put another way, capital cycle analysis looks at how the</p><p>competitive position of a company is affected by changes in the industry’s</p><p>supply side. In his book, Competitive Advantage, Professor Michael Porter</p><p>of the Harvard Business School writes that the “essence of formulating</p><p>competitive strategy is relating a company to its environment.”1 Porter</p><p>famously described the “five forces” which impact on a firm’s competitive</p><p>advantage: the bargaining power of suppliers and of buyers, the threat of</p><p>substitution, the degree of rivalry among existing firms and the threat</p><p>of new entrants. Capital cycle analysis is really about how competitive</p><p>advantage changes over time, viewed from an investor’s perspective.</p><p>1 Michael Porter, Competitive Strategy (1980), p. 3. See also Capital Account, pp. 6–7.</p><p>CAPITAL RETURNS2</p><p>A STYLIZED CAPITAL CYCLE</p><p>Here’s how the capital cycle works. Imagine a widget manufacturer – let’s call</p><p>it Macro Industries. The firm is doing well; so well, that its returns exceed</p><p>Macro’s cost of capital. The firm’s CEO, William Blewist-Hard, has recently</p><p>featured on the front cover of Fortune magazine. His stock options are in</p><p>the money, and his wife no longer complains about being married to a bor-</p><p>ing industrialist. Of the nine investment bank analysts who cover Macro’s</p><p>stock, seven have buy recommendations and</p><p>share –</p><p>around 50 per cent in its seven core European markets – and the fragmenta-</p><p>tion of the plumbing industry help to maintain profitability.</p><p>Of course, the company would argue that these arrangements ultimately</p><p>benefit customers, as profits finance new product development. That’s as may</p><p>be. What’s clear is that Geberit has an extremely effective business model,</p><p>with 8 per cent annual growth at the top line level over two decades.</p><p>An unholy alliance between producers and distributors exploiting cus-</p><p>tomer ignorance is also prevalent in the healthcare sector. Without going</p><p>into the dubious marketing ethics of the pharmaceutical industry, we have</p><p>found agency models similar to Geberit’s among European dental implant</p><p>and hearing aid manufacturers. Nobel Biocare and Straumann are Swiss</p><p>leaders in the field of dental implant technology. Constant innovation and</p><p>customer (in this case, the dentist) education has driven strong growth and</p><p>high margins. Nobel Biocare has grown revenues at 17 per cent p.a. since</p><p>1995, and its latest operating profit margin was 24 per cent. Dentists who</p><p>adopt its implant technique, which replaces the traditional crown and bridge</p><p>solution, earn higher revenues. Customers end up with better teeth, and</p><p>shareholders are smiling!</p><p>In the upscale hearing aid market, a field dominated by European firms</p><p>– Siemens, William Demant, GN Store Nord, and Phonak – there is a similar</p><p>emphasis on continuous innovation. The fitters of hearing aids, like den-</p><p>tists, are keen to sell high-end products which earn them more money. We</p><p>understand from William Demant (a portfolio holding with margins above</p><p>20 per cent after spending around 7 per cent of sales on R&D) that one of</p><p>the defining characteristics of the high-end products is that they require a</p><p>customized fitting, since everyone’s “ocular canal” is unique. Their hearing</p><p>aids cost around $1,000; on top of this, the fitter charges another $2,000</p><p>for customized service. As with Geberit’s plumbing business, innovation in</p><p>hearing aid technology has been a boon for raising product prices. Once</p><p>again, the customer (the fitter-agent) is not price-sensitive. The producers of</p><p>CAPITAL RETURNS60</p><p>hearing aids and dental implants are helped by the fact that the markets into</p><p>which they sell their products are so fragmented.</p><p>Another example of the agency model is when the paying customer</p><p>doesn’t actually choose the service. Labtest is the Hong Kong subsidiary of</p><p>Intertek, a company listed on the London Stock Exchange. The company’s</p><p>role is to serve as a gatekeeper between Chinese consumer goods manu-</p><p>facturers and American retailers. We understand that the US firms select</p><p>Labtest to check the prototypes of new Chinese products to ensure that they</p><p>meet the appropriate specifications. Intertek charges the Chinese firms,</p><p>rather than the US retailers, for this service, a fee that constitutes a relatively</p><p>low proportion of the product price (less than 1 per cent of the manufac-</p><p>turer’s cost). This distancing of payer from the service selector lies at the</p><p>heart of Labtest’s remarkable profitability – with margins around 33 per cent</p><p>– alongside more obvious network and scale effects.</p><p>Munger is right. Customers will often pay more when agents are</p><p>involved. In each of the cases we’ve discussed, the business models – whether</p><p>in plumbing, dentistry, hearing aids, or product testing – involved value</p><p>being transferred from the person who pays to the agent, with the producer</p><p>taking a large slice of the pie. Each of these models has evolved over time and</p><p>appears reasonably robust, even as consumers become better informed in</p><p>the Internet age. Just as agency problems in the fund management industry</p><p>have shown remarkable persistence, we expect the superior profitability of</p><p>companies that exploit agency to endure.6</p><p>2.4 DIGITAL MOATS (AUGUST 2007)</p><p>Internet companies investing in their competitive positions can afford to</p><p>ignore short-term profitability</p><p>Eight years ago, when it looked as though the future belonged to Internet com-</p><p>panies, it was possible to double your money in a matter of months by investing</p><p>in any company with dotcom attached to its name. At the time, we were unable</p><p>to justify the valuations of any of these companies, nor identify any which we</p><p>could safely say would still be going strong in years to come. Consequently,</p><p>Marathon’s global portfolios avoided any exposure to Internet companies. Yet</p><p>some of the best recent performers in our global portfolios are companies which</p><p>execute all of their business online. Two of them are even former highfliers</p><p>6 Between August 2007 and the end of 2014, Intertek’s share price rose by 83 per cent in</p><p>US dollars, Geberit was up by 152 per cent, and William Demant fell by 13 per cent. The</p><p>MSCI Europe Index, over the same period, was down by 21 per cent.</p><p>VALUE IN GROWTH 61</p><p>from the dotcom bubble, Amazon.com and Priceline.com. Given that these</p><p>firms have little in the way of current profitability, why do we own them?</p><p>For a start, these companies are building sustainable competitive advan-</p><p>tages. Their strategy is to use the low cost and scalability of Internet technol-</p><p>ogy to provide savings for their customers. They recognize the importance</p><p>of securing a dominant position in their respective markets by operating</p><p>their businesses with low margins, in the short-term, so as to maximize their</p><p>earnings potential in the long-term.</p><p>Amazon.com is the best known and most established of the businesses,</p><p>having expanded well beyond its origins as an online discount book retailer.</p><p>A lot of scepticism surrounds the stock, partly because of its high profile at</p><p>the time of the Internet bubble, and more recently because of the volatile pro-</p><p>gression of the company’s margins. The variation in the margin stems from</p><p>Amazon’s desire to continue to expand its offer, and the fact that a number</p><p>of the new services – including Amazon Web Services, which provides com-</p><p>puting services for clients, and “Fulfilment by Amazon,” which enables other</p><p>retailers to use Amazon’s expertise in processing inventory and orders – have</p><p>required large up-front investments and will take some time to develop into</p><p>profitable businesses. This investment, most of which is written off as an</p><p>expense in the accounts, has made margins rather volatile over recent years</p><p>(as can be seen below).</p><p>While Wall Street fretted about the collapse in margins, without think-</p><p>ing of the longer-term benefits of the investment, the stock declined from</p><p>$60 to $40. Now there are signs that Amazon’s margins are recovering, while</p><p>sales are growing at 35 per cent year-on-year. The stock has almost doubled</p><p>since the start of 2007. Amazon gives frustratingly little long-term guid-</p><p>ance about the potential profitability of its new initiatives, but hints at an</p><p>ambition for margins in the high single digits once these businesses have</p><p>reached maturity. The company’s track record gives us confidence that they</p><p>Table 2.1 Amazon’s net profit margin</p><p>Year Net margin (%)</p><p>2003 0.7</p><p>2004 8.5</p><p>2005 4.2</p><p>2006 1.8</p><p>Source: Bloomberg.</p><p>CAPITAL RETURNS62</p><p>can achieve this, and at the current valuation of 2.3 times current sales, the</p><p>shares are far from overvalued.7</p><p>Priceline.com shares took one of the biggest tumbles when the Internet</p><p>bubble burst, falling from a peak of $974 to a low of $7. The company had</p><p>been operating an undifferentiated “name-your-own-price” model, until</p><p>the acquisition of Booking.com in 2005 shifted the corporate strategy</p><p>towards developing its European agency hotels business. Some 32,000</p><p>hotels have signed up so far; with over 100,000 hotels to target, along</p><p>with increasing Internet use by Europeans, Booking.com is well placed to</p><p>capture a much larger share of hotel bookings in Europe. Operating the</p><p>platform requires minimal cost, and the company is already generating</p><p>good cash f low which is being used to repurchase stock. It may be that</p><p>the management of Priceline.com stumbled on</p><p>this European opportu-</p><p>nity by chance, but they have been smart enough to recognize the poten-</p><p>tial to create a business which could be generating enough cash in three</p><p>to five years’ time to make the valuation of the company look far too</p><p>conservative.</p><p>The basic corporate model of low margins in order to maximize long-</p><p>term absolute profit is a well-trodden path, with Wal-Mart the most notable</p><p>exponent. It is not surprising that some companies will have the good sense</p><p>to apply this old model to the new medium of the Internet. This strategy dra-</p><p>matically reduces business risks (via reduced competition) while simultane-</p><p>ously raising long-term rewards (via likely growth). Internet technology will</p><p>help these firms secure competitive advantage, and investors should benefit</p><p>in the long run.</p><p>2.5 QUALITY TIME (AUGUST 2011)</p><p>Our portfolios have shifted towards higher quality companies with</p><p>sustainable barriers to entry</p><p>A few discordant commentators question whether the elevated current levels</p><p>of corporate profits in the US and Europe are sustainable. As bottom-up</p><p>investors, however, we are more interested in the capital cycle as it affects</p><p>individual companies than in aggregate corporate profitability. We are on</p><p>the lookout for factors which might lead to improved returns on equity, in</p><p>7 The positions in Amazon.com and Priceline were eventually sold in February and</p><p>September 2013, having risen respectively by 231 per cent and 1,055 per cent since the date</p><p>of this piece. Amazon’s stock has continued to perform strongly, up 18 per cent from the date</p><p>of sale to the end of 2014, yet the company still shows nothing in the way of profit (its net</p><p>margin in 2014 was −0.3 per cent.)</p><p>VALUE IN GROWTH 63</p><p>particular: (1) the emergence of oligopolies in industries hitherto character-</p><p>ized by low returns and excessive competition; (2) the evolution of business</p><p>models with high and rising barriers to entry; and (3) management behav-</p><p>iour which encourages these trends.</p><p>Even if European corporate profits decline in aggregate, our portfo-</p><p>lio companies should be able to resist the trend. That’s because over time,</p><p>Marathon’s European portfolio has shifted gradually towards higher quality</p><p>companies with superior barriers to entry.</p><p>We have discussed at length our investments in so-called agency business</p><p>models, including medical devices and building equipment (locks, electrical</p><p>and plumbing fittings, etc). Essentially, these companies rely on an interme-</p><p>diary to sell their products (a doctor, plumber, locksmith etc.) whose advice</p><p>is relied upon by uninformed consumers who do not perceive the common</p><p>interest of the producer and agent to sell high-margin products. These busi-</p><p>ness models account for approximately 10 per cent of Marathon’s European</p><p>portfolio and have an average estimated RoE for 2011 of 27 per cent, some 11</p><p>percentage points above the average for European non-financials. Exposure</p><p>to branded consumer goods has also increased in recent years – including</p><p>additions of beer stocks, Unilever and Swedish Match – and now represents</p><p>around 9 per cent of the portfolio, with an average RoE of 48 per cent.</p><p>Another class of business whose weight in our portfolios has expanded</p><p>in recent years has been subscription-based service companies with annu-</p><p>ity-like revenue streams. Excluding telecom companies, which also have a</p><p>high degree of subscription-based revenue, these companies now account</p><p>for around 12 per cent of the European portfolio and have a forecast RoE of</p><p>42 per cent. The common theme here is a longer-term commitment made by</p><p>the customer, together with an element of inertia when it comes to renewals.</p><p>These factors, in combination with the scale economies which often arise in</p><p>the provision of subscription services, make for significant barriers to entry</p><p>and high and sustainable returns.</p><p>This is particularly true where the cost of the service is only a small</p><p>proportion of the customer’s total spending, as is the case for a number of</p><p>our portfolio companies, including Rightmove, Capita and a handful of</p><p>information providers. Rightmove, the UK property listings website, enjoys</p><p>a winner-takes-all network benefit from being the most popular website</p><p>for property searchers. The company charges estate agents a subscription</p><p>price per office which is well below the cost of less effective print advertis-</p><p>ing. When we met the company in March 2011, 65 per cent of subscriptions</p><p>for the year had already been received, and a further 20 per cent were to be</p><p>received in May. Price increases this year are in the order of 16 per cent.</p><p>CAPITAL RETURNS64</p><p>In the area of dialysis treatment, Fresenius Medical Care (FMC) has a 34</p><p>per cent market share in the US and makes substantial profits from private</p><p>insurers for whom the cost of dialysis care is only 2 per cent of total outgo-</p><p>ings. Negotiations with private insurers are on a state-by-state basis, limiting</p><p>customer buying power, and increasingly insurers are moving to multiyear</p><p>contracts with built-in price escalators. Capita, the UK business processing</p><p>outsourcing company, has built up a base of multiyear contracts with local</p><p>and central government and, increasingly, in the life insurance and pensions</p><p>administration market. It has been able to improve its margins over time by</p><p>delivering substantial cost savings for customers and in some cases building</p><p>competence centres whose costs are spread across a number of clients.</p><p>In the area of information providers, portfolio companies such as</p><p>Experian, Reed Elsevier, Wolters Kluwer and Informa have businesses with</p><p>unique information whose value for customers depends on having a com-</p><p>plete data set. Hence, it is hard to consider cancelling subscriptions even</p><p>during economic downturns. Even Experian, whose data collection business</p><p>is linked to the growth of credit markets generally, delivered modest growth</p><p>during the financial crisis.</p><p>Together, the above three categories of stocks account for approximately</p><p>31 per cent of Marathon’s European portfolio. To these, one can add hold-</p><p>ings in pharmaceutical and telecom companies, which have high returns</p><p>(although there are more doubts about their sustainability), and one arrives</p><p>at a total of close to 40 per cent of the total portfolio (nearer 50 per cent ex-</p><p>financials). The average RoE of this group of stocks is 39 per cent, 2.4 times</p><p>the average for non-financial stocks generally.</p><p>Although there is variability among this group in terms of sensitivity to</p><p>the economic cycle and some business models will undoubtedly prove more</p><p>durable than others, these high RoE business models are likely to outper-</p><p>form more discretionary areas, particularly those exposed to weak domestic</p><p>European consumption. Other more cyclically sensitive portfolio holdings</p><p>are increasingly oriented towards global growth, especially in relation to</p><p>emerging markets, whose prospects appear more promising than those in the</p><p>mature Western economies. This shift to quality should render Marathon’s</p><p>European portfolios less dependent on a precise answer to the question of</p><p>whether aggregate corporate profits, whether for cyclical or structural rea-</p><p>sons, are about to be squeezed.8</p><p>8 Of the 11 companies referred to in this article (Assa Abloy, Legrand, Geberit, Unilever,</p><p>Swedish Match, Rightmove, Capita, Fresenius Medical Care, Experian, Reed Elsevier and</p><p>VALUE IN GROWTH 65</p><p>2.6 ESCAPING THE SEMIS’ CYCLE (FEBRUARY 2013)</p><p>Niche semiconductor businesses have escaped the ravages of the industry’s</p><p>capital cycle</p><p>Driven by Moore’s law, the semiconductor sector has achieved sustained</p><p>and dramatic performance increases over the last 30 years, greatly benefit-</p><p>ing productivity and the overall economy. Unfortunately, investors have</p><p>not done so well. Since inception in 1994, the Philadelphia Semiconductor</p><p>Index has underperformed the Nasdaq by around 200 percentage points,</p><p>and exhibited greater volatility.</p><p>The reason for this poor performance is no</p><p>secret. No part of the tech-</p><p>nology world has been more prone to cyclical booms and busts than the</p><p>semiconductor industry. In good times, prices pick up, companies increase</p><p>capacity, and new entrants appear, generally from different parts of Asia</p><p>(Japan in the 1970s, Korea in 1980s, Taiwan in the mid-1990s, and China</p><p>more recently). Excess capital entering at cyclical peaks has led to relatively</p><p>poor aggregate industry returns.</p><p>While the history of the semiconductor business provides a classic</p><p>example of the capital cycle, there are companies operating in niches of the</p><p>industry which have delivered excellent long-term returns for sharehold-</p><p>ers. Two of them are recent additions in our US portfolio: Analog Devices,</p><p>based in Norwood, Massachusetts, and Linear Technology, headquartered</p><p>in Milpitas, California.</p><p>Wolters Kluwer), 10 outperformed the MSCI Europe Index between August 2011 (date of</p><p>publication) and the end of 2014 – the exception being Swedish Match.</p><p>Reduced</p><p>supply &</p><p>higher</p><p>prices</p><p>Excess</p><p>capex</p><p>Over supply</p><p>Reduced</p><p>capex</p><p>Chart 2.1 The semiconductor cycle</p><p>Source: Marathon.</p><p>CAPITAL RETURNS66</p><p>Semiconductors are essential electronic building blocks for electronic</p><p>systems and equipment. Analog semiconductors represent around 15 per</p><p>cent of the total semiconductor market, with the rest being digital. The func-</p><p>tion of an analog semiconductor is to bridge the gap between the real world</p><p>and the electronic one – monitoring, amplifying and transforming phenom-</p><p>ena such as temperature, sound and pressure. End-markets include mobile</p><p>phone handsets (e.g., the digitization of voice), automobiles (e.g., the crash</p><p>sensor in an airbag) and the industrial economy (e.g., a temperature sensor</p><p>in process automation equipment). This is in contrast to digital semicon-</p><p>ductors which operate, predominantly, in the purely digital world of binary</p><p>code.</p><p>The analog sub-sector has been a notable exception to the low and vola-</p><p>tile investment returns of the semiconductor industry. Analog Devices, for</p><p>example, has consistently generated high margins over many years, with</p><p>robust profits even in stressed environments. On average, between 2000 and</p><p>2012, the company’s gross margin was 60 per cent and operating margin was</p><p>25 per cent. The level of capital intensity required to achieve these impressive</p><p>returns was relatively low. Capex to sales at Analog Devices has averaged 6</p><p>per cent since 2000, and has fallen to 4 per cent over the last five years. This</p><p>low level of capital intensity has allowed free cash flow conversion at a con-</p><p>sistently high level, on average at over 100 per cent of net income.</p><p>Linear Technology has displayed even stronger economics. Since the turn</p><p>of the century, it has enjoyed an average gross margin of 76 per cent and aver-</p><p>age operating margin of around 50 per cent. The ratio of capex to sales has hov-</p><p>ered around 5 per cent, with cash conversion again greater than 100 per cent.</p><p>In addition to having robust margins, both companies have historically expe-</p><p>rienced strong sales growth, driven by the increasing penetration of technol-</p><p>ogy into everyday life. Since 1990, Analog Devices’s revenue has compounded</p><p>at 8 per cent annually, and Linear’s sales have grown by 14 per cent a year.</p><p>How have these companies generated such high returns and to what</p><p>extent are these returns sustainable? The answer lies in an understanding</p><p>of the supply side of this industry – the specifics of the production process,</p><p>market structure, competitive dynamics and pricing power, which together</p><p>constitute the essence of capital cycle analysis. Consider first the mechanics</p><p>of the analog semiconductor business. As the real world is far more complex</p><p>and heterogeneous than the digital one, the product design required to cap-</p><p>ture it has to be more complex and heterogeneous. This means that product</p><p>differentiation of analog semiconductors is higher and company-specific</p><p>intellectual property (whether physical or human capital) more important.</p><p>VALUE IN GROWTH 67</p><p>The human capital component is especially hard to replicate because</p><p>engineering talent deepens with experience. The design process is much</p><p>more trial and error than in other technology disciplines, and less reliant on</p><p>computer modelling and simulation. To become an expert in analog semi-</p><p>conductor design takes many years – the tenure of the average engineer at</p><p>Analog Devices is 20 years. This forms an important barrier to entry. In</p><p>addition, each analog company’s process technologies are quite distinct (dig-</p><p>ital utilizes a more generic process).</p><p>Thus, it is difficult for an engineer to be poached by another analog</p><p>company without his productivity being significantly impaired. The supply</p><p>of new engineers tends to be constrained for the analog sector – new science</p><p>graduates are much more likely to pursue the digital semiconductor route.</p><p>This is largely because the learning curve is less steep in digital, and expe-</p><p>rience on the job less valued. As a result, research capacity in the world of</p><p>analog semis has been, and will likely to continue to be, constrained.</p><p>These factors – a differentiated product and company-specific “sticky”</p><p>intellectual capital – reduce market contestability. These strategic advantages</p><p>are compounded by the fact that analog has a more diverse end market than</p><p>digital, with a much wider range of products, numbering in the thousands,</p><p>and smaller average volume size. Such market characteristics make it dif-</p><p>ficult for a new entrant to compete effectively. Thus pricing power tends to</p><p>be robust and market positions relatively stable over long periods. While the</p><p>overall market is relatively fragmented – the five firm concentration ratio</p><p>is around 50 per cent – it is more consolidated in the various market sub-</p><p>segments. Analog Devices, for instance, has over a 40 per cent share in data</p><p>converters.</p><p>Pricing power is further aided by the fact that an analog semiconductor</p><p>chip typically plays a very important role in a product (for example, the air-</p><p>bag crash sensor) but represents a very small proportion of the cost of mate-</p><p>rials. The average selling price for Linear Technology’s products is under $2.</p><p>As a result, competition tends to be less on price and more on product qual-</p><p>ity. In addition, once a chip has been designed into an application – a proc-</p><p>ess on which the original equipment manufacturer and the analog company</p><p>often collaborate, it is costly for the manufacturer to replace it, as the whole</p><p>production process has to be revised. Hence switching costs are high, both</p><p>improving pricing power over the product lifecycle (often ten years or more)</p><p>and the degree to which revenues are recurring.</p><p>Finally, and of critical importance, the analog production process is less</p><p>standardized than most tech components, and thus far less vulnerable to</p><p>CAPITAL RETURNS68</p><p>obsolescence from the endless march of Moore’s law, significantly reducing</p><p>capital intensity. More than a third of sales at Analog Devices come from</p><p>products which are more than ten years old. This shelters the sector from</p><p>the destructive force of the capital cycle which has wreaked such havoc in the</p><p>digital semiconductor industry. Hence there are good reasons to believe that</p><p>the high returns historically achieved by these companies can be sustained</p><p>into the future.</p><p>We are also confident that management will allocate future surplus cash</p><p>flow for the benefit of equity investors. Historically, most of the growth of</p><p>these businesses has been organic, with excess cash returned to shareholders.</p><p>This is a significant achievement for companies in the technology sector, an</p><p>area where the temptation to do strategic deals has been strong, often to the</p><p>detriment of shareholders. We expect the long-serving management teams</p><p>of both companies to continue to allocate capital prudently. Both Analog</p><p>Devices and Linear Technology currently offer free cash flow yields of 5 per</p><p>cent. With long-term growth in free cash flow</p><p>likely to be similar to histori-</p><p>cal levels, our total annual return expectation is in the low double digits.9</p><p>2.7 VALUE IN GROWTH (AUGUST 2013)</p><p>A Chinese Internet firm’s market dominance justifies its high valuation</p><p>It should never be forgotten that, in its most basic form, investing is always</p><p>and everywhere about price and value. Price is what you pay, says the Sage</p><p>of Omaha, and value is what you get. By this definition, every serious inves-</p><p>tor must be a value investor. This is not to say that investors should restrict</p><p>themselves to buying companies with low valuation multiples. The business</p><p>of investment is ultimately about buying stocks at a discount to intrinsic</p><p>value.</p><p>So how do you calculate value? Well, in theory the value received is</p><p>derived from future cash flows discounted back to today at the appropriate</p><p>discount rate. The trouble is that we are rather poor at making predictions,</p><p>especially about the future. But that doesn’t put us off. We suffer from what</p><p>Nassim Taleb calls the “epistemic arrogance” – in plain English, we think we</p><p>are better at making predictions than we really are.10 The result is that we</p><p>9 Between inception in 1994 and the end of 2014, the Philadelphia Stock Exchange</p><p>Semiconductor Index rose by 474 per cent, underperforming the Nasdaq Composite by</p><p>nearly 19 per cent. Over the same period, Linear Technologies was up 729 per cent and</p><p>Analog Devices up 1,059 per cent.</p><p>10 Nassim Taleb, Black Swan: the Impact of the Highly Improbable. The glossary of this</p><p>book defines epistemic arrogance as a measurement of “the difference between what some-</p><p>one actually knows and how much he thinks he knows. An excess will imply arrogance,</p><p>VALUE IN GROWTH 69</p><p>have a misplaced sense of confidence in our forecasts. Investors like model-</p><p>ling because it appears scientific (the more spreadsheet tabs, the greater the</p><p>effect).</p><p>Investment models, however, encourage anchoring. Most models are</p><p>calibrated to produce a current value for a company within a reasonable</p><p>range of the current price. Another wrinkle is the discount rates. If you don’t</p><p>accept that historical volatility (beta) is a good measure of risk (which we</p><p>do not), then it’s not clear how to calculate the appropriate discount rate. At</p><p>Marathon, we believe that detailed forecasting adds little value.</p><p>One common response to the difficulty of forecasting is to turn to simple</p><p>value proxies, such as the price-to-book ratio, price-to-earnings (PE) ratio,</p><p>and free cash flow yield. Many “value” investors advocate buying a basket</p><p>of stocks which are cheap by these measures. There’s nothing inherently</p><p>dumb about this approach. Each of the measures is a very useful indicator of</p><p>potential value, but there’s a danger of oversimplification. Traditional valua-</p><p>tion measures say nothing about the specific context of an investment – for</p><p>instance, a company’s business model, its industry structure, and manage-</p><p>ment’s ability to allocate capital – which determines future cash flows.</p><p>Quantitative valuation measures also tend to encourage a narrow cat-</p><p>egorization of investment styles. Take for example the S&P US Style Indices.</p><p>Value stocks are defined by their ratios of price-to-book, price-to-earnings,</p><p>and price-to-sales. The growth index, on the other hand, is defined by the</p><p>three-year change in earnings per share, three-year sales per share growth</p><p>rate, and 12-month price momentum. While some of these factors are pow-</p><p>erful, they are too crude to be the sole framework for assessing value. An</p><p>analysis of our portfolios often creates confusion as to which box Marathon</p><p>fits best. Conventional labels – “growth” or “value” – tend not to suit our</p><p>capital cycle approach to investment.</p><p>Take Baidu, for example, the dominant Internet search engine in China,</p><p>which happens to be a recent addition to the Marathon portfolios. At the</p><p>time of purchase, the stock was priced at 7.2 times book and 18 times earn-</p><p>ing, neither of which look particularly appetizing from a value perspective.</p><p>Consider, however, that Baidu has a 70 per cent market share in an</p><p>industry where profits accrue disproportionally to the market leader, mak-</p><p>ing it difficult for competitors to thrive. Baidu also operates a business model</p><p>which requires little capital investment and converts profit to cash at a rate in</p><p>excess of 100 per cent. The asset-light nature of the balance sheet is helpful in</p><p>a deficit humility. An epistemocrat is someone of epistemic humility, who holds his own</p><p>knowledge in greatest suspicion.”</p><p>CAPITAL RETURNS70</p><p>managing overinvestment and working capital creep, the two great dangers</p><p>of a rapid growth model. Baidu’s current level of monetization per search</p><p>is less than a tenth of that achieved by its developed market peers, leaving</p><p>significant opportunity for improvement. Furthermore, the founder, CEO</p><p>and Chairman Robin Li has a 20.7 per cent stake, which aligns his interests</p><p>with those of outside investors. Although there are a number of risks to the</p><p>investment case (not least that that of supply side disruption), we believe</p><p>that the “expensive” Baidu stock provides a compelling value opportunity</p><p>for long-term investors.</p><p>2.8 QUALITY CONTROL (MAY 2014)</p><p>Capital cycle analysis helps to identify investments with high and</p><p>sustainable returns</p><p>The capital cycle approach to investing is often associated with stocks from</p><p>the “value” universe, where low and falling returns lead to capital flight, lay-</p><p>ing the foundations for an eventual recovery in profitability and valuations.</p><p>It is perhaps less well understood how the capital cycle can also be applied to</p><p>companies which have high and sustainable returns. This class of business</p><p>has produced some of Marathon’s best performers over the last ten years –</p><p>Coloplast, Intertek, Geberit, Gartner, Kao and Priceline, to name a few. How</p><p>do such investments fit in the capital cycle framework?</p><p>Pricing power has arguably been the most enduring determinant of high</p><p>returns for these investments. It has come from two main sources. The first</p><p>is a concentrated market structure, closely associated with effective man-</p><p>agement of capacity through the demand cycle which encourages a rational</p><p>approach to pricing. The second is “intrinsic” pricing power within the</p><p>product or service itself. Intrinsic pricing power is created when price is not</p><p>the most important factor in a customer’s purchase decision. Most often,</p><p>this property is generated by the existence of an intangible asset. There are</p><p>several classes of intangible assets, examples of which can be found among</p><p>Marathon’s holdings.</p><p>An obvious one is consumer brands. In the toothpaste category, private</p><p>label penetration is only 2 per cent, supporting Colgate’s excellent econom-</p><p>ics.11 An intangible asset can also derive from a long-term customer rela-</p><p>tionship, as in case of the agency business models (Legrand, Assa Abloy or</p><p>Geberit), where the customer relies on intermediaries (electricians, architects</p><p>11 See above, 2.2 “The long game.”</p><p>VALUE IN GROWTH 71</p><p>and plumbers respectively). The agent’s interest is safety, quality, reliability,</p><p>availability, and perhaps his own ability to earn a commission. Under such</p><p>circumstances, price is a pass-through to the end customer, for whom prod-</p><p>uct costs represent a small part of the total bill.12</p><p>Sometimes a product is so embedded in a customer’s workflow that</p><p>the risk of changing outweighs any potential cost savings – for instance,</p><p>in subscription-based services like computer systems (Oracle) or payroll</p><p>processing (ADP, Paychex). Networks where the customer benefits from</p><p>a company’s scale, as in the security business (Secom), industrial gases</p><p>(Praxair, Air Liquide), car auctions (USS) or testing centres (Intertek) are</p><p>another example. Finally, technological leadership (Intel, Linear Technology)</p><p>can be another important intangible asset – although this is perhaps one of</p><p>the less durable sources of pricing power, unless combined with others. The</p><p>very best</p><p>economics appear when some of the above characteristics combine</p><p>in a situation in which the cost of the product or service is low relative to its</p><p>importance: for example, the analog semiconductor chip which activates the</p><p>car airbag, yet costs little more than a dollar.</p><p>The presence of intangible assets acts as a powerful barrier to entry. They</p><p>are by nature durable, difficult to replicate and tending to economies of scale.</p><p>Importantly, these barriers often strengthen over time, as high returns on</p><p>capital throw off abundant free cash flow which is in turn reinvested in the</p><p>business. For example, over the last five years, P&G has spent over $40bn in</p><p>advertising, while Intel has invested roughly the same amount on R&D. This</p><p>repels new entrants, short-circuiting the destructive side of the capital cycle –</p><p>whereby excess profits normally attract competitors, which over time erodes</p><p>profitability. Thus, the presence of intangible assets creates a virtuous cycle,</p><p>allowing intrinsic value to compound over sustained periods at above average</p><p>rates, an extremely powerful combination for the long-term shareholder when</p><p>allied with prudent use of free cash flow. (The importance of management in</p><p>this process is paramount – high organic returns can be diluted quickly by</p><p>poorly conceived investment decisions or badly timed buybacks.)</p><p>Critically, this higher rate of compounding comes at a lower level of risk</p><p>as the economics of a high return business tend to be more resilient to adverse</p><p>shocks. This is partly mathematical – a 1 per cent fall in margin has a greater</p><p>impact on a 5 per cent margin business compared to one that earns 20 per</p><p>cent. Equally though, the factors which create sustainably high returns –</p><p>intangible assets, strong market position and rational management – also</p><p>12 See above, 2.3 “Double agents.”</p><p>CAPITAL RETURNS72</p><p>make a business more robust in the face of adverse changes in the business</p><p>environment, whether of a macroeconomic or industry-specific nature.</p><p>For investors with short-term horizons, the virtue of compounding at a</p><p>higher rate can appear insignificant. Over short time periods, share prices</p><p>are generally driven by other factors such as macroeconomic or stock-spe-</p><p>cific news flow. Investing in a high-quality company can seem dull and</p><p>unrewarding in the near-term. The lower risk which comes from investing</p><p>in quality companies is only properly observed over the long-term. The fact</p><p>that investors are often focused more on the short-term is partly a function</p><p>of psychology – the human brain is simply not attuned to multiyear plan-</p><p>ning, being far better at responding to short-term threats and stimuli. This</p><p>is seen in several behavioural heuristics – notably hyperbolic discounting13</p><p>and recency bias. Short-termism can be intensified in an institutional set-</p><p>ting. Performance-related pay for money managers at most investment firms</p><p>is weighted to annual performance, which discourages long-term thinking.</p><p>Finally, there is another more technical reason why the virtues of a high</p><p>return business are not always fully appreciated by investors. This is the ten-</p><p>dency of investors to focus on the income statement. This fosters a fixation</p><p>on price-earnings (P/E) valuation metrics and not price to free cash flow (P/</p><p>FCF). Thus, all earnings growth is seen as equal, even though it is materi-</p><p>ally more value creative when return on capital and cash flow generation</p><p>is higher. Faced with a choice between investing in two companies with</p><p>the same earnings growth, we are prepared to pay materially more (in P/E</p><p>terms) for the business with high returns on equity and superior cash flow</p><p>generation.</p><p>In short, there are any number of good reasons to invest in businesses</p><p>with durable high returns. Now appears an especially good time to do so.</p><p>The rationale is simple – across nearly all sectors, margins are close to peak</p><p>levels. It is sensible, therefore, to consider whether current profitability is</p><p>sustainable given the historical tendency of margins to mean revert. In addi-</p><p>tion, tail risks lurking in the background – namely elevated debt levels in the</p><p>private and public sectors, and the uncertain consequences of the unprec-</p><p>edented degree of monetary stimulus – are likely to impact the profits of</p><p>lower quality firms at some stage in the future. Current valuation levels do</p><p>13 There is evidence that investors’ discount rate increases when cash flows are further</p><p>out – a phenomenon known as “hyperbolic discounting.” See, for example, Andrew Haldane,</p><p>“The Short Long”, Bank of England (Speech May 2011).</p><p>VALUE IN GROWTH 73</p><p>not require investors to pay a premium for this superior durability, hence the</p><p>preponderance of higher return names in our global accounts.14</p><p>2.9 UNDER THE RADAR (FEBRUARY 2015)</p><p>Companies which provide indispensable services to their customers often</p><p>prove to be excellent investments</p><p>The typical growth stock starts out with high returns, rising turnover, and</p><p>glorious prospects, only to stumble in later years. The trouble is that profit-</p><p>able and growing businesses tend to attract lots of competition, especially</p><p>when they operate in exciting areas, such as technology. Investors who buy</p><p>growth at high starting valuations generally end up disappointed. There</p><p>is, however, a certain class of company which we have found is well worth</p><p>paying a premium for. Our preferred growth stocks undertake apparently</p><p>unglamorous activities that are essential to their customers – so essential, in</p><p>fact, that customers pay little attention to what they’re being charged.</p><p>When Marathon encounters such companies, the common refrain of</p><p>managers is that their products (or services) constitute only a small part of</p><p>the customers’ total cost and yet are of vital importance to them. It may be</p><p>that a particular component is “mission critical” for an industrial process or</p><p>a company’s workflow. For instance, customers may face a very high cost if</p><p>they have to shut down a production line when a crucial component fails.</p><p>Hence, reliability weighs more highly than price. The product may also be</p><p>essential by virtue of its quality, safety or performance attributes.</p><p>Having a high perceived value for customers often combines with some</p><p>other advantages, which limits competition, ensuring high and sustained</p><p>returns. These may be economies of scale in manufacturing and distribu-</p><p>tion, regulatory barriers and high switching costs. Companies talk about</p><p>“value based,” or “technical” selling, which often involves having highly</p><p>qualified sales staff “embedded” in the R&D departments of their custom-</p><p>ers. Sometimes this means that the component is mandated for use over the</p><p>lifecycle of a product, as is commonplace in the automotive and aerospace</p><p>industries.</p><p>We have observed such “under-the-radar” companies in a diverse range</p><p>of industries. In the technology field, analog semiconductor companies such</p><p>14 At the time of writing, Marathon’s top ten positions in its global accounts had an aggre-</p><p>gate operating margin and return on equity of 25 per cent, while trading on a similar trailing</p><p>P/E multiple (18 times) to the MSCI World Index. The superior free cash flow conversion of</p><p>these businesses (92 per cent vs. 65 per cent) means that they trade at a discount on a price</p><p>to free cash flow basis.</p><p>CAPITAL RETURNS74</p><p>as Linear Technologies (return on capital employed a stupendous 141 per</p><p>cent) and Analog Devices (ROCE at 25 per cent) fulfil a vital function, link-</p><p>ing real world phenomena (heat, sound, light) to the digital world. The cost</p><p>of the chips is just small percentage of the total cost of the equipment [as dis-</p><p>cussed above.] Certain software companies display similar characteristics.</p><p>Payroll processing companies such as Paychex (ROCE at 35 per cent) and</p><p>ADP (ROCE at 25 per cent) provide an important service, which, in the case</p><p>of ADP, costs the employer around $3 per pay check. Small companies don’t</p><p>want to be bothered with this detailed, time-consuming</p><p>work which carries</p><p>a high risk of error for the inexperienced administrator. Better to outsource</p><p>to Paychex, which has been able to raise prices regularly by over 3 per cent a</p><p>year without losing clients. In Europe, CAD-CAM software companies such</p><p>as Aveva and Dassault Systèmes provide mission critical services to design</p><p>engineers. Operating as an essential link in the supply chain provides their</p><p>businesses with an effective barrier to entry.</p><p>In the consumer goods area, flavour and fragrance companies sell key</p><p>ingredients that are important for the ultimate consumer purchase deci-</p><p>sion. And yet their products account for only a small fraction of the mer-</p><p>chandise. In the case of enzymes, dominated by Novozymes of Denmark,</p><p>numerous processes now use small quantities of enzymes which provide</p><p>both efficiency savings and product differentiation. Enzymes used in deter-</p><p>gents typically represent less than 5 per cent of the total cost. Novozymes,</p><p>with its 50 per cent plus global market share, also enjoys huge economies</p><p>of scale.</p><p>Similarly, speciality chemical companies can earn very high margins on</p><p>specific products. Executives at Croda (ROCE at 23 per cent), a UK listed</p><p>company, once described to us how they made a 90 per cent margin on a</p><p>particular active ingredient for an anti-ageing cosmetic. Given the success</p><p>of the product (Matrizyl), they now regret not negotiating a royalty fee since</p><p>the price charged represented less than one per cent of the total sale price.</p><p>Another UK niche chemical company, Victrex, which is the world leader</p><p>in the production of polyetheretherketone (a polymer used in engineering</p><p>applications), described to us how their specialist sales teams worked with</p><p>OEMs like Apple in the design phase for new products. The company gen-</p><p>erates impressive operating margins of more than 35 per cent and earns a</p><p>return on capital of around 25 per cent.</p><p>The market for laboratory supplies is highly profitable. The key here is</p><p>that the customer (scientist/lab technician) cares more about product qual-</p><p>ity, availability and service and not so much about price, orders are regular</p><p>(daily) and relatively small. So price is scarcely perceptible to the customer.</p><p>VALUE IN GROWTH 75</p><p>Examples include Waters (liquid chromatography), Pall Corporation (filtra-</p><p>tion), and Mettler-Toledo (measurement) which sell both equipment and</p><p>then consumables. Scientists are extremely reluctant to change suppliers –</p><p>Waters claims that they cannot even displace their own old technologies!</p><p>Regulations create barriers to entry. Products often require FDA approval as</p><p>part of the drug manufacturing process, raising potential switching costs. If</p><p>they attempt to switch a single small supplier, pharma companies may need</p><p>to get the FDA to recertify the entire production process.</p><p>Engineering companies can also generate very high returns from seem-</p><p>ingly mundane products, like valves and actuators. Actuators made by Rotork</p><p>(ROCE at 24 per cent) are used to control flows and feedback data in huge</p><p>oil and gas refineries. These are so crucial to the function and safety of the</p><p>plant that the owner of the facility, say Royal Dutch Shell, may specify that</p><p>subcontractors use Rotork actuators. Over the past decade, Rotork’s organic</p><p>sales have compounded by 12 per cent annually. Spirax-Sarco, whose return</p><p>on capital employed (ROCE) is around 17 per cent, sells engineered kits for</p><p>steam-based applications in industrial processes. Its large army of engineers</p><p>visit customer plants to demonstrate how their products can improve energy</p><p>efficiency and environmental impact. The company enjoys margins of 20</p><p>per cent. Finally, IMI (ROCE at 20 per cent plus) has refocused its business</p><p>on products which control liquids and gases in critical applications.</p><p>While the high profitability of the companies under discussion may be</p><p>below the radar of their customers, it has not escaped the attention of inves-</p><p>tors. In the past, when we encountered such wonderful businesses we were</p><p>prone to assume that high valuations meant they were fairly priced, or even</p><p>overpriced, in the stock market. A few years later, however, when we reen-</p><p>gage with the same firms, we often find that their share prices have shot up.</p><p>When we first met with Spirax-Sarco in 2005, for instance, it was valued at</p><p>17.5 times earnings and the shares were trading around £8. We demurred.</p><p>Five years later, at our next meeting, the stock was trading above £18. Again,</p><p>we concluded that it was fully valued. Since then, the share price has almost</p><p>doubled again. The lesson seems to be that a full price is often justified for</p><p>high quality, “under-the-radar” businesses.15</p><p>15 Spirax-Sarco shares were recently changing hands for around £35.</p><p>3</p><p>MANAGEMENT MATTERS</p><p>Like many other investors, Marathon never tires of quoting Warren Buffett.</p><p>One particular comment of the Sage of Omaha has become something of a</p><p>mantra at the firm: namely, Buffett’s observation that “after ten years on the job,</p><p>a CEO whose company retains earnings equal to 10 per cent of the net worth</p><p>will have been responsible for the deployment of more than 60 per cent of all</p><p>capital at work in the business.” What this means is that investors should pay</p><p>particular attention to the capital allocation skills of management.</p><p>As Marathon’s investment holding periods became more extended, in</p><p>contrast to the fund management industry as a whole, the notion that a man-</p><p>ager’s skill in capital allocation is decisive to the investment outcome has</p><p>been reinforced. The study of management, via face-to-face meetings and</p><p>general observation, has become one of the main elements of the daily job at</p><p>Marathon. The case of Björn Wahlroos of Finland’s Sampo, outlined in this</p><p>chapter, shows how the ideal corporate manager is one who understands his</p><p>industry’s capital cycle and whose interests are aligned with those of outside</p><p>investors.</p><p>3.1 FOOD FOR THOUGHT (SEPTEMBER 2003)</p><p>The failure of specialist analysts to anticipate a Dutch corporate collapse</p><p>comes as no surprise</p><p>It is often said that one can learn more from failure than from success. Having</p><p>experienced a fair number of failures in our European portfolios over time,</p><p>we can confirm that this maxim applies to investment. Looking at the fail-</p><p>ures of others can also be instructive (and replete with Schadenfreude). The</p><p>case of Ahold, the Dutch-based international food retailer, provides one of</p><p>MANAGEMENT MATTERS 77</p><p>Europe’s most significant implosions of shareholder value in recent years.1</p><p>Fortunately, our small team of generalist investment professionals spotted in</p><p>advance the dangers created by capital misallocation, mismanagement and</p><p>murky accounting at the world’s third largest supermarket group. The ques-</p><p>tion remains why teams of highly specialized (and highly paid) analysts failed</p><p>to do so. We have retrospectively examined research on Ahold, published by</p><p>some of the leading brokers. To our mind, this research reveals systematic</p><p>flaws in the specialist analyst model, which largely derive from the relation-</p><p>ship between research analysts and the companies they follow.</p><p>1. Too close to management</p><p>There is always a danger that an analyst is “captured” by management. This</p><p>risk rises for specialist analysts who spend most of their time covering a</p><p>small handful of companies, whereas a generalist might cover a few hundred.</p><p>Capture poses the threat that an analyst lands up becoming the mouthpiece</p><p>of management. In the case of Ahold, capture was a real and present danger.</p><p>Take, for instance, the titles of one brokerage analyst’s reports: “Live From</p><p>Zaandam” (the company’s headquarters), “Visit with Stop & Shop,” and “A</p><p>day with top performing CT Stop & Shop team and a night with the CFO.”</p><p>The analyst’s choice of titles reveals, to our minds, an unhealthy proximity</p><p>to Ahold’s management.</p><p>Ahold was also notoriously opaque when it came to disclosure. By occa-</p><p>sionally giving privileged information to particular</p><p>analysts, the recipient</p><p>may have felt (consciously or not) that he or she owed management a favour</p><p>– what is known as “reciprocation tendency.” And when things started to go</p><p>wrong, the weird and wonderful effects of Stockholm syndrome – whereby</p><p>the hostage becomes the mouthpiece for his captor – may have taken hold.2</p><p>2. Too much information</p><p>Having more information doesn’t necessarily improve decision-making. We</p><p>know from studies of horse racing that when handicappers receive more</p><p>information about the horses and riders, they become proportionately more</p><p>confident even though they are no more likely to pick the winner. When</p><p>1 On 24 February 2003, shares in Royal Ahold fell 63 per cent on the NYSE after the</p><p>Dutch supermarket group announced earnings had been overstated by close to $500m. The</p><p>accounting problems related to the operations of its US foodservice business.</p><p>2 In The Economist (27 February 2003), a brokerage analyst complained of Ahold man-</p><p>agement’s “attempt to frighten us.”</p><p>CAPITAL RETURNS78</p><p>analysts have too much data, there’s a danger they won’t see the wood for the</p><p>trees. Obsessing over Ahold’s quarterly like-for-like sales per square foot and</p><p>a multiplicity of other metrics did not provide a good insight into what was</p><p>to come. Analyzing the company’s cash flow over a five-year period, on the</p><p>other hand, got one quickly to the key point that Ahold’s management had</p><p>failed to generate cash from its core business.</p><p>Then there’s the danger of “cognitive dissonance,” when information</p><p>which conflicts with a previously formed conviction is blocked out. This</p><p>appears to have afflicted one broker who, having reached the conclusion that</p><p>Ahold had been unfairly derated (in valuation terms) after diversifying into</p><p>the foodservice business, subsequently appeared blind to negative informa-</p><p>tion about the company. It later transpired that the profitability of the food-</p><p>service operations had been fraudulently misstated. Our racecourse punters</p><p>apparently become more confident of their opinion after having placed their</p><p>bet. The danger is that the analyst reaches a conclusion based on a single line</p><p>of thought and then sticks with this view, come what may.</p><p>3. Living in a cocoon</p><p>Specialist analysts operate in a cocoon, in which they are overexposed to</p><p>company management and peer analysts and underexposed to what is going</p><p>on in the rest of the world. Herding instincts may tend to reinforce similar</p><p>opinions among peer analysts. Their thinking starts to reflect what Daniel</p><p>Kahneman calls the “insider view.” In the case of Ahold, the specialist retail</p><p>analysts spent a great deal of time comparing the company’s performance,</p><p>on a range of measures, with US peers such as Albertson’s and Kroger. As</p><p>global investors, however, we find it more useful to compare the returns of a</p><p>company in a particular industry with those in other industries and coun-</p><p>tries. A specialist analyst couldn’t say whether Ahold was a good investment</p><p>relative to, say, a Scandinavian paper company or a Thai cement plant.</p><p>4. Poor incentives</p><p>Management has a huge influence over the capital allocation of a business.</p><p>Decisions taken by senior executives are likely to be influenced by their</p><p>incentives. Yet specialist research rarely addresses the key issue of incentives.</p><p>(In the brokerage reports on Ahold, there was no comment on the subject of</p><p>incentives.) Perhaps, this oversight on the part of sell-side analysts relates to</p><p>their own incentives and the bad feeling that such a discussion might provoke</p><p>MANAGEMENT MATTERS 79</p><p>with their colleagues across the Chinese Wall in corporate finance. While</p><p>there was a good deal of spin from Ahold about the introduction of incentives</p><p>schemes based on Economic Value Added (EVA), we were told that the chief</p><p>executive was primarily rewarded on the basis of earnings per share (EPS)</p><p>growth – a metric which can be boosted with acquisitions and by the use</p><p>of leverage. This did not give us a very warm feeling, given the malleability</p><p>of Dutch GAAP accounting and Ahold’s acquisition roll-up growth model.</p><p>Things appeared even worse when we discovered that the CEO owned fewer</p><p>than 1,700 shares (worth $70,000 at their peak) in the company.</p><p>5. An even worse performance metric</p><p>Unsurprisingly, in the light of these incentives, Ahold turned out to be excep-</p><p>tionally good at delivering earnings per share (EPS) growth. The company</p><p>achieved the notable feat of 23 consecutive quarters of double-digit EPS</p><p>growth. This record turned out to be too good to be true: Ahold’s annual</p><p>results for 2000, 2001, and the first three quarters of 2002 were all restated.</p><p>Why do specialist analysts pay so much attention to earnings per share? One</p><p>reason relates to short measurement periods. As we observed above, quarterly</p><p>cash flow statements are relatively meaningless. Using the principles of accrual</p><p>accounting, management has a certain leeway in what numbers they report.</p><p>Unfortunately, there is a good deal of scope for cheating. Quarterly EPS figures</p><p>also play a role in a stock market game. Once analysts set the market’s EPS</p><p>expectations for the next quarter and management beats the expected num-</p><p>bers, the share price can be expected to rise. We have previously discussed the</p><p>futility of this game, vulnerable as it is to “Goodhart’s Law” (namely, that once</p><p>a data point is widely used as a measuring stick, it ceases to be reliable).3</p><p>The above is not to say that specialist analysts are without merit. We</p><p>call on them to help us cut through the jargon that each industry produces</p><p>and to help us stay abreast of key industry trends. At the same time, we have</p><p>no intention of importing the specialist analyst model in-house because of</p><p>the dangers we have outlined above. The difficulty we have is in persuading</p><p>others that “expertise” (i.e., a lot of knowledge) doesn’t necessarily lead to</p><p>superior investment results. The reasons, we believe, are subtle and complex.</p><p>The sorry tale of Ahold sheds some light on what can go wrong.4</p><p>3 See Capital Account, pp.209–12.</p><p>4 Marathon subsequently acquired shares in Ahold in mid-2014, after the company had</p><p>shrunk its business and shifted the focus of executive remuneration from an EPS target to</p><p>return on capital employed.</p><p>CAPITAL RETURNS80</p><p>3.2 CYCLICAL MISSTEPS (AUGUST 2010)</p><p>A great mystery of the corporate world is the tendency of</p><p>management to buy high and sell low</p><p>Now that the capital markets have settled somewhat, it’s an interesting exer-</p><p>cise to look at how managements behaved both before and after the Lehman</p><p>crisis. It is generally the case that most managements, and indeed whole</p><p>industries, engage in procyclical behaviour. It is greatly dispiriting to see</p><p>companies repeatedly buying back their shares as the cycle peaks, only to</p><p>raise fresh capital at the trough. Shareholders invariably lose out in the pro-</p><p>cess. Alas, this time was no different.</p><p>It remains one of the great mysteries of corporate behaviour, why compa-</p><p>nies tend to buy high and sell low, even when this involves their own equity.</p><p>This has been very much the case over the last few, tumultuous years. As the</p><p>markets climbed towards their 2007 highs, companies spent a record amount</p><p>on acquiring overvalued equity through cash-based M&A transactions and</p><p>buybacks, as Chart 3.1 shows. Although equity issuance also reached a peak</p><p>level, one suspects most of that was used to purchase overvalued equity in</p><p>other companies. This was certainly the case with the €19bn Fortis rights</p><p>issue, which funded the purchase of certain parts of ABN Amro, and the</p><p>Veolia equity issuance of some €3bn at the top of the market, which was used</p><p>to purchase assets that were clearly overvalued (if the subsequent 66 per cent</p><p>decline in Veolia’s share price fall is anything to go by).</p><p>The herd-like behaviour of companies and their managements never</p><p>loses its power to astound. All too often, when one company decides that</p><p>buybacks are the thing to do, then its competitors</p><p>will play the game too. By</p><p>Chart 3.1 European capital allocation</p><p>Source: Nomura, Dealogic.</p><p>0</p><p>200</p><p>400</p><p>600</p><p>800</p><p>1,000</p><p>1,200</p><p>1,400</p><p>2003 2004 2005 2006 2007 2008 2009</p><p>Buybacks Dividend Cash M&A Issuance</p><p>US$bn</p><p>MANAGEMENT MATTERS 81</p><p>the same token, capital raising (secondary issues) often appears at the same</p><p>time among multiple companies in the same industry. One reason they act</p><p>together is that no company wants to see competitors gain a funding advan-</p><p>tage. For instance, European building material groups – including Holcim,</p><p>Lafarge and Saint-Gobain – raised a total of nearly €10bn around the market</p><p>low in early 2009, having been marginal repurchasers of their equity in 2008.</p><p>These same companies invested heavily at the top of the cycle, spending a</p><p>phenomenal €46bn in the 2005–08 period, before making disposals of €9bn</p><p>in 2009. Lafarge, the French cement group, exemplified this value destruc-</p><p>tion by buying Egyptian cement group Orascom in late 2007 for €10.2bn in</p><p>cash and shares, only to be forced into a rights issue in 2009 at the market low.</p><p>Lafarge’s share price has fallen by around 64 per cent since that acquisition.</p><p>Procyclical behaviour has not been exclusive to the building materi-</p><p>als industry. European homebuilders also bought back €1.95bn of stock in</p><p>2003-08, only to raise more than that amount in fresh equity in 2009 and</p><p>2010 – the sector is now capitalized at a third of its peak level in 2007. The</p><p>European auto sector has performed true to type, being a modest net retirer</p><p>of equity throughout the 2000–08 period to the tune of €7bn (of which nearly</p><p>two-thirds was done at the top in 2008), before producing a deluge of paper</p><p>in 2009–10 of some €12.1bn to refinance an industry laid low by the financial</p><p>crisis.</p><p>A small number of companies took advantage of the crisis and were</p><p>able to conclude deals at what may well turn out to be bargain basement</p><p>prices. These took place mostly in the banking sector, where BNP pounced</p><p>on Fortis (the Belgian and Luxembourg businesses); Barclays bought the</p><p>Lehman’s US business; Sampo acquired a significant stake in Nordea</p><p>(which is already showing a €1bn profit); Santander snapped up Alliance</p><p>& Leicester, Sovereign Bancorp and parts of BNP. In the auto sector, Fiat</p><p>acquired Chrysler for nothing and some government guarantees. These</p><p>acquisitions may prove to be the European equivalent of Warren Buffett</p><p>using his cash pile to invest in GE, Harley Davidson, Swiss Re and Goldman</p><p>Sachs near market lows.</p><p>While boards acting on behalf of shareholders have generally mistimed</p><p>their equity purchases and sales, insiders have done rather better when trad-</p><p>ing for their own account. In the case of the aforementioned Veolia, the CEO</p><p>sold most of his exposure (€4m worth) near the top. While insiders were</p><p>net sellers of equities in the run-up to the financial crisis, an examination</p><p>of director dealings over this tumultuous period shows that directors then</p><p>became net buyers rather too early and remained so throughout the period of</p><p>the market decline until the end of Q1 2009, from which point they became</p><p>CAPITAL RETURNS82</p><p>heavy net sellers, just as the market was beginning to recover. This may have</p><p>been because they had been forced to defer sales during the market turmoil,</p><p>and also because they were responding to widespread concerns about a dou-</p><p>ble dip.</p><p>Looking back over recent years, our overwhelming impression is that</p><p>the most companies mistimed the cycle and misjudged the crisis. As a result,</p><p>poor capital allocation decisions were made over that period. The lure of</p><p>cheap debt and apparently rosy growth prospects enticed many manage-</p><p>ments into thinking that not only were their own shares cheap, but that the</p><p>equity of other companies also offered good value, particularly given the</p><p>extremely low cost of capital at the time. This herd-like behaviour was exac-</p><p>erbated by the private equity bubble. The inevitable appearance of corporate</p><p>excess at a high point in the cycle represents a significant drag on returns for</p><p>investors in public equities.</p><p>3.3 A CAPITAL ALLOCATOR (SEPTEMBER 2010)</p><p>The best managers understand their industry’s capital cycle and invest in a</p><p>countercyclical manner</p><p>When an investor makes a long-term investment in a company, success or</p><p>failure generally turns on the investing skills of senior management. Over</p><p>the medium term, return on capital is generally determined by the CEO’s</p><p>decisions about capital expenditure, merger and acquisition activity, and the</p><p>level of debt and equity used to finance the business. In addition, the ques-</p><p>tion of whether to issue or buy back shares, and the stock price at the time</p><p>of these decisions, can have a huge impact on shareholder returns. When</p><p>portfolio managers buy shares, they are effectively outsourcing investment</p><p>responsibilities to the incumbent management team. The CEO’s “fund man-</p><p>agement” skills can be just as important as his skills in managing day-to-day</p><p>operations. Unfortunately, as we have noted elsewhere, European busi-</p><p>ness leaders tend to be herd-like and procyclical when it comes to capital</p><p>allocation.</p><p>The problem is they often lack the right skills. As Warren Buffett has</p><p>pointed out: The heads of many companies are not skilled in capital alloca-</p><p>tion. Their inadequacy is not surprising. Most bosses rise to the top because</p><p>they have excelled in an area such as marketing, production, engineering –</p><p>or sometimes, institutional politics.</p><p>Financial companies are probably the most challenging of all for CEOs to</p><p>manage, as they require many more capital allocation decisions compared</p><p>with, say, running a large food retailer or consumer products company. In</p><p>MANAGEMENT MATTERS 83</p><p>recent years, there have been too many examples of bank CEOs wrecking</p><p>their firms with ill-conceived capital allocation, of which the most notorious</p><p>example is perhaps Fred “the Shred” Goodwin’s decision to blow RBS’s bal-</p><p>ance sheet on the acquisition of ABN Amro assets immediately prior to the</p><p>onset of the global financial crisis.</p><p>Occasionally, though, a managerial exception to the general rule</p><p>emerges. A case in point is Björn Wahlroos’ tenure as CEO and now chair-</p><p>man of Sampo, a Finnish financial services group. This has been a long-</p><p>term Marathon holding and is one of the largest financial positions in our</p><p>European portfolios.</p><p>Björn Wahlroos arrived at Sampo in 2001, after selling his boutique</p><p>investment bank (Mandatum) with excellent timing to Sampo for €400m.</p><p>The consideration was paid in Sampo shares, with Wahlroos’ 30 per cent</p><p>holding in Mandatum converting into a 2 per cent stake in Sampo. The</p><p>transaction was effectively a reverse takeover, with Wahlroos becoming CEO</p><p>as part of the agreement. At the time, Sampo comprised three domestically-</p><p>oriented businesses in banking, property & casualty (P&C) insurance, and</p><p>life insurance. The group owned around 1 per cent of Nokia’s outstanding</p><p>shares, at the time worth €1.5bn or 22 per cent of Sampo’s net asset value.</p><p>One of Wahlroos’ first acts as CEO was to sell down the Nokia stake from</p><p>35m to 6.7m shares by November 2001 at an average price of €35 per share.</p><p>Today, the Nokia share price stands at €7.2 per share.</p><p>His next step involved the company’s primarily Finnish P&C insurance</p><p>business, which enjoyed a 34 per cent market share in the domestic market</p><p>but was essentially mature. Wahlroos injected this asset into a pan-Nordic</p><p>P&C business called “If” for which Sampo received a 38 per cent share (and</p><p>half the voting rights), plus €170m of cash. The combined group controlled a</p><p>37 per cent market share in Norway, 23 per cent in Sweden and 5 per cent in</p><p>Denmark. New discipline (read: oligopolistic pricing) was introduced, and</p><p>the combined ratio5 was quickly reduced from 105 per cent in 2002 to 90 per</p><p>cent by 2005.</p><p>In 2003, before the full benefits of the new strategy were realized, Sampo</p><p>took advantage of the financial distress of its partners and bought out 100</p><p>per cent of the</p><p>equity in the P&C operations at an implied value for the whole</p><p>business of €2.4bn. Today, the lowest valuation of “If” in brokers’ sum-of-</p><p>5 Used in both insurance and reinsurance, the combined ratio is calculated as the sum of</p><p>incurred losses and expenses, divided by earned premium. A combined ratio of more than</p><p>100 per cent indicates an underwriting loss, while below 100 per cent indicates an under-</p><p>writing profit.</p><p>CAPITAL RETURNS84</p><p>the-parts valuations of Sampo is €4bn, and Mr Wahlroos has an open invi-</p><p>tation to potential buyers of the business at a price tag of €8–9bn. The next</p><p>major strategic move came in 2007, immediately before the global financial</p><p>crisis struck, when Sampo announced the sale of its Finnish retail banking</p><p>operation to Danske Bank. For this transaction, Sampo achieved a top of the</p><p>market price of €4.1bn in cash. Gradually, this cash has been reinvested in a</p><p>higher quality retail banking franchise, as Sampo has since built up a stake</p><p>of over 20 per cent in Nordea, the largest Nordic banking group. They have</p><p>now invested €5.3bn in Nordea at an average price of €6.39 per share, which</p><p>compares with the current price of €7.70. Almost half of the position was</p><p>acquired at a price of around 0.6 times book value, implying an impressive</p><p>arbitrage compared with the 3.6 times book value achieved on the sale of the</p><p>Finnish business.</p><p>The capital allocation masterstroke before the Lehman bust was</p><p>Wahlroos’ decision to reduce the weighting in equities down to 8 per cent of</p><p>Sampo’s investment portfolio, while maintaining a large position in liquid</p><p>fixed income assets. As a result, the company was able to invest €8bn–€9bn</p><p>in commercial credit in autumn 2008, purchased at bargain prices from dis-</p><p>tressed sellers. Sampo was particularly active in acquiring bonds in Finland’s</p><p>largest paper company, UPM-Kymmene, which at the time yielded over 8</p><p>per cent. The decision to invest in the bonds of this company must have been</p><p>made easier by the fact that UPM’s chairman at the time was a certain Björn</p><p>Wahlroos. This investment in corporate bonds has already yielded a €1.5bn</p><p>gain, according to the company.</p><p>As a result of these astute capital allocation decisions, the Sampo share</p><p>price has comfortably outperformed its financial services peer group and</p><p>has outperformed the overall European stock market by a factor of nearly</p><p>2.5 times since January 2001. The Sampo case study combines many of</p><p>the key elements that we look for in management; namely, it has a chief</p><p>executive who both understands and is able to drive the industry’s capital</p><p>cycle (the Nordic P&C consolidation story), allocates capital in a counter-</p><p>cyclical manner (selling equities prior to the GFC), is incentivized properly</p><p>(large equity stake) and takes a dispassionate approach to selling assets</p><p>when someone is prepared to overpay (Finnish bank divestment). The pity</p><p>is that there are so few examples of Sampo-esque management elsewhere</p><p>in Europe.6</p><p>6 Sampo’s share price has continued to perform strongly, up 75 per cent in US dollars</p><p>from the time this article was written to the end of 2014.</p><p>MANAGEMENT MATTERS 85</p><p>3.4 NORTHERN STARS (MARCH 2011)</p><p>The superior long-term performance of Nordic stocks reflects the quality of</p><p>management</p><p>To an observer steeped in the laissez-faire tenets of Anglo-Saxon capital-</p><p>ism, the success of Nordic corporations presents a conundrum. Why have</p><p>the quasi-socialist societies of Northern Europe, with their high taxation</p><p>and comprehensive welfare systems, proved to be such successful havens</p><p>of capitalist enterprise? Given our longstanding overweight position in</p><p>Scandinavian stocks, we thought we might try to answer this question.</p><p>For stock market returns, Sweden ranks as the world’s top performer</p><p>over the course of the twentieth century, delivering annual real returns of</p><p>7.6 per cent compared with 6.7 per cent from US stocks. Compounded over</p><p>a hundred years, an investor in Swedish equities would have done more than</p><p>twice as well as his American counterpart. Scandinavia has also produced a</p><p>number of world-beating companies across a number of different industries,</p><p>including H&M and Ikea (retail), Maersk (shipping), and successful capital</p><p>goods companies including Atlas Copco (compressors), Sandvik (carbide</p><p>tools), and Volvo and Scania (truck manufacturers). In the technology field,</p><p>Ericsson and Nokia still hold market-leading positions, despite the latter’s</p><p>widely publicized difficulties in recent years.</p><p>As well as benefiting from a generous endowment of natural resources,</p><p>the Nordic countries have enjoyed stable legal and political structures, rein-</p><p>forced in the case of Sweden by the policy of neutrality in armed conflict. A</p><p>Protestant work ethic, generally cooperative relations between unions and</p><p>management, and a willingness to engage with the rest of the world are also</p><p>factors driving success.</p><p>A Nordic capacity for hard work is combined with a geographical open-</p><p>ness. The total population of the Scandinavian states of Sweden, Norway,</p><p>Finland and Denmark, with Iceland thrown in as an honorary member, is</p><p>less than 25m (Sweden with a population of 9m is the largest). As the boss</p><p>of Sweden’s Atlas Copco likes to point out, that is considerably less than the</p><p>Chinese city of Chongqing, whose population exceeds 30m. Scandinavia’s</p><p>small population and limited domestic markets have forced its companies</p><p>to look abroad for their living. Many have thrived in the era of globaliza-</p><p>tion. China has become Atlas Copco’s largest geographical market. Nordic</p><p>governments have also been active in promoting the interests of companies</p><p>via trade promotion and other means, unfettered by Western foreign policy</p><p>agendas. Atlas Copco has been in China since the 1920s, ABB since 1907,</p><p>and Ericsson can date its operation there to 1894. Scandinavian companies</p><p>CAPITAL RETURNS86</p><p>have been able to operate in countries which would be deemed off-limits for</p><p>US or Western European firms.</p><p>Our historical tendency to be overweight the Nordic stock markets has</p><p>mostly been influenced by the perceived quality of Nordic management</p><p>teams. Generally speaking, Nordic managers have been able to articulate their</p><p>case clearly and apply a degree of focus that is not always the case elsewhere</p><p>in Europe. One can also discern a high degree of adaptability. Scandinavian</p><p>companies are not just open to foreign excursions. It was striking to note on</p><p>a recent trip just how many of the large and successful companies are run by</p><p>foreigners. A Belgian is head of Atlas Copco, a Scot runs SKF, and Nokia and</p><p>Electrolux have recently recruited American bosses. This openness to out-</p><p>siders stands in contrast to recent developments in Southern Europe, where</p><p>Italy and France are engaged in a race to the bottom to redefine strategic</p><p>industries for protectionist purposes.</p><p>Protectionism of sorts is, nevertheless, prevalent in Scandinavia. Many of</p><p>the largest companies are cossetted from the vagaries of the stock market by</p><p>their ownership structures. The influence of significant shareholder group-</p><p>ings is an inescapable feature of the Nordic corporate world. On a recent visit</p><p>to a conference at the Grand Hotel in Stockholm (owned by the Wallenberg</p><p>family since 1968), two out of three large capitalization Swedish compa-</p><p>nies providing one-on-one meetings to Marathon were also Wallenberg-</p><p>controlled, namely Electrolux (owned since 1956) and Atlas Copco (since</p><p>the company’s foundation in 1873). The third company we met, Alfa Laval,</p><p>was acquired from the Wallenberg family by the Rausing family of Tetra Pak</p><p>fame in 1991, after more than 50 years of Wallenberg ownership.</p><p>While one can debate the investment skills of the later generations of</p><p>Wallenbergs, executives at their family-controlled companies frequently</p><p>argue that the presence of a long-term shareholder with disproportionate</p><p>voting rights (via A and B share structures) has provided stability and focus</p><p>for their organizations. It</p><p>is interesting to examine, in brief, how some of</p><p>these Nordic companies got ahead of the competition.</p><p>Atlas Copco has become the global leader in compressed air equip-</p><p>ment, outperforming its initially more strongly positioned competitors</p><p>from the UK and US. The current chief executive puts his company’s suc-</p><p>cess down to a consistent long-term strategy, global reach, tradition of</p><p>innovation and early exploitation of the aftermarket for its products. Alfa</p><p>Laval has achieved similar success in its chosen markets of f luid handling</p><p>and heat exchangers. The company’s strategy of remaining focused on a</p><p>limited range of growing industrial applications around the world has paid</p><p>off in competitive terms.</p><p>MANAGEMENT MATTERS 87</p><p>A high level of focus combined with a global orientation is further exem-</p><p>plified by Assa Abloy, the world leader in the locks business and a Marathon</p><p>portfolio holding. A former CEO, Carl Henric Svanberg, once stressed to us</p><p>how Assa benefited from having a board which enjoyed talking exclusively</p><p>about locks. One can easily imagine such a group of earnest Swedes. In recent</p><p>years, the company has been relocating its manufacturing operations to low</p><p>cost countries. Here they have benefited from the enlightened approach of</p><p>the Nordic trade unions, whose attitude towards restructuring stands in</p><p>contrast to the inflexible attitudes found in France and Belgium. According</p><p>to Assa’s current chief financial officer, Scandinavian unions recognize that</p><p>healthy job prospects are only possible if the company has a secure future,</p><p>and that this demands both continuing profitability and overcoming com-</p><p>petitive threats, whether current or prospective.</p><p>Within Marathon’s normal analytical framework, management incen-</p><p>tives are considered of paramount importance. We want the financial inter-</p><p>ests of management to be inextricably linked with the fate of the shareholders.</p><p>But this view does not fit well with Scandinavian social democracy. In many</p><p>cases, Nordic companies continue to eschew stock options for management,</p><p>while the tax system for such compensation is often unfavourable. The lack</p><p>of enthusiasm for lavish executive pay and the uproar over relatively minor</p><p>(by international standards) corporate scandals reflect Scandinavia’s social-</p><p>democratic norms.</p><p>That is not to say that individuals have not created large fortunes as a</p><p>result of their success. The Rausing brothers at Tetra Pak, Stefan Persson at</p><p>H&M, and Ingvar Kamprad of Ikea are high on the list of the world’s bil-</p><p>lionaires. Even at some public companies, CEOs have built up significant</p><p>wealth, although this has generally involved taking on more risk than is com-</p><p>monly found in the Anglo-Saxon boardroom. A prime example would be</p><p>Carl-Henric Svanberg who, by borrowing $3m to acquire shares at the outset,</p><p>made over $36m from his time as CEO of Assa Abloy. Svanberg also invested</p><p>$12m in Ericsson when he joined in 2003, at a low point in that company’s</p><p>fortunes, and later realized a gain of over two and a half times his initial</p><p>investment. Other CEOs who have built up significant equity exposure, hav-</p><p>ing taken risks with their own money, include Björn Wahlroos at Sampo,</p><p>Johan Molin, the current CEO of Assa Abloy, and Ola Rollen at Hexagon.</p><p>Marathon’s holdings have tended to be concentrated in such companies.</p><p>While personal taxation and disdain for conspicuous consumption are</p><p>high in egalitarian Scandinavia, corporate taxation is relatively low by interna-</p><p>tional standards. In Denmark, nearly half of the full-time workforce pays the</p><p>top marginal tax rate of 63 per cent, while business profits are taxed at just 25</p><p>CAPITAL RETURNS88</p><p>per cent. Corporation tax rates in the other Scandinavian countries range from</p><p>26 to 28 per cent. That contrasts with an effective rate of corporation tax of 43</p><p>per cent for a company based in that bastion of capitalism, New York City.</p><p>The environment for wealth generation at the company level is thus very</p><p>favourable in Scandinavia despite the social egalitarianism of the region.</p><p>Stability of ownership and consistent strategic focus have created a long-term</p><p>competitive advantage for many Scandinavian companies. The necessity of</p><p>having to look to foreign markets for growth has lately proven beneficial in a</p><p>world where growth seems to reside almost exclusively in emerging markets.</p><p>The sustainability of emerging market growth is probably the main threat</p><p>to the now elevated stock market valuations of a number of these successful</p><p>companies.</p><p>3.5 SAY ON PAY (FEBRUARY 2012)</p><p>Long-term insider ownership is the best of all imperfect solutions to the</p><p>principal-agent problem</p><p>The architects of executive pay schemes at publicly-quoted companies in</p><p>the UK are under increasing pressure to justify their work. This is partly</p><p>cyclical. After each stock market bust, scrutiny of bonus schemes increases,</p><p>particularly in relation to “rewards for failure.” There is also a secular ele-</p><p>ment as income inequality has risen, driven in large measure by globaliza-</p><p>tion. Politicians are keen to play on public discontent. Since 1998, average</p><p>CEO remuneration at FTSE 100 companies has risen by a factor of 4 times,</p><p>whereas average employee earnings have gone up by 50 per cent, according</p><p>to Manifest. Over the same period, the price level of the FTSE 100 Index is</p><p>unchanged. We have a certain sympathy for the pay consultants. It is no easy</p><p>matter to design incentives schemes which align the interests of manage-</p><p>ment with those of long-term shareholders.</p><p>Increasingly, shareholders have been voting against remuneration</p><p>reports at company AGMs. Marathon receives more and more visits from</p><p>company chairmen and heads of remuneration committees, often accompa-</p><p>nied by remuneration consultants, seeking to pre-empt a shareholder revolt</p><p>on pay. In part, this direct contact with investors is designed to circumvent</p><p>the independent proxy advisory service companies (such as ISS Governance</p><p>Services and Pirc). These organizations act as a healthy counterweight to the</p><p>remuneration consultants whose peer group analyses of company remunera-</p><p>tion has acted as an upward-only ratchet on pay. We cannot recall a situation</p><p>where a company proposed to reduce remuneration of top executives on the</p><p>basis that it was above the peer group median.</p><p>MANAGEMENT MATTERS 89</p><p>While the increasing influence of the proxy advisory services is welcome,</p><p>the prescriptive, rule-based approach of these organizations does not suit</p><p>every case, particularly when it comes to executive remuneration. What is</p><p>the optimal incentive scheme, then? The answer is it depends on the circum-</p><p>stances. Remuneration structures based on earnings per share (EPS) growth</p><p>and total shareholder return (TSR) performance measures are increasingly</p><p>commonplace. Yet they suffer from the problem identified long ago by the</p><p>management guru, Peter Drucker, who observed that the search for the right</p><p>performance measure is “not only likely to be as unproductive as the quest</p><p>for the philosopher’s stone; it is certain to do harm and to misdirect.” This is</p><p>particularly the case when pay is linked to EPS – a particular bête noire for</p><p>Marathon over many years.</p><p>The earnings per share measure is prone to manipulation by unscru-</p><p>pulous executives; it takes no account of risk and encourages value destroy-</p><p>ing acquisitions and buybacks, especially when interest rates are low. It also</p><p>encourages the quarterly EPS guessing game beloved by the sell-side. At times,</p><p>it seems that meeting the EPS target has become the main strategic purpose of</p><p>the company. This is regrettable. Corporate strategy should be about how best</p><p>to allocate resources. If a turnaround requires a three-year investment phase,</p><p>management may not pursue the optimal business plan if their compensa-</p><p>tion is linked to interim EPS results. While these inter-temporal issues can</p><p>be partly resolved by phasing in performance rewards over a period of years,</p><p>investor myopia and management’s</p><p>two have holds. The shares are</p><p>trading at a price-earnings multiple of 14 times, below the market average.</p><p>Macro’s stock is held by several well-known value investors.</p><p>Macro’s strategy department anticipates strong demand growth for its</p><p>products, especially in emerging markets where widget consumption per</p><p>capita is less than one-tenth the level found in the advanced economies. After</p><p>discussions with the board, Macro’s CEO announces his plans to increase</p><p>manufacturing capacity by 50 per cent over the next three years in order</p><p>to meet growing demand. A leading investment bank, Greedspin, arranges</p><p>the secondary share offering to fund the capital expenditure. Stanley Churn</p><p>of Greedspin, a close friend of Macro’s Blewist-Hard, is the lead banker on</p><p>the deal. The expansion is warmly received in the FT’s Lex column. Macro’s</p><p>shares rise on the announcement. Growth investors have lately been buying</p><p>the stock, excited by the prospect of rising earnings.</p><p>Five years later, Bloomberg reports that Macro Industries’ chief exec-</p><p>utive has resigned after longstanding disagreements over corporate strat-</p><p>egy with a group of activist shareholders. The activists, led by hedge fund</p><p>Factastic Investment, want Macro to shutter under-performing opera-</p><p>tions. Macro’s profits have collapsed, and its share price is down 46 per</p><p>cent over the last twelve months. Analysts say that Macro’s problems stem</p><p>from over-expansion – in particular, its $2.5bn new plant in Durham,</p><p>North Carolina, was delayed and over budget. The widget market is cur-</p><p>rently in the doldrums, suffering from excess supply. Macro’s long-estab-</p><p>lished competitors have also increased capacity in recent years, while a</p><p>number of new low-cost producers have also entered the industry, includ-</p><p>ing Dynamic Widget, whose own shares have disappointed since its IPO</p><p>last year.</p><p>The market for widgets is suffering from the recent slowdown in emerg-</p><p>ing markets. China, the world’s largest consumer of widgets, has vastly</p><p>expanded domestic widget production over the last decade and has lately</p><p>become a net exporter. Macro is reportedly considering a merger with its</p><p>largest rival. Although its stock is trading below book, analysts say there’s</p><p>INTRODUCT ION 3</p><p>little near-term visibility. Of the remaining three brokerages that still cover</p><p>Macro, two have sell recommendations with one hold.</p><p>The ups and downs of this fictional widget manufacturer describes a</p><p>typical capital cycle. High current profitability often leads to overconfidence</p><p>among managers, who confuse benign industry conditions with their own</p><p>skill – a mistake encouraged by the media, which is constantly looking for</p><p>corporate heroes and villains. Both investors and managers are engaged in</p><p>making demand projections. Such forecasts have a wide margin of error and</p><p>are prone to systematic biases. In good times, the demand forecasts tend to</p><p>be too optimistic and in bad times overly pessimistic.</p><p>High profitability loosens capital discipline in an industry. When returns</p><p>are high, companies are inclined to boost capital spending. Competitors</p><p>are likely to follow – perhaps they are equally hubristic, or maybe they just</p><p>don’t want to lose market share. Besides, CEO pay is often set in relation to</p><p>a company’s earnings or market capitalization, thus incentivizing managers</p><p>to grow their firm’s assets. When a company announces with great fanfare</p><p>a large increase in capacity, its share price often rises. Growth investors like</p><p>growth! Momentum investors like momentum!</p><p>Investment bankers lubricate the wheels of the capital cycle, helping to</p><p>grow capacity during the boom and consolidate industries in the bust. Their</p><p>analysts are happiest covering fast-growing sexy sectors (higher stock turno-</p><p>ver equals more commissions.) Bankers earn fees by arranging secondary</p><p>issues and IPOs, which raise money to fund capital spending. Neither the</p><p>M&A banker nor the brokerage analysts have much interest in long-term out-</p><p>comes. As the investment bankers’ incentives are skewed to short-term pay-</p><p>offs (bonuses), it’s inevitable that their time horizon should also be myopic.</p><p>It’s not just a question of incentives. Both analysts and investors are given to</p><p>extrapolating current trends. In a cyclical world, they think linearly.</p><p>The Macro example also shows the lag between a rise in capital spend-</p><p>ing and its impact on supply, which is characteristic of the capital cycle. The</p><p>delay between investment and new production means that supply changes</p><p>are lumpy (i.e., the supply curve is not smooth, as portrayed in the economics</p><p>textbooks) and prone to overshooting. In fact, the market instability created</p><p>by lags between changes in supply and production has long been recognized</p><p>by economists (it is known as the “cobweb effect”).</p><p>The capital cycle turns down as excess capacity becomes apparent and</p><p>past demand forecasts are shown to have been overly optimistic. As prof-</p><p>its collapse, management teams are changed, capital expenditure is slashed,</p><p>and the industry starts to consolidate. The reduction in investment and con-</p><p>traction in industry supply paves the way for a recovery of profits. For an</p><p>CAPITAL RETURNS4</p><p>investor who understands the capital cycle this is the moment when a beaten</p><p>down stock becomes potentially interesting. However, brokerage analysts</p><p>and many investors operating with short time horizons generally fail to spot</p><p>the turn in the cycle but obsess instead about near-term uncertainty.</p><p>SOME RECENT CAPITAL CYCLES</p><p>The capital cycle described above might seem rather simplistic and contrived.</p><p>Yet it is surprisingly common. Some industries, such as the semiconductor</p><p>and airline industries, are particularly prone to violent capital cycles, result-</p><p>ing in frequent bouts of excess capacity and generally disappointing invest-</p><p>ment returns.2 We have witnessed this boom-bust process in many other</p><p>sectors in recent years. Marathon’s earlier book, Capital Account, described</p><p>the mistaken demand forecasts and overinvestment which accompanied the</p><p>TMT bubble of the late 1990s.</p><p>During the tech boom, many telecoms companies operated on the mis-</p><p>taken assumption that Internet traffic was doubling every 100 days. This fore-</p><p>cast was used to justify enormous capital spending by the likes of WorldCom,</p><p>Global Crossing and a host of long-forgotten “alternative carriers” (as the</p><p>2 For more on the semiconductor cycle, see below 2.6 “Escaping the semis’ cycle.”</p><p>Rising competition causes</p><p>returns to fall below cost of</p><p>capital:</p><p>share price underperforms</p><p>Business investment</p><p>declines, industry</p><p>consolidation, firms exit:</p><p>investors pessimistic</p><p>Improving supply side causes</p><p>returns to rise above cost of</p><p>capital:</p><p>share price outperforms</p><p>Industry capital cycle</p><p>New entrants attracted by</p><p>prospect of high returns:</p><p>investors optimistic</p><p>Chart I.1 The capital cycle</p><p>Source: Marathon.</p><p>INTRODUCT ION 5</p><p>minor telecoms players were then known). After the bubble burst, the misal-</p><p>location of capital was revealed and, for several years afterwards, telecoms</p><p>networks were plagued with massive excess capacity (known as “dark fibre,”</p><p>as much of the networks’ expensively laid fibre optic cable remained unlit.)</p><p>Following the dotcom bust, a number of capital cycles appeared across</p><p>a variety of industries. The global shipping industry provides a classic</p><p>example.3 Between 2001 and 2007, daily rates for “Panamax” class ships</p><p>rose tenfold as China’s rapidly increasing share of global trade boosted</p><p>shipping demand. New orders in the shipbuilding industry are strongly</p><p>correlated with daily spot rates. The supply response was inevitable if not</p><p>immediate – it takes up to three years for a new ship order to be delivered.</p><p>Between 2004 and 2009, however, the global dry bulk fleet doubled from</p><p>75 to 150m deadweight tonnes.4 The effect of this new supply combined</p><p>with the global slowdown resulted in a 90 per cent fall in Panamax daily</p><p>rates, which wiped out all the gains from earlier in the decade. An investor</p><p>own interest tend to lead to an exclusive</p><p>focus on the calendar year EPS, which bears no relation to long-term value</p><p>creation.</p><p>Linking compensation to total shareholder return (TSR), the most</p><p>common share price-based measure, is better than EPS, as it forces man-</p><p>agement to think about what drives shares prices over the medium term.</p><p>Such schemes suffer from point-to-point measurement, which can be dis-</p><p>torted if the stock price at either the start or end date is inflated by takeover</p><p>speculation or by general overvaluation in the stock market. Then, there</p><p>are questions over what time frame to measure the returns; also, whether</p><p>the benchmark should be absolute or relative – both have their merits,</p><p>neither is perfect. In the case of relative schemes, should the benchmark</p><p>be provided by a peer group or by the broader market index? Sir Martin</p><p>Sorrell, the head of advertising giant WPP, has become a very wealthy man</p><p>thanks to his ability to outperform a small group of marketing service</p><p>companies. Unfortunately, this wealth creation has not been shared with</p><p>the company’s owners due to the under-performance of this sector over</p><p>many years.</p><p>CAPITAL RETURNS90</p><p>For this reason, we normally prefer corporate incentives schemes to be</p><p>benchmarked against the stock market index, in line with our own per-</p><p>formance fees. Company managers might feel aggrieved that they have no</p><p>control on performance relative to a broad index, which may be driven by</p><p>moves in some heavily-weighted sector, such as mining or pharmaceuti-</p><p>cals in the FTSE 100. Some companies have come to us seeking to switch</p><p>from a relative TSR scheme to an absolute one – often after a period of</p><p>relative outperformance which presumably management believes will end</p><p>imminently.</p><p>As regards the time frame over which performance should be measured,</p><p>here one runs into the problem of investor myopia. Since the average holding</p><p>period for European shares is down to 12 months (see Chart 3.2), the “aver-</p><p>age” investor has little interest in the performance of a company over a five-</p><p>year period. We prefer longer measurement periods, with multiyear phasing</p><p>in of benefits to encourage long-range strategic thinking. The views of high</p><p>frequency traders and investors obsessed with quarterly EPS should be given</p><p>a very low weight by management. Time frames may also need to vary by sec-</p><p>tor. In the capital goods and extractive industries, project terms may be well</p><p>in excess of five years (for aero engines, product life cycles can be decades).</p><p>Given that each measure has pros and cons, it is not surprising that</p><p>remuneration consultants seek a compromise, bundling together a mixture</p><p>of measures in the incentive scheme. But so-called “balanced” approaches,</p><p>such as those which mix an EPS target with a return on capital overlay and</p><p>Chart 3.2 Average holding period for equities by geographic region (February 2012)</p><p>Source: World Federation of Exchanges Limited, HSBC estimates.</p><p>14</p><p>12</p><p>10</p><p>8</p><p>6M</p><p>on</p><p>th</p><p>s</p><p>4</p><p>2</p><p>0</p><p>Europe Asia-Pacific Americas</p><p>MANAGEMENT MATTERS 91</p><p>a TSR override, are likely to confuse both management and investors and,</p><p>even worse, can encourage sophisticated gaming strategies.</p><p>Insider ownership has always seemed to us as the most direct way to deal</p><p>with the principal-agent problem, which arises with the separation of corpo-</p><p>rate management from ownership. Our portfolios have tended to be skewed</p><p>towards companies where successful entrepreneurs run their companies and</p><p>retain sizeable shareholdings. Pleasingly, a number of companies have fol-</p><p>lowed the example set by Reckitt Benckiser, where executives are required to</p><p>build up significant shareholdings. Along similar lines, HSBC has recently</p><p>revamped its incentives so that generous deferred share awards, which vest</p><p>after five years, have to be held until retirement. Long-term share owner-</p><p>ship is probably the best way of concentrating the minds of management</p><p>on the true drivers of value. The manager’s instinct for wealth protection</p><p>should guard against excessive risk-taking, the unfortunate counterexample</p><p>of Lehman’s Dick Fuld notwithstanding.7</p><p>3.6 HAPPY FAMILIES (MARCH 2012)</p><p>Family control can cause problems for outside shareholders, but it can also</p><p>provide an elegant solution to the agency problem</p><p>The evils which arise at joint-stock companies where management and own-</p><p>ership are separated are not of recent vintage. In the year of the American</p><p>Revolution, Adam Smith observed what we now call principal-agent problem:</p><p>The directors of such companies ... being the managers rather of other</p><p>people’s money rather than of their own, it cannot well be expected</p><p>that they should watch over it with the same anxious vigilance with</p><p>which [they would] watch over their own ... Negligence and profu-</p><p>sion, therefore, must always prevail, more or less, in the management</p><p>of the affairs of such a company. (Wealth of Nations, 1776)</p><p>One potential solution to this problem is to invest in companies which</p><p>remain under family control. Unfortunately, this is not without its pitfalls.</p><p>It’s often the case that the interests of the family are elevated above outside</p><p>investors. Aside from this, such businesses are often prone to nepotism and</p><p>paralysing family disputes. Everyone knows the saying that rich families</p><p>7 The Lehman CEO held nearly 11m shares in the Wall Street bank. From their peak valu-</p><p>ation to Lehman’s bankruptcy in September 2009, Fuld may have suffered a paper loss of up</p><p>to $931m (see Lucian Bebchuk et al., “The Wages of Failure: Executive Compensation at Bear</p><p>Stearns and Lehman 2000–2008,” Yale Journal on Regulation, 2010).</p><p>CAPITAL RETURNS92</p><p>go from rags to riches and back to rags in three generations. As a result,</p><p>many investors prefer to stay away. That’s pretty difficult, since around of</p><p>a third the S&P 500 companies are under family control. Besides, this type</p><p>of corporate control can also bring significant benefits to outside share-</p><p>holders. There’s some evidence to suggest that in the US, at least, compa-</p><p>nies with large family stakes have outperformed the rest of the market (see</p><p>Chart 3.3). Families which are united and committed to handing down</p><p>wealth to later generations have often proven themselves to be good stew-</p><p>ards of capital.</p><p>At its best, family control can be an elegant solution to the agency prob-</p><p>lem. Families are better able to withstand short-term profit fluctuations</p><p>and to invest for the long-term benefit of themselves and outside sharehold-</p><p>ers. The Internet company, Amazon.com, which is 20 per cent-owned by</p><p>founder Jeff Bezos, appears happy to endure operating margins of 4 per cent</p><p>while it invests in technology and dominates competitors on price, just as</p><p>Wal-Mart, another family-controlled firm, achieved in bricks and mortar</p><p>retailing. The support of stable family ownership can also enable manage-</p><p>ment to enter new and profitable lines of business, as was the case when a</p><p>beverage and financial business acquired a shipping company (Quiñenco,</p><p>Chile), a supermarket and hotel group bought an Indonesian automotive</p><p>0</p><p>50</p><p>100</p><p>150</p><p>200</p><p>250</p><p>300</p><p>Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12</p><p>Credit Suisse Family Index</p><p>MSCI World Index</p><p>Chart 3.3 Credit Suisse Family Index</p><p>Source: Bloomberg.</p><p>MANAGEMENT MATTERS 93</p><p>producer (Jardine Matheson in Singapore), and a British food company</p><p>built a successful clothing retail business (AB Foods).8</p><p>The problem for investors is to determine between the good and bad fam-</p><p>ily stewards. Readers of a scientific bent may be aware of the Anna Karenina</p><p>principle,9 in which a deficiency in just one of a number of factors dooms an</p><p>endeavour to failure. What follows is a list of common family deficiencies,</p><p>any one of which is liable to undermine a company’s success:</p><p>1. Lack of family unity</p><p>Family schisms and internal squabbling can do lasting damage to the inter-</p><p>ests of both family and non-family shareholders. Italy’s Gucci family was</p><p>too busy infighting</p><p>to prepare to face competition or to professionalise</p><p>management. Only after Gucci was taken over by the French luxury goods</p><p>group, Pinault-Printemps-Redoute, did its fashion business revive.10 The</p><p>Mondavi family, California’s great wine dynasty, suffered two generations</p><p>of sibling rivalry before the business was finally sold in 2004 to beverage</p><p>giant Constellation Brands. The Ambani brothers’ dispute in India led to</p><p>the break-up of the textiles-to-telecommunications conglomerate Reliance</p><p>Group in 2005. Occasionally, however, disputes within the family or between</p><p>families over control of an asset can work in minority shareholders’ favour,</p><p>driving large share buybacks.</p><p>Not all family businesses are unhappy ones. The Parisian luxury goods</p><p>group Hermès – the last buggy whip company, as we like to call it – has</p><p>enjoyed great success. Despite there being over 70 adult descendants of the</p><p>Hermès founder, the family has remained unified within its shareholder</p><p>group. On occasion, a particularly dominant family member has been able</p><p>impose his, or her, will on the rest of the family in order to maintain the fam-</p><p>ily’s dominance and the long-term success of the company – one thinks of</p><p>Ferdinand Piëch at Volkswagen, Gina Rinehart at Hancock Resources, and</p><p>Jan Stenbeck at Investment AB Kinnevik in Sweden.</p><p>8 Diversification (or “diworsification,” as Peter Lynch calls it) does not always bring unal-</p><p>loyed benefits. Marathon itself had longstanding issues with the Keswick family’s control of</p><p>Jardine Matheson.</p><p>9 The principle, widely applied from statistics to ecology, derives from Leo Tolstoy’s</p><p>book Anna Karenina, which presents an idea that for a marriage to be happy it must suc-</p><p>ceed in several key aspects, while failure on even one such aspect can produce an unhappy</p><p>marriage.</p><p>10 Gucci got into trouble in the 1980s as family disputes ran out of control. The last Gucci</p><p>family member to head the company was murdered in 1995. His wife was later convicted of</p><p>hiring the killers. PPR gained control of Gucci in 2003.</p><p>CAPITAL RETURNS94</p><p>2. Loss of business acumen</p><p>The “Buddenbrooks’ effect,” named after Thomas Mann’s novel of that name,</p><p>describes how family businesses deteriorate over time as later generations</p><p>become more interested in the trappings of wealth than its generation. The</p><p>decline of US beauty company Estée Lauder shows what can happen when a</p><p>controlling family becomes uninterested and ineffective. At that point, the</p><p>appointment of an outside professional is key to turning around the com-</p><p>pany. The British catalogue company Littlewoods owned by the Moores</p><p>family failed to prepare for Internet competition and was finally sold.</p><p>3. Self-dealing</p><p>Companies controlled by families which pay scant regard to principles of</p><p>corporate governance have tended to trade on lower earnings multiples than</p><p>their peer group. Actual theft is rare, but it is not uncommon to see corporate</p><p>dealing between the family and the listed entity which appear to favour the</p><p>former. Questions were raised, for example, when CSN, the Brazilian steel</p><p>company, acquired Metalic, a steel can firm owned by the controlling fam-</p><p>ily. The family, which controls Mayora Indah, an Indonesian food company,</p><p>owns the distribution business outside of the listed entity. Gerdau, another</p><p>Brazilian steel firm, was challenged after it made a loan to a stud farm owned</p><p>by the controlling family and paid royalties to its controlling shareholders</p><p>for use of the family name. Since companies which enjoy good governance</p><p>tend to attract higher valuation multiples, there is an incentive for family-</p><p>controlled companies to desist in self-dealing. Duratex and Embraer in</p><p>Brazil, for example, improved corporate governance as they looked to reduce</p><p>the agency discount embedded in their share prices.</p><p>4. Poor succession planning</p><p>Family-controlled companies must prepare to hand over the reins to the next</p><p>generation. When the success of the company is not tied to the family, but to</p><p>the social and political connections of the founder, minorities should brace</p><p>themselves for occasional whiplash. This has been a particular feature of Asian</p><p>family-owned companies whose fortunes have been built on the monopolies</p><p>and concessions derived from political connections, and where a lack of suc-</p><p>cession planning by octogenarian founders has led to stock price weakness.</p><p>5. Politics of rent-seeking</p><p>MANAGEMENT MATTERS 95</p><p>While companies which rely on extracting rents can do very well, it’s naïve</p><p>to assume those rents will continue once the founder has departed. What</p><p>is good for the family (and non-family shareholders) may not be so advan-</p><p>tageous for the country. Close relationships with politicians and regulators</p><p>appear to have allowed Carlos Slim’s Telmex to maintain a near monopoly</p><p>on Mexican fixed-line telephony, whose interconnection rates have been sig-</p><p>nificantly higher than the OECD average. The dominance of a small number</p><p>of high-profile families in the Philippines, Hong Kong, Mexico, Israel and</p><p>Turkey has rewarded families and minority shareholders, but stifled compe-</p><p>tition and entrepreneurship.</p><p>Under such circumstances, there’s the danger of a political backlash.</p><p>Carlos Slim’s American Movil received a near $1bn fine for “monopolistic</p><p>practice.”11 Israel seems finally to be tackling its powerful family conglomer-</p><p>ates, such as Delek Group and IDB Holdings. One needs only to look at the</p><p>abrupt change in the fortunes of Egyptian companies close to the Mubarak</p><p>regime, such as Palm Holdings and EFG Hermes, to see how quickly the</p><p>tables can turn. By contrast, successful family companies – such as Koç</p><p>Holding, Investor and Quiñenco – seem adept at keeping out of the direct</p><p>heat of the political arena.</p><p>Family-operated businesses which are competitive and not-flagrantly</p><p>rent-seeking generally turn out to be better long-term investments than those</p><p>businesses whose success derives from the family’s political and financial</p><p>dominance. Despite the problems family control can bring, we sleep a little</p><p>better at night having put some of your money to work with the Wallenbergs</p><p>(Investor), Bezos (Amazon.com), Koç (Koç Holding), Lukšić (Quiñenco) and</p><p>Ayala (Ayala Corporation).</p><p>3.7 THE WIT AND WISDOM OF JOHANN RUPERT (JUNE 2013)</p><p>The departing boss of Richemont is a true corporate star</p><p>Marathon looks to invest with corporate managers who know how to allo-</p><p>cate capital effectively. This requires certain character traits in the individ-</p><p>ual, such as suspicion of investments fads (and investment bankers), and a</p><p>willingness to swim against the tide. One of our more successful decisions</p><p>has been to invest alongside Johann Rupert, until recently the executive</p><p>chairman and CEO of Richemont, the Swiss luxury goods group in which</p><p>his family owns a controlling interest. As Mr. Rupert prepares to move on,</p><p>11 A couple of months after this piece was written, Mexico’s Federal Competition</p><p>Commission rescinded Slim’s $925m fine.</p><p>CAPITAL RETURNS96</p><p>we decided to look back over our meeting notes to remind us of the qualities</p><p>which attracted us to this truly outstanding manager.</p><p>First, some background. Richemont has been part of Marathon European</p><p>portfolios since March 2002, and its predecessor company, Vendôme, was</p><p>owned from at least 1994 (when our computerized shareholding record</p><p>begins) until its buyout in 1998. When the company was founded in 1988,</p><p>with Mr Rupert as CEO, its main businesses were the non-South African</p><p>assets of the Rembrandt Group, which had been established by Mr Rupert’s</p><p>father. These consisted of holdings in the Rothmans cigarette business and a</p><p>collection of luxury goods brands, including Cartier, Alfred Dunhill, Chloé</p><p>and Mont Blanc.</p><p>Over time, the cigarette business was expanded and eventually spun</p><p>off to shareholders. After a lucky escape from the European pay TV busi-</p><p>ness during the TMT bubble, Richemont has focused on luxury goods, in</p><p>particular high-end Swiss watches and jewellery. Acquired</p><p>brands include</p><p>Vacheron Constantin, Panerai, Van Cleef & Arpels, Jaeger LeCoultre, IWC</p><p>and A. Lange & Söhne. Over the 25 years since its foundation, an original</p><p>investment of SF 5 is now worth SF 120, taking account of dividends and</p><p>spin-offs, an annual compound return of 13.5 per cent.</p><p>Mr. Rupert has not been one to spend much time schmoozing inves-</p><p>tors – Marathon has never had a one-on-one meeting with him. Over the</p><p>years, however, we have attended many group meetings and listened in on</p><p>many conference calls with Richemont. We have collected below a number</p><p>of throwaway comments from Mr Rupert, who speaks with a distinctive</p><p>South African accent, which illustrate to our mind why he has been such a</p><p>successful steward of other people’s money.</p><p>On management:</p><p>“The danger sign is always when a manager does not understand the busi-</p><p>ness that he or she is in.”</p><p>[On relations with a dominant supplier] “Don’t play cat and mouse games if</p><p>you’re the mouse.”</p><p>“I think if you want to be successful you need a very healthy dose of paranoia</p><p>that every day there’s somebody out there who wants to eat your breakfast,</p><p>and if you’re not alert they will do.”</p><p>“Don’t postpone until tomorrow what you can delegate today.”</p><p>“I learned many years ago – that from the day you’re born until you ride the</p><p>hearse, things are never so bad that they can’t get worse.”</p><p>MANAGEMENT MATTERS 97</p><p>“The real question is do companies redeploy free cash flow accretively, or do</p><p>they waste it?”</p><p>On short-termism:</p><p>“I raised a glass of champagne when Al Dunlap fell on his chainsaw.”</p><p>“So anybody who’s going to ask, so what do you think the next year looks like,</p><p>why don’t you just not ask the question because we’re not going to answer</p><p>any. And it’s not because we’re coy or funny. We don’t know.”</p><p>“I’m not going to tell you what I think our third quarter XYZ is going to be.”</p><p>On M&A and buybacks:</p><p>“Ultimately, if any asset is wrongly priced, it is abused.”</p><p>“If you pay an excessive multiple, deals will never make it.”</p><p>“No, no, no, no. I didn’t lose a lot of money when I tried to sell the business.</p><p>I lost the money when I bought the bloody thing. That’s when you park your</p><p>money, it’s not when you try to find a bigger idiot than you to take it off your</p><p>hands.”</p><p>[On successfully exiting pay TV] “Never confuse luck with genius.”</p><p>“Our job here is to create goodwill and not to pay other people for</p><p>goodwill.”</p><p>“[There are] three stages of [an] acquisition, which [are] euphoria and then</p><p>disillusionment. And the next thing is looking for somebody to blame for</p><p>buying the place.”</p><p>“The grass is always greener on the other side of the fence. But you only find</p><p>out when you climb over that the reason why it’s greener is because of all the</p><p>cow dung hidden in the grass. And as soon as you start stepping in all this</p><p>stuff then you wonder why you ever crossed the fence.”</p><p>“You can discount us ever using equity for acquisitions. Equity is always the</p><p>most expensive way to pay.”</p><p>[On share-financed takeovers during the TMT bubble] “Like a child selling</p><p>his dog for $1m, only he gets paid with two severed cat’s paws.”</p><p>“If you talk up your share price, when the price comes down, the folks come</p><p>looking for you.”</p><p>“We don’t talk about a load of rubbish that I also had a hand in buying.”</p><p>CAPITAL RETURNS98</p><p>“If you look at share buybacks, and at the prices at which companies bought</p><p>their shares back, they inevitably bought the shares back at very close to the</p><p>top of the market because that’s when they had a lot of cash. And boy, do</p><p>they regret it when two years later all hell breaks loose.”</p><p>On investment bankers:</p><p>“Recessions occur because the investment bankers provide capital at too low</p><p>a cost which leads to overcapacity and a slump.”</p><p>“When you really need firepower, the banks are not there and the funds are</p><p>gone.”</p><p>On corporate governance:</p><p>“So if you want a perfect governance score, get somebody you don’t know,</p><p>whom you’ve never met, who knows nothing about your business because</p><p>he’s never been involved, employ him and give him a nice bonus for sit-</p><p>ting on a committee. Then you get all the boxes ticked [by the proxy voting</p><p>services]. And guess what happens? After five years, chaos. There’s a direct,</p><p>inverse correlation between the best corporate governance box-ticking and</p><p>medium-term performance.”</p><p>On the luxury business:</p><p>“The only way we know how to maintain a sustainable competitive advan-</p><p>tage is to grow the brand equity ... . because that brand equity creates demand</p><p>and will result in pricing power.”</p><p>“I’m just a normal business person who thinks that the luxury business is a</p><p>great business to be in to create shareholder value”</p><p>[Quoting Coco Chanel] “Fashion fades, only style remains the same.”</p><p>“Coco Chanel years ago said that money is money is money. It’s only the</p><p>pockets that change. We’ve got to find those pockets.”</p><p>“Anniversaries, birthdays and girlfriends are always going to be there.”</p><p>“If your business model, or your intellectual property, is in ones and zeros,</p><p>you’re going to have issues. So luckily our intellectual property resides in</p><p>atoms and it’s tough to wreck.”</p><p>“Cartier sleeps in the vault.”</p><p>[On brand integrity] “You cannot make Ferraris in Fiat factories.”</p><p>MANAGEMENT MATTERS 99</p><p>On China:</p><p>“When the Chinese nouveau riche want to spend, they do not want to buy</p><p>Chinese.”</p><p>“In the East, authenticity, originality and history matters.”</p><p>“I feel like I’m having a black-tie dinner on top of a volcano. That volcano</p><p>is China ... . Personally I don’t think anything’s going to go wrong in China,</p><p>that’s my view, but I know nothing and I mean it.”12</p><p>3.8 A MEETING OF MINDS (JUNE 2014)</p><p>One can learn a lot from meeting with managers, providing the setting is</p><p>right</p><p>Over the last two years, Marathon has engaged in nearly two thousand meet-</p><p>ings with company management. This activity, along with preparation and</p><p>the writing of notes, consumes most of the investment team’s working hours.</p><p>Yet many commentators view such meetings as a waste of time. One can see</p><p>their point. Managers are now so well prepared by PR advisers that meet-</p><p>ings can seem like a promotional exercise. Investors still turn up. But for</p><p>many of them, we suspect, their purpose is to gain an informational advan-</p><p>tage about the short-term outlook for the business – in our view, a fruitless</p><p>endeavour. Given the long-term nature of our investment approach, capital</p><p>allocation is of paramount importance. The prime purpose of our company</p><p>meetings is to assess the skill of managers at investing money on behalf of</p><p>their shareholders.</p><p>Meeting management is not a scientific process. Rather, it involves</p><p>making judgements about individuals, an activity which is prone to error</p><p>(witness the rate of divorce). We go into meetings looking for answers to</p><p>questions such as: does the CEO think in a long-term strategic way about the</p><p>business? Understand how the capital cycle operates in their industry? Seem</p><p>intelligent, energetic and passionate about the business? And interact with</p><p>colleagues and others in an encouraging way? Appear trustworthy and hon-</p><p>est? Act in a shareholder-friendly way even down to the smallest detail?</p><p>To assess such questions, the format of the meeting is important. In gen-</p><p>eral, the smaller the number of people in attendance the better. Having fewer</p><p>attendees on both sides of the table – large meetings often include company</p><p>managers, investor relations personnel, financial PR types, stock brokers,</p><p>12 Mr. Rupert’s departure from Richemont turned out to be short-lived. He returned to</p><p>the company as chairman in September 2014.</p><p>CAPITAL RETURNS100</p><p>and other hangers-on – encourages a more open and friendly dialogue. It</p><p>also reduces the risk of attendants showing off, which can result in the con-</p><p>versation becoming hopelessly bogged down in detail. A new and dreadful</p><p>manifestation of the quest for redundant detail is the “fireside-chat” format</p><p>used at many sell-side conferences, which typically involves</p><p>a CEO being</p><p>quizzed by the specialist analyst. The conversation generally turns into a</p><p>“deep dive” into factors impacting short-term earnings, which can be of no</p><p>interest to long-term investors. Questions of this sort can be ludicrous. At a</p><p>recent conference we attended, the boss of a major industrial firm was asked</p><p>whether we could expect that same pattern of seasonality as the year before.</p><p>Large delegations from a company can be a sign that the CEO lacks</p><p>confidence, resorting to a safety-in-numbers approach. This is often the</p><p>case when dealing with companies in difficulty, as well as with many</p><p>Japanese, Spanish and Italian firms. Contrast this with Geberit, the highly</p><p>successful Swiss plumbing equipment company, whose CEO tends to</p><p>arrive alone at our offices, having seemingly made his own travel arrange-</p><p>ments, fitting us in between meetings with plumbers, architects and other</p><p>customers.</p><p>When it comes to discussing a company’s strategy, it is alarming how fre-</p><p>quently one finds managers confused on the topic. Too often, the CEO mis-</p><p>takes a short-term target – say an earnings per share target or a return on capital</p><p>threshold – with a strategy. “Our strategy is to deliver a 15 per cent return on</p><p>capital,” they say. Real strategy, whether military or commercial, involves an</p><p>assessment of the position one finds oneself in, the threats one faces, how one</p><p>plans to overcome them, and how opponents might in turn respond. During</p><p>his tenure at General Electric, Jack Welch required managers of GE’s divisions</p><p>to prepare a few simple slides describing their operating environment in terms</p><p>of: what does your global competitive environment look like? In the last three</p><p>years, what have your competitors done to alter the competitive landscape? In</p><p>the same period, what have you done to them? How might they attack you in</p><p>the future? What are your plans to leapfrog them?</p><p>Getting CEOs to open up about their competitors can be difficult. They</p><p>fear that too much openness may lead to a breach of confidentiality (profes-</p><p>sional investors are a thoroughly untrustworthy bunch) or that revelations</p><p>about the firm’s true market dominance might raise anti-trust issues. Besides,</p><p>many managers are so fixated on growth, they fail to anticipate the likely</p><p>competitor response (another example of the “insider view”). Still, on occa-</p><p>sions something useful slips out. When a management team compliments a</p><p>competitor, this can be like gold dust to investors. Learning that DMGT, the</p><p>MANAGEMENT MATTERS 101</p><p>UK media company, found it hard to compete with Rightmove, the property</p><p>listings website, contributed to our decision to invest in the company.13</p><p>Discussing how a firm uses investment bankers and how it makes acqui-</p><p>sitions (e.g., whether it prefers friendly negotiated deals to contested auc-</p><p>tions) can be revealing. Unexpected diversifications into an unrelated area</p><p>may suggest that something is not right in the core business. Views on share</p><p>buybacks can also be highly informative. Very few CEOs see this as a legiti-</p><p>mate investment on a par with capital expenditure or M&A decisions, pre-</p><p>sumably due to an aversion to shrinking any aspect of the company. Many</p><p>fear that buybacks are an admission that the company has run out of invest-</p><p>ment ideas. On this subject, we like to hear managers justify buybacks based</p><p>on an internal valuation model, as this can then lead to an interesting dis-</p><p>cussion about valuation of their business.</p><p>Forming impressions of the CEO’s character, intelligence, energy and</p><p>trustworthiness can be gleaned using a variety of questioning techniques.</p><p>Intellectual honesty can be tested by asking the CEO to pick out what he or</p><p>she thinks is important. To unsettle the more promotional CEOs, we like to</p><p>ask what is not working and wait to see whether they have given the matter</p><p>much thought. Sometimes the boss will seek to evade responsibility by ask-</p><p>ing a colleague to talk about a problematic area of the business. The CEO</p><p>in denial often blames problems on a divisional boss and follows up by say-</p><p>ing that management has now been changed. How the chief executive inter-</p><p>acts with colleagues, such as the CFO or investor relations personnel, often</p><p>reveals their leadership qualities. We like to see signs of individual curiosity</p><p>at meetings – revealed, for instance, by their taking an interest in our own</p><p>business. Signs of humility – say a recognition of past mistakes – give us</p><p>some confidence that the chief executive has a grip on reality.</p><p>Appearances can also be revealing. A CEO of an industrial company who</p><p>wears expensive shoes, or a snappy suit, is more likely to enjoy the expensive</p><p>company of investment bankers than spend his time visiting factories and cus-</p><p>tomers. Signs of vanity are generally off-putting. One CEO was spotted before</p><p>a meeting carefully adjusting his elaborate bouffant hair style in our wash-</p><p>room. Several months later, he launched a large and foolhardy acquisition.</p><p>Meetings can also provide insights into a management’s approach to</p><p>costs. This frequently comes out in discussions about compensation. Learning</p><p>about something as mundane as corporate travel policy can also tell us a lot.</p><p>After Brazil’s AmBev took over the Belgian-based Interbrew, its managers</p><p>13 Rightmove has developed a lock on the market for UK residential listings, and by the</p><p>end of 2014, its shares were up over 400 per cent in US dollars since floating in 2006.</p><p>CAPITAL RETURNS102</p><p>told us about a new edict limiting business-class flights to those lasting six</p><p>hours or more. This insight into corporate frugality was a pointer to the</p><p>same management’s ability to cut costs at Anheuser-Busch – which prior to</p><p>the merger sported a fleet of eight Falcon executive jets – and increase the</p><p>US beer company’s operating margins by a massive ten percentage points</p><p>(between 2005 and 2011). We were equally impressed to learn that senior</p><p>executives at another company preferred the underground to chauffeured</p><p>limousine when travelling around London. The number of IR representa-</p><p>tives in attendance is a good indicator as to how carefully a company counts</p><p>its pennies. Of course, we have made mistakes when assessing management</p><p>teams. But, in our view, trying to spot a great manager remains a game very</p><p>much worth playing.</p><p>3.9 CULTURE VULTURE (FEBRUARY 2015)</p><p>Marathon’s focus on management forces us to think about corporate culture</p><p>Corporate culture is constituted by a set of shared assumptions and values</p><p>that guide the actions of employees, and encourage workers to act collec-</p><p>tively towards a specific goal. Cultures both reflect the values, and are a</p><p>prime responsibility, of management. Yet strong cultures can persist long</p><p>after the careers of those who put them in place. Still, sceptics might ask, why</p><p>should investors bother with something so ineffable, so intangible? Well, the</p><p>evidence suggests that culture pays.</p><p>Perhaps the best-known study of the subject is Corporate Culture and</p><p>Performance by John Kotter and James Heskett. This work examines the</p><p>relationship between corporate culture and company performance in over</p><p>200 firms during the 1980s. The authors asked employees their opinions of</p><p>attitudes to customers and shareholders at competitor firms. Shares in com-</p><p>panies exhibiting strong and positive cultures outperformed rivals by more</p><p>than 800 per cent during the study period. Other studies which measure</p><p>corporate culture according to how employees regard their own workplace</p><p>have found a similar link between esprit de corps and stock market returns.</p><p>Kotter and Heskett’s work established that strong cultures are liable to</p><p>produce extreme outcomes, both exceptionally good and dreadfully bad.</p><p>Positive cultures can take different forms. Perhaps the most commonly suc-</p><p>cessful corporate trait is an emphasis is on cost control. Almost every firm</p><p>periodically engages in bouts of cost-cutting. Exceptional firms, however,</p><p>are involved in a permanent revolution against unnecessary</p><p>expenses. In the</p><p>early days of Admiral, the British insurance company, employees wishing to</p><p>use the printer were required to do a push up in sight of the CEO. Another</p><p>MANAGEMENT MATTERS 103</p><p>example of the corporate Scrooge is Fastenal, a US distributor of low-value</p><p>industrial products, which boasted the “cheapest CEO in America.” There are</p><p>legends of Fastenal executives being required to share hotel rooms at confer-</p><p>ences. Company offices are said to be equipped with second-hand furniture.</p><p>Frugal cultures may not sound attractive to employees, but when married to</p><p>decentralized profit-sharing schemes, they can work wonders. Between 1987</p><p>and 2012, Fastenal provided a return of over 38,000 per cent (excluding divi-</p><p>dends), better than any other company in the index. Take that, Bill Gates.</p><p>Cost-cutting is not the only successful cultural model. In fact, some</p><p>firms have strengthened their cultures by spending more, not less. The clas-</p><p>sic example is Costco, the North American discount retailer. Bucking the</p><p>conventional retail model, Costco pays its staff more than the legal mini-</p><p>mum wage – and far more than rivals. The average Costco employee makes</p><p>in excess of $20 an hour, compared to average US national retail pay of less</p><p>than $12 an hour. The company also sponsors healthcare for nearly 90 per</p><p>cent of workers. Wall Street is constantly pressuring Costco to cut its wage</p><p>bill, with the cacophony reaching a peak during the crisis of 2009. Instead,</p><p>the company raised wages over the following three years. The return for this</p><p>munificence is that Costco employees stay on longer, thus saving on training</p><p>costs. Turnover for employees who have been with the company for more</p><p>than one year is a paltry 5 per cent. Loyal employees are more likely to excel.</p><p>Costco is regularly rated as excellent for customer service.</p><p>The point is that a strong corporate culture constitutes an intangible</p><p>asset, potentially as valuable as a high-profile brand or network of customer</p><p>relationships. As Warren Buffett says of Berkshire Hathaway’s family of</p><p>businesses:</p><p>If we are delighting customers, eliminating unnecessary costs and</p><p>improving our products and services, we gain strength ... . On a daily basis,</p><p>the effects are imperceptible; cumulatively, though, their consequences are</p><p>enormous. When our long-term competitive position improves as a result of</p><p>these almost unnoticeable actions, we describe the phenomenon as “widen-</p><p>ing the moat.”</p><p>On the other hand, a rotten culture can be a firm’s undoing. Look no fur-</p><p>ther than AIG, one of the major disasters in the recent financial meltdown.</p><p>Dominated for so long by an imperial CEO, Hank Greenberg, the global</p><p>insurance company developed in the words of one commentator “a culture</p><p>of complicity.” Unthinking obedience, the lack of an “outside view,” and</p><p>an obsession with growth at any cost led to riskier and riskier positioning.</p><p>Even as the end grew nearer, AIG executives proved incapable of recognizing</p><p>the danger the company faced. In August 2007, the head of AIG Financial</p><p>CAPITAL RETURNS104</p><p>Products commented on his division’s positions in the credit derivatives mar-</p><p>ket: “It is hard for us, without being flippant, to even see a scenario within</p><p>any kind of realm of reason that would see us losing one dollar in any of</p><p>these transactions.” Little more than a year later, AIG announced a quarterly</p><p>loss of $11bn, which largely derived from its Financial Products division.</p><p>Just as positive cultures take a number of different forms, so too can</p><p>negative ones. An obsession with growing earnings occasionally results in</p><p>outright fraud. In the 1990s, during the tenure of Al “Chainsaw” Dunlap, the</p><p>accounts of consumer appliance maker Sunbeam were concocted to meet</p><p>aggressive earnings targets. In extreme cases, a poor corporate culture can</p><p>have tragic consequences. In 2010, 29 miners were killed in an explosion at</p><p>one of Massey Energy’s coal mines. The US Labor Department investigation</p><p>blamed a corporate culture that “valued production over safety” and fostered</p><p>“fear and intimidation.”</p><p>If a beneficial culture is a valuable intangible asset, and a corrosive one</p><p>an existential threat, it becomes important to ask: how can an outside inves-</p><p>tor tell the difference? As with so much of investment, the process is one of</p><p>piecing together incomplete and obscure pieces of evidence, gathered over</p><p>time through meetings and research.</p><p>Some quantitative measures can be helpful: staff loyalty and inside share</p><p>ownership are liable to be higher at firms in which employees believe in what</p><p>they are doing. Corporate incentive schemes say a lot about the firm’s cul-</p><p>ture. Is management being greedy? What performance metrics are valued –</p><p>growth for its own sake or customer satisfaction? What do employees think?</p><p>Opinions can be unearthed through websites such as glassdoor.com (a sort</p><p>of TripAdvisor for companies). We are constantly looking out for signs of</p><p>management extravagance and vanity. Danger signs include expensive exec-</p><p>utive travel (a corporate jet is liable to elicit groans), too numerous pictures</p><p>of the CEO in the annual report, and dandyish attire.</p><p>There are numerous examples of successful cultures among our portfo-</p><p>lio companies: the empowerment of branch managers that promotes respon-</p><p>sible banking at Sweden’s Svenska Handelsbanken, for instance. Reckitt</p><p>Benckiser, another holding, fosters an entrepreneurial spirit among its sen-</p><p>ior managers. Yet even if a strong culture is instilled in a company, it can take</p><p>many years for its full effects to play out. That may be beyond Wall Street’s</p><p>limited investment horizon. Long-term investors, however, would be wise to</p><p>take heed.</p><p>PART I I</p><p>BOOM, BUST , BOOM</p><p>4</p><p>ACCIDENTS IN WAIT ING</p><p>After the financial crisis erupted, the Queen famously asked on a visit to</p><p>the London School of Economics why the problems hadn’t been spotted in</p><p>advance. The true answer – one which the Queen presumably was not supplied</p><p>with – is that economists had developed a deeply flawed paradigm for how the</p><p>economy operates. Economists posited a world of equilibrium and rationality,</p><p>in which money and the operations of finance were essentially inert. This aca-</p><p>demic model turned out to be far removed from reality.</p><p>It’s not true, however, to say that nobody in the financial world saw it</p><p>coming. On the contrary, in the years prior to 2008 many serious investors</p><p>and independent strategists were alert to the dangers posed by strong credit</p><p>growth, dubious financial innovation and the appearance of various housing</p><p>bubbles around the world. From its ring-side seat on the financial markets,</p><p>Marathon became concerned about the risks associated with securitization</p><p>and excessive credit growth from as early as 2002. Such fears were exacer-</p><p>bated by meetings over the years with managements at various banks which</p><p>seemed to be steering their institutions at high speeds towards the rocks.</p><p>The case of Anglo Irish Bank, a financial institution which came close to</p><p>sinking the sovereign credit of the Irish state, is examined in detail below.</p><p>The looming financial crisis also can be understood from a capital cycle</p><p>perspective. During the boom years, the banks were rapidly growing their</p><p>assets (loans) and competition was increasing – as evidenced by the appear-</p><p>ance of a shadow banking system and the decline in bank lending spreads.</p><p>This outward shift in the supply side for the finance industry impacted even-</p><p>tually on the industry’s profitability. Viewed in this way, there is nothing</p><p>particularly special about the banking sector. Capital cycle analysis could</p><p>also applied usefully to the housing markets in the pre-crisis world. High and</p><p>C</p><p>ha</p><p>rt</p><p>4</p><p>.1</p><p>A</p><p>ng</p><p>lo</p><p>Ir</p><p>is</p><p>h</p><p>Ba</p><p>nk</p><p>: e</p><p>xt</p><p>ra</p><p>ct</p><p>s f</p><p>ro</p><p>m</p><p>M</p><p>ar</p><p>at</p><p>ho</p><p>n</p><p>m</p><p>ee</p><p>tin</p><p>g</p><p>no</p><p>te</p><p>s</p><p>So</p><p>ur</p><p>ce</p><p>: M</p><p>ar</p><p>at</p><p>ho</p><p>n.</p><p>20</p><p>02</p><p>20</p><p>03</p><p>20</p><p>04</p><p>20</p><p>05</p><p>20</p><p>06</p><p>20</p><p>07</p><p>20</p><p>08</p><p>20</p><p>09</p><p>17</p><p>.5 15</p><p>12</p><p>.5 10 7.</p><p>5 5</p><p>2.</p><p>5</p><p>Anglo Irish Bank Share Price</p><p>0</p><p>(€</p><p>)</p><p>O</p><p>ct</p><p>o</p><p>b</p><p>er</p><p>2</p><p>00</p><p>4</p><p>–</p><p>“C</p><p>hu</p><p>nk</p><p>y</p><p>lo</p><p>an</p><p>s</p><p>m</p><p>ak</p><p>e</p><p>it</p><p>vu</p><p>ln</p><p>er</p><p>ab</p><p>le</p><p>to</p><p>a</p><p>d</p><p>ec</p><p>lin</p><p>in</p><p>g</p><p>cr</p><p>ed</p><p>it</p><p>en</p><p>vi</p><p>ro</p><p>nm</p><p>en</p><p>t/p</p><p>ro</p><p>pe</p><p>rt</p><p>y</p><p>do</p><p>w</p><p>nt</p><p>ur</p><p>n”</p><p>N</p><p>ov</p><p>em</p><p>b</p><p>er</p><p>2</p><p>00</p><p>5</p><p>–</p><p>“T</p><p>hi</p><p>s</p><p>m</p><p>us</p><p>t</p><p>bl</p><p>ow</p><p>u</p><p>p</p><p>at</p><p>s</p><p>om</p><p>e</p><p>po</p><p>in</p><p>t –</p><p>s</p><p>ur</p><p>el</p><p>y?</p><p>” M</p><p>ar</p><p>ch</p><p>2</p><p>00</p><p>6</p><p>–</p><p>“S</p><p>til</p><p>l h</p><p>ar</p><p>d</p><p>to</p><p>be</p><p>lie</p><p>ve</p><p>in</p><p>th</p><p>e</p><p>Ir</p><p>is</p><p>h</p><p>pr</p><p>op</p><p>er</p><p>ty</p><p>in</p><p>ve</p><p>st</p><p>or</p><p>s’</p><p>m</p><p>ag</p><p>ic</p><p>al</p><p>a</p><p>bi</p><p>lit</p><p>ie</p><p>s.</p><p>”</p><p>M</p><p>ay</p><p>2</p><p>00</p><p>2</p><p>–</p><p>“T</p><p>hi</p><p>s</p><p>w</p><p>ill</p><p>o</p><p>ne</p><p>d</p><p>ay</p><p>b</p><p>e</p><p>a</p><p>su</p><p>pe</p><p>r</p><p>sh</p><p>or</p><p>t”</p><p>M</p><p>ay</p><p>2</p><p>00</p><p>3</p><p>–</p><p>“P</p><p>os</p><p>si</p><p>bl</p><p>y</p><p>an</p><p>ac</p><p>ci</p><p>de</p><p>nt</p><p>w</p><p>ai</p><p>tin</p><p>g</p><p>to</p><p>h</p><p>ap</p><p>pe</p><p>n”</p><p>M</p><p>ay</p><p>2</p><p>00</p><p>3</p><p>–</p><p>“P</p><p>os</p><p>si</p><p>bl</p><p>y</p><p>an</p><p>ac</p><p>ci</p><p>de</p><p>nt</p><p>w</p><p>ai</p><p>tin</p><p>g</p><p>to</p><p>h</p><p>ap</p><p>pe</p><p>n”</p><p>M</p><p>ar</p><p>ch</p><p>2</p><p>00</p><p>4</p><p>–</p><p>“T</p><p>he</p><p>re</p><p>is</p><p>a</p><p>st</p><p>ro</p><p>ng</p><p>w</p><p>hi</p><p>ff</p><p>of</p><p>P</p><p>on</p><p>zi</p><p>fi</p><p>na</p><p>nc</p><p>e</p><p>ab</p><p>ou</p><p>t a</p><p>ll</p><p>th</p><p>is</p><p>”</p><p>M</p><p>ay</p><p>2</p><p>00</p><p>4</p><p>–</p><p>“o</p><p>bv</p><p>io</p><p>us</p><p>ly</p><p>o</p><p>ne</p><p>ca</p><p>n’</p><p>t p</p><p>re</p><p>di</p><p>ct</p><p>w</p><p>he</p><p>n</p><p>th</p><p>e</p><p>m</p><p>us</p><p>ic</p><p>w</p><p>ill</p><p>s</p><p>to</p><p>p.</p><p>..”</p><p>N</p><p>ov</p><p>em</p><p>b</p><p>er</p><p>2</p><p>00</p><p>4</p><p>–</p><p>“T</p><p>he</p><p>ne</p><p>w</p><p>C</p><p>E</p><p>O</p><p>h</p><p>as</p><p>in</p><p>he</p><p>rit</p><p>ed</p><p>th</p><p>e</p><p>pr</p><p>om</p><p>ot</p><p>io</p><p>na</p><p>l z</p><p>ea</p><p>l o</p><p>f S</p><p>ea</p><p>n</p><p>F</p><p>itz</p><p>P</p><p>at</p><p>ric</p><p>k”</p><p>M</p><p>ay</p><p>2</p><p>00</p><p>5</p><p>–</p><p>“A</p><p>ll</p><p>of</p><p>th</p><p>e</p><p>m</p><p>an</p><p>ag</p><p>er</p><p>s</p><p>ha</p><p>ve</p><p>bo</p><p>oz</p><p>y</p><p>fa</p><p>ce</p><p>s</p><p>(D</p><p>ub</p><p>lin</p><p>ta</p><p>ns</p><p>!)</p><p>a</p><p>nd</p><p>c</p><p>an</p><p>ta</p><p>lk</p><p>at</p><p>le</p><p>ng</p><p>th</p><p>w</p><p>ith</p><p>ou</p><p>t r</p><p>ea</p><p>lly</p><p>s</p><p>ay</p><p>in</p><p>g</p><p>th</p><p>at</p><p>m</p><p>uc</p><p>h”</p><p>D</p><p>ec</p><p>em</p><p>b</p><p>er</p><p>2</p><p>00</p><p>8</p><p>–</p><p>th</p><p>e</p><p>Ir</p><p>is</p><p>h</p><p>go</p><p>ve</p><p>rn</p><p>m</p><p>en</p><p>t</p><p>na</p><p>tio</p><p>na</p><p>liz</p><p>es</p><p>A</p><p>ng</p><p>lo</p><p>-I</p><p>ris</p><p>h</p><p>B</p><p>an</p><p>k</p><p>ACCIDENTS IN WAIT ING 109</p><p>rising house prices in some countries elicited an enormous supply response,</p><p>notably in Spain and Ireland. Those economies which experienced the most</p><p>extreme capital cycle – in terms of increased stocks of credit and housing –</p><p>later suffered from the most severe hangovers.</p><p>4.1 ACCIDENTS IN WAITING: MEETINGS WITH ANGLO IRISH</p><p>BANK (2002–06)</p><p>In the years before the crisis, our meetings with British and Irish bank</p><p>management teams created a strong sense of foreboding</p><p>Many people in the investment industry are sceptical of the value of meet-</p><p>ing with management teams. Armchair analysts take the view that the pro-</p><p>cess has become an exercise in promotion which is likely to lead an investor</p><p>not nearer to but further from the truth. In his book Behavioural Investing,</p><p>James Montier devotes an entire chapter to the topic entitled “Why Waste</p><p>Your Time Listening to Company Management?” Montier argues that meet-</p><p>ings can overload fund managers with information and are likely to con-</p><p>firm pre-conceptions, especially overly optimistic ones. Fund managers</p><p>may also become too impressed with authority figures. Admittedly, there’s</p><p>a danger that the naïve will be gulled into dreadful mistakes. On the other</p><p>hand, exposure to a truly terrible manager can help investors steer clear of</p><p>the rocks. Marathon’s own experience of avoiding some of the worst banking</p><p>disasters of the credit bubble suggests that meetings can have considerable</p><p>value. We keep notes of our meetings. Below are some pre-crisis observa-</p><p>tions of a banking accident waiting to happen.</p><p>Anglo Irish Bank</p><p>Meeting Date: May 2002 (Market Cap: $1,900m)</p><p>Business assessment:</p><p>Anglo Irish lends to proprietary (i.e., owner-manager) directors, primar-</p><p>ily in the service sector in Eire, the UK and Boston. Ninety per cent of the</p><p>security for this lending is property. Unashamedly, they pronounce that the</p><p>cost of borrowing from Anglo Irish is higher than from a normal bank with</p><p>whom a customer does his or her everyday banking business. So aren’t they</p><p>providing a risky, lender-of-last-resort service, asks yours truly? Why should</p><p>I borrow from them when I know their rates are higher – unless I know that</p><p>Lloyds won’t give me the loan?</p><p>CAPITAL RETURNS110</p><p>The answer given is that their loans tend to be large in size (on average</p><p>€4.5m in the UK) and it will take weeks for Lloyds to give me an answer,</p><p>whereas they can decide more or less on the spot. A typical loan for them is</p><p>when a client comes to them to finance a €20m property purchase, but only</p><p>has €5m in cash. They look at the leasing agreement with the tenant and try</p><p>to understand the creditworthiness of the underlying tenant.</p><p>They claim not to care if the property market goes down, as the tenant</p><p>has undertaken to pay rent on a long-term contractual basis, and so long as</p><p>the tenant stays solvent, they are confident that the interest will be paid. That</p><p>raises a question about repayment of the principal – but that is far enough off</p><p>in the future for no one to worry for now at any rate! Surely if property prices</p><p>halve, they will be paid the interest but lose a lot of the principal?</p><p>Regarding the [bank’s] infrastructure, there is basically very little. The</p><p>client base does not require a vast branch network. Two-thirds of the busi-</p><p>ness over the last seven years has come from the existing client base, and new</p><p>clients come to them by word of mouth. The result is an extremely low cost</p><p>income ratio of around 30 per cent. In 1H 2002 the loan book (€18bn) grew</p><p>by 12 per cent, with the UK and the US growing at 21 per cent and 26 per</p><p>cent respectively. Eire represents 50 per cent of lending today compared with</p><p>80 per cent five years ago.</p><p>Overall, I find it very hard not to believe that this is an extremely risky</p><p>business model built on the back of the Irish property boom and now hinged</p><p>on something similar in the UK.</p><p>Management assessment:</p><p>“I am here unashamedly to sell you Anglo Irish Bank!” [says CEO Sean</p><p>FitzPatrick], as if it were not obvious, so hard is the sell (one of the worst</p><p>I’ve seen). The shares have more than doubled since last September and have</p><p>risen seven-fold since 1997.</p><p>Valuation assessment:</p><p>This will one day be a super short – the problem is that FitzPatrick will captivate</p><p>his audience to the extent that one can’t tell whether it might not double again.</p><p>Meeting Date: May 2003 (Market Cap: $2,648m)</p><p>Management assessment:</p><p>The management are very promotion-oriented and everything appears</p><p>fantastic. The CFO [William McAteer] is one of those people who imme-</p><p>diately learns somebody’s first name and uses it for the rest of the meet-</p><p>ing. He seemed to know a lot of the audience at the [investor] conference</p><p>ACCIDENTS IN WAIT ING 111</p><p>presentation as well, which is always worrying since it means that he has</p><p>developed a close interest in investors and knows who can buy his shares.</p><p>His finance junior was also overly promotional.</p><p>Valuation assessment:</p><p>The shares don’t look that expensive for a return on equity of 25 per cent;</p><p>however, there are risks implicit in their lending strategy and their high</p><p>growth rate. One also can’t help feeling uncomfortable with their demeanour.</p><p>Possibly an accident waiting to happen ... .</p><p>Meeting Date: March 2004 (Market Cap: $5,000m)</p><p>Business assessment:</p><p>The business model, as discussed previously, is to lend to businesses (mainly</p><p>property related) in Eire and the UK (and a bit in Boston) without a branch</p><p>network. The competitive advantage is the speed at which they approve loans</p><p>(95 per cent of what goes to the weekly credit committee gets passed) and</p><p>their flexibility and speed of execution. (Is being able to say “yes” quickly</p><p>really an advantage in the banking business?) ... .</p><p>Their “mission” is to make rich people richer. They rely on existing cus-</p><p>tomers and word of mouth for growth and do not use brokers. Last year,</p><p>net lending grew by €4.3bn or 33 per cent ... There is a strong whiff of Ponzi</p><p>finance about all this, since repayment of principal cannot be as secure as</p><p>the interest. For instance, if I borrow £10m over ten years to finance a prop-</p><p>erty purchase and McDonalds is my tenant, there should be no problem</p><p>paying the interest on the loan. But when I have to pay back the £10m prin-</p><p>cipal, I have to rely on the market being as buoyant ten years from now.</p><p>Because these are long-tail liabilities, they will not affect Mr. FitzPatrick</p><p>in his Marbella villa, particularly after recent share sales!1 Their provisions</p><p>are at 217 per cent of NPLs [non-performing loans], which compares with a</p><p>European average</p><p>of 80 per cent. But they would need to be higher to reflect</p><p>the chunky size of the individual loans.</p><p>1 Marathon’s prediction that the retiring Anglo Irish chief would enjoy a prosperous</p><p>retirement in the south of Spain turned out to be wide of the mark. Despite the share sales</p><p>mentioned above, FitzPatrick retained nearly 5m Anglo Irish shares with a peak value of over</p><p>€85m, which were rendered worthless by the bank’s collapse. It transpired that FitzPatrick</p><p>had also borrowed heavily from Anglo Irish. In 2010, he was declared bankrupt. Three years</p><p>later, the former bank boss went on trial, accused of failing to inform auditors of loans made</p><p>to himself or connected entities by the Irish Nationwide Building Society that, it was alleged,</p><p>temporarily replaced loans provided by Anglo Irish, thereby avoiding accounting disclosure</p><p>requirements. In 2015, The Irish Government was still struggling to secure the extradition</p><p>of David Drumm, FitzPatrick’s replacement as CEO, from the US to face charges of fraud.</p><p>CAPITAL RETURNS112</p><p>Management assessment:</p><p>FitzPatrick mentioned in his presentation how the directors had “misread”</p><p>the market with the heavy insider selling in February – presumably referring</p><p>to the market reaction as opposed to their timing (the share price was then at</p><p>€13). He got quite angry when I asked why directors were such enthusiastic</p><p>sellers of shares. He justified his own sale of some €20m as diversification as</p><p>he approached retirement. His total holding was worth €60m. The 42-year</p><p>old head of the UK business [John Rowan], however, sold €3m of shares (40</p><p>per cent of his holding) at the same time and FitzPatrick appeared to suggest</p><p>that this had affected his chances of succeeding him. Doesn’t it show that he</p><p>is a smart as FitzP., i.e., a worthy successor?</p><p>Valuation assessment:</p><p>With equity of €1bn it wouldn’t take many €10m loans to wipe out the half</p><p>of the equity (in fact, only 50 loans – and they are approving 20–25 loans</p><p>per week). Insider selling and the long-tail liability time bomb are the really</p><p>scary features of this. And it looks expensive at four times book.</p><p>Meeting Date: May 2004 (Market Cap: $5,000m)</p><p>Business assessment:</p><p>A combative presentation from the CEO of the niche lender – “We’re not full</p><p>service – we just ask customers to put a few eggs in our basket”... . The UK</p><p>and Boston are seen as “an extension of Ireland.” The UK is growing faster</p><p>than Ireland so now accounts for around 40 per cent of the loan book or</p><p>about €8.7bn, with the average loan being €5–7m. A “large chunk” of this is</p><p>investment property ... .</p><p>The other thing that occurs to me about the word of mouth expansion</p><p>strategy is that it probably means that the company has a fairly lopsided cus-</p><p>tomer exposure – all Paddy ex-pats and their mates? Anglo is also chang-</p><p>ing its strategy on provisioning. The bank currently has around €290m of</p><p>bad debt provisions, or around 134 basis points of the €21bn loan book. The</p><p>actual bad debt level is 66 basis points, giving a provision to non-performing</p><p>loan ratio of 207 per cent, compared to a European bank average of 80 per</p><p>cent, which one would imagine is appropriate given the nature of the second-</p><p>ary lending here. However, FitzPatrick says they have decided to add nothing</p><p>to provisions until the loan book is up to €55bn, which more than halves the</p><p>provisioning ratio.</p><p>Is this a vindication of their model or hubris looming?</p><p>ACCIDENTS IN WAIT ING 113</p><p>Management assessment:</p><p>FitzPatrick glowers from the speaker’s rostrum, daring anyone to disagree</p><p>with his business model, which of course, this being an Irish conference, no</p><p>one does. Size is clearly important – he began by boasting, “We’re bigger now</p><p>than Bank of Ireland was in 1998.” He thinks they can double their current</p><p>14 per cent of the Irish business market within ten years, but it is hard to see</p><p>how there can be 28 per cent of the market who are willing and able to pay</p><p>up for Anglo type service – so presumably the niche model must be diluted</p><p>to grow. He claims that 2004 and 2005 [earnings] are both “in the bag.”</p><p>Valuation assessment:</p><p>It is hard to escape the conclusion that this sort of growth and profitability are</p><p>unsustainable, but obviously one can’t predict when the music will stop....</p><p>Meeting Date: October 2004 (Market Cap: $6,270m)</p><p>Management assessment:</p><p>The new CEO [designate David Drumm] is 37 and previously head of bank-</p><p>ing in Dublin and the US. He seemed fairly low key particularly compared</p><p>with the outgoing CEO and won’t one suspects be able to razz up investors in</p><p>quite the same way. John Rowan is the chap who scuppered his chances of suc-</p><p>ceeding FitzPatrick by selling shares quite aggressively alongside FitzPatrick</p><p>earlier in the year. He was made to look quite uncomfortable when someone</p><p>in the audience asked a question about succession disruption.</p><p>Valuation assessment:</p><p>The bank trades at 4.2 times book value with a 30 per cent return on equity.</p><p>Chunky loans make it vulnerable to a declining credit environment/prop-</p><p>erty downturn. The bull case is based on the very rapid (+25 per cent p.a.)</p><p>growth in book value.</p><p>Meeting Date: November 2004 (Market Cap: $7,580m)</p><p>Business assessment:</p><p>To recap: 80 per cent of profit comes from lending to businesses on a secured</p><p>(property) basis, with half the loan book in Eire, 41 per cent in the UK and</p><p>the rest in the Boston area. The UK loan book has grown faster than the Irish</p><p>one over the last five years and is likely to overtake Eire soon as their largest</p><p>market. This is a bit weird given that the UK is hardly immature or uncom-</p><p>petitive and the Irish economy has been growing at much faster rates....</p><p>CAPITAL RETURNS114</p><p>On a new loan, the loan to value ratio is typically 70 per cent and usually</p><p>the collateral is at the level of 35 per cent when the tenancy expires. Thus</p><p>they estimate that property prices would have to fall by 65 per cent for Anglo</p><p>Irish to suffer ... .</p><p>I suspect that this market is highly dependent on the relationship</p><p>between rental yields, lending rates and the outlook for property prices.</p><p>The management team talked about the dangers of the current frenzied</p><p>speculation in Irish residential property, where rental yields have collapsed</p><p>and yet property prices continue to rise, Ponzi-style. One suspects that the</p><p>residential and commercial markets (e.g., a dentist’s surgery) are related in</p><p>some ways.</p><p>Management assessment:</p><p>The new CEO has inherited the promotional zeal of Sean FitzPatrick, and it</p><p>is quite hard to get one’s questions in, as each answer contains another long</p><p>string of bull points.</p><p>New investment and rationale:</p><p>The loan book grew by €6.3bn last year (35 per cent) which actually rep-</p><p>resented a gross increase of €9bn with €3bn of repayments. They con-</p><p>tinually make the point that they do not reach for growth (i.e., a target</p><p>to increase lending year-on-year), which has the ring of “doth protest too</p><p>much” about it.</p><p>Meeting Date: May 2005 (Market Cap: $8,600m)</p><p>Business assessment:</p><p>This was the first time the company has held a results meeting in London</p><p>on account of the “growing interest” in the stock. As usual, the results show</p><p>very strong growth with total assets up +17 per cent in 1H to €40bn on the</p><p>back of a net €4bn of new loans ... .</p><p>They admit that rental yields have declined in the UK (now at c.4 per</p><p>cent) and Eire, but insist that their clients are not banking on capital appre-</p><p>ciation and that their (Anglo’s) repayment cover calculations are secure. But</p><p>they also make the point that their clients are smart property people (i.e.,</p><p>they made money in the upswing!) who will benefit from a downturn as new</p><p>opportunities arise. This story doesn’t seem terribly consistent with 15 per</p><p>cent loan growth at the top of the cycle. Nevertheless, the stock market con-</p><p>tinues to believe in the EPS growth story (+30 per cent in 1H) and the shares</p><p>rose by 5–6 per cent on the day of the announcement.</p><p>ACCIDENTS IN WAIT ING 115</p><p>Management assessment:</p><p>All of the managers have boozy faces (Dublin tans!) and can talk at length</p><p>without really saying that much.</p><p>Valuation assessment:</p><p>The equity base now stands at €1.5bn (or 4.4 times book value), having dou-</p><p>bled over the last two and a half years, and the return on equity currently</p><p>stands at 33 per cent. There are lots of reasons to remain sceptical about the</p><p>solidity of Anglo’s business model, not least of which is how an overbanked</p><p>market like the UK can really provide such a wonderful growth opportunity</p><p>in commercial property lending over the next five years.</p><p>Meeting Date: November 2005 (Market Cap: $9,350m)</p><p>Business assessment:</p><p>Anglo Irish continues to deliver very strong loan growth (+40 per cent for</p><p>the year ended 30 September 2005) as the Irish loan book (56 per cent of the</p><p>total lending) grew at a rip-roaring 46 per cent. The UK, which represented</p><p>40 per cent of lending in 2005, grew at 27 per cent. They had previously</p><p>talked about the UK being the main engine of growth, and one suspects</p><p>that even they are a little surprised at the continuing buoyancy of the Irish</p><p>business. Its strength is put down to the dynamism of the Irish economy.</p><p>Nevertheless, their loan growth of 46 per cent is considerably higher than</p><p>the market, which grew at 26–27 per cent. Gross lending during the year</p><p>was an additional €10bn ... [which] actually represents 80 per cent of the loan</p><p>book at the start of the year ... .</p><p>As before, they insist that all lending is asset (i.e., property) backed and</p><p>70 per cent is to existing customers, and they prize their ability to make fast</p><p>decisions because of devolved decision-making combined with an effective</p><p>credit committee ... .</p><p>In the UK, net new lending was €2.6bn and the gross figure was €5bn,</p><p>on a starting base of €9.9bn ... . Recall that the UK boss [John Rowan] left</p><p>recently (having missed out on the top job), apparently forfeiting a fair for-</p><p>tune in stock options (1m options with a strike price of €6.3 so worth c.€8m!),</p><p>which was a bit suspicious. McAteer indicated that it was at the discretion of</p><p>the remuneration committee [to decide] whether Mr Rowan would be able</p><p>to keep some of these options despite the fact that their first exercise date is</p><p>December 2006 and the primary purpose of the options (to retain and incen-</p><p>tivize management) could hardly be said to still apply!</p><p>CAPITAL RETURNS116</p><p>New investment and rationale:</p><p>They raised €300m by way of preferred shares in 2005 as the Irish regulator</p><p>deemed that their “core” Tier One ratio “was a bit tight.”</p><p>Valuation assessment:</p><p>The P/E ratio has been rerated recently (from 10–11 times to the current</p><p>level of 14 times) at the same time as earnings have been growing rapidly.</p><p>Most brokers have buy notes on the stock and [the Irish broker] Goodbody</p><p>uses a group of Eastern European bank stocks (its growth “peers”) to show</p><p>how cheap Anglo remains! The stock still feels like a play on Irish property</p><p>bullishness – there has been strong growth in lending for Eastern European</p><p>property (up to €1bn of 4 per cent of underlying assets, a growth of 66 per</p><p>cent on 2004). This must blow up at some point – surely?</p><p>Meeting Date: March 2006 (Market Cap: $11,500m)</p><p>Business assessment:</p><p>The spin remains as bullish as ever. Loan assets by location are 41 per cent in</p><p>Eire, whereas 56 per cent of the loan book is to Irish clients, which indicates</p><p>the extent to which they fund Irish investors abroad. Total Irish lending is up</p><p>46 per cent in 2005! They are, for instance, setting up an office in Prague to</p><p>service Irish property investors. They have great faith in the abilities of their</p><p>clients (the Irish have bigger brains when it comes to property investing?) ... .</p><p>Since our last meeting, the bank slipped out a placing of 5 per cent [of</p><p>outstanding shares], which was 4 times oversubscribed. Of course, they</p><p>maintain that this [share issuance] has nothing to do with stretched capital</p><p>ratios (risk-weighted assets are €40bn compared with €1.7bn of equity and</p><p>Tier 1 capital is only 4 per cent). There was no EPS dilution and no immedi-</p><p>ate plan for M&A. “The market was there.” In Eire, they claim not to have</p><p>been affected by new entrants such as Danske and RBS.</p><p>In the UK, the emphasis is now on growing outside London in “the regions”</p><p>(Manchester, Birmingham, Glasgow and Belfast). RBS is their biggest competi-</p><p>tor in the UK commercial market, whereas in Eire it is Allied Irish. Overall,</p><p>Anglo Irish has benefited from cyclical growth in commercial property, fuelled</p><p>by low interest rates, increased liquidity, and exceptionally benign credit condi-</p><p>tions. This should make the bank vulnerable in a rising rate environment.</p><p>Management assessment:</p><p>[CFO Willie] McAteer seemed more shifty than usual. The remuneration</p><p>committee decided to gift one-third of the options owned by John “friend</p><p>ACCIDENTS IN WAIT ING 117</p><p>of the bank” Rowan, even though they had not vested at the time of his</p><p>departure.</p><p>Valuation assessment:</p><p>Still hard to believe in the Irish property investors’ magical abilities. The</p><p>business model is unlikely to be easily adaptable to a different credit envi-</p><p>ronment. Corporate governance grubby too.2</p><p>4.2 THE BUILDERS’ BANK (MAY 2004)</p><p>A pre-crisis look at the Anglo Irish can of worms</p><p>“Time is a great story teller.”</p><p>Irish proverb</p><p>Anyone who thinks Europe is a mature economic region suffering from scle-</p><p>rosis and doomed to perpetually low rates of growth, should have attended</p><p>a recent Irish equity conference in Dublin. Growth featured heavily on the</p><p>menu, nowhere more so than in the presentations of Ireland’s leading finan-</p><p>cial institutions. The main driver of growth is mortgage lending, which last</p><p>year expanded by 26 per cent in Ireland (curiously, all of the principal banks</p><p>reported that their own mortgage lending growth exceeded the national</p><p>growth rate). Ireland is experiencing a housing boom, as low nominal rates of</p><p>interest – in Ireland’s case negative real rates thanks to the Eurozone’s mon-</p><p>etary umbrella – entice individuals to bid up property prices. The arguments</p><p>for and against the sustainability of this megatrend, and its implications for</p><p>banks, are well rehearsed.3 What is perhaps more instructive is to observe</p><p>the case of an especially successful Irish banking story, namely that of Anglo</p><p>Irish Bank, and to imagine what lies in store.</p><p>2 Postscript: Anglo’s former CEO Sean FitzPatrick resigned as chairman in December</p><p>2008 amid mounting revelations of hidden loans at the bank. The scandal led to the collapse</p><p>in the company’s share price and subsequent nationalization in January 2009. Total losses</p><p>sustained by the Irish state from assuming Anglo’s liabilities have been estimated at over</p><p>€30bn.</p><p>3 Capital cycle footnote: Unlike in the United Kingdom, high Irish property prices pro-</p><p>voked a boom in new supply. In 2003, 69,000 homes were built in the Irish Republic, which</p><p>had a population of 4m. This compares with 180,000 new homes in the UK, with a popula-</p><p>tion of around 60m, a housing supply differential of nearly 6 times on a per capita basis. This</p><p>huge difference in relative housing supply explains why the UK housing market and UK</p><p>homebuilders weathered the global financial crisis far better than their Irish counterparts.</p><p>CAPITAL RETURNS118</p><p>Anglo Irish has grown from a small finance business, with a market cap-</p><p>italization of €8m in 1986 and an asset base of €138m, into a large bank with</p><p>a market capitalization of €4.3bn and assets of €25.5bn. The bank’s growth</p><p>has been fuelled by lending against property in the booming Irish economy,</p><p>and it has expanded into the UK and Boston markets. Currently 90 per cent</p><p>of the loan book is secured against property. Rather than individual mort-</p><p>gages, however, Anglo Irish generally lends to small businesses that either</p><p>wish to expand their property base, acquire premises that had previously</p><p>been leased, or are borrowing against property to release capital.</p><p>The bank’s success has been achieved without a</p><p>branch network.</p><p>Although this deprives it of low cost deposits, not having a branch network</p><p>also means lower overheads. Anglo Irish boasts an impressive cost-to-income</p><p>ratio of only 30 per cent. Average loan size is €4.5–5.5m in Ireland (€7–8m in</p><p>the UK), reflecting the fact that the bank is not significantly involved with</p><p>residential mortgages. In the UK, which now accounts for €7bn of the total</p><p>loan book of €17bn, a greater proportion of lending is for investment prop-</p><p>erty, where the borrower finances the purchase of a property (often a shop or</p><p>a warehouse) which is then let to tenants on long-term lease arrangements.</p><p>0</p><p>10</p><p>20</p><p>30</p><p>40</p><p>50</p><p>60</p><p>70</p><p>80</p><p>90</p><p>0</p><p>2</p><p>4</p><p>6</p><p>8</p><p>10</p><p>12</p><p>14</p><p>16</p><p>18</p><p>20</p><p>1998 1999 2000 2001 2002 2003</p><p>Advances to customers LHS Earnings per share (cent) RHS</p><p>€</p><p>bn</p><p>Chart 4.2 Anglo Irish Bank EPS growth and customer advances</p><p>Source: Anglo Irish.</p><p>ACCIDENTS IN WAIT ING 119</p><p>Provisions against non-performing loans are 217 per cent, compared</p><p>with a European average of 80 per cent. As for valuation, the bank earns a</p><p>return on equity of 32 per cent, trades at 4.2 times book value and offers a</p><p>yield of 1.6 per cent. Earnings per share grew at 34 per cent last year, having</p><p>compounded by 41 per cent annually since 1998.</p><p>A central feature of the business model appears to be the relationship</p><p>between Anglo Irish and its property-owning customers. Chief executive</p><p>Sean FitzPatrick, who has run the bank since 1986, suggests that its competi-</p><p>tive advantage is based on the speed with which they approve loans compared</p><p>with bureaucratically-challenged peers. At the weekly credit committee meet-</p><p>ings, up to 25 loans are approved with an approval rate of 95 per cent. The</p><p>bank’s publicly professed mission is to “make our customers richer.”</p><p>Management presents Anglo Irish’s credit risk in terms of current debt-</p><p>servicing, but this overlooks potential repayment risk. Even though interest</p><p>payments may be secure in a falling property market – assuming that tenants</p><p>stay solvent, under such circumstances there must be a large question mark</p><p>over property developers’ ability to repay the loan principal. To use the ter-</p><p>minology of the maverick American economist Hyman Minsky, it appears</p><p>that Anglo Irish is engaging in “speculative finance” whereby borrowers are</p><p>only able to cover their interest payments from earnings, as opposed to the</p><p>more prudent “hedge finance” whereby borrowers can meet all their liabili-</p><p>ties, including interest and principal payments, from current cash flows. We</p><p>are not yet at the point of Minsky’s “Ponzi finance,” which describes the</p><p>situation when borrowers are unable to fund even interest payments from</p><p>current cash flow.</p><p>The bank’s business model works particularly well in a falling interest</p><p>rate environment. On the cost side, the bank’s cost of funding in the whole-</p><p>sale loan market declines in line with EURIBOR rates. On the revenue side,</p><p>lower interest rates have made mortgages more affordable, leading to higher</p><p>property values, and strong credit growth. As Irish rents have so far moved</p><p>in step with values, leveraged property developers have more income to meet</p><p>lower interest payments.</p><p>If rates were to increase, however, this virtuous cycle could turn vicious.</p><p>Without a deposit base, Anglo Irish’s cost of funds would rise quickly. On</p><p>the revenue side, declining property values would make capital repayments</p><p>on existing loans problematic, raising default risk. In other words, Anglo</p><p>Irish is a wonderful money-making machine when interest rates are declin-</p><p>ing, but not one to invest in under different circumstances. Not many €10m</p><p>loans would have to turn sour before Anglo Irish’s €1bn equity base was seri-</p><p>ously compromised.</p><p>CAPITAL RETURNS120</p><p>It might be argued that management has anticipated these risks and</p><p>prepared for longer-term contingencies. The trouble is that the equity-</p><p>based incentives paid to senior executives favour growth in the near-term,</p><p>while bad debt problems are likely to have a very long tail. The bank has</p><p>issued stock options for over 6.2m shares (2 per cent of the total share</p><p>capital), with strike prices of between €1.09 and €6.70 compared with the</p><p>current market price of €13. Management have responded to the enormous</p><p>rise in the share price – which fails to discount what a myopic stock mar-</p><p>ket cannot see – by selling vast numbers of shares. Mr. FitzPatrick, who is</p><p>retiring at the tender age of 55, recently sold half of his holding for around</p><p>€20m, and the 46-year old boss of the UK business has disposed of 40 per</p><p>cent of his holding.</p><p>Charles T. Munger is fond of saying that there are “more banks than</p><p>bankers.” A competitive advantage based on a willingness to make loans</p><p>in an instant would be anathema to old-fashioned bankers. Of particular</p><p>concern to us is the extent to which Irish bankers engage in the hard-sell</p><p>to investors. One of them declared at the conference we recently attended:</p><p>“I am here unashamedly to sell you X bank!” This rather goes against our</p><p>preference for bankers as cautious individuals, obsessed with long-term</p><p>downside risks. As we have seen in many other businesses, an obsession</p><p>with growth, combined with overpromotion, is likely to end in tears. As</p><p>to when this will happen, we must wait for time, Ireland’s proverbial story</p><p>teller.</p><p>4.3 INSECURITIZATION (NOVEMBER 2002)</p><p>Securitization has flooded certain sectors with too much cheap capital</p><p>Marathon’s investment methodology is based on the tendency for returns on</p><p>capital for any particular company, or industry, to trend towards a normal</p><p>level over time. Depending on how quickly this evolution takes place, rela-</p><p>tive to the market’s expectations, an investment opportunity may arise. For</p><p>this process to work, however, poor and failing businesses must be deprived</p><p>of cheap funding. Yet the securitization process now supplies capital at an</p><p>abnormally low cost to inherently risky activities, delaying the normalisation</p><p>of profits and storing up losses for the future. This has capital cycle implica-</p><p>tions. Shareholder returns in industries funded with easy money from securi-</p><p>tizations are likely to oscillate around the low marginal cost of funding.</p><p>For those unfamiliar with the practice, it may be useful to describe</p><p>briefly the mechanics of a typical asset securitization. In the airline indus-</p><p>try, for example, the process begins with a purchase order from the aircraft</p><p>ACCIDENTS IN WAIT ING 121</p><p>manufacturer at a significant, bulk discount to list price. Upon delivery, this</p><p>asset is sold by the airline to a newly established securitization vehicle at</p><p>a price closer to list price, and subsequently leased back for the life of the</p><p>aircraft. The vehicle issues Enhanced Equipment Trust Certificates (EETC)</p><p>to investors. Lease payments are tranched, with investors who take on the</p><p>greatest default risk (junior note holders) receiving more and those who take</p><p>on the least risk (senior tranches) getting less. Compared to a conventional</p><p>debt instrument, what makes securitization so attractive is the fact that the</p><p>airline often retains the junior tranches. These become an asset on its bal-</p><p>ance sheet. Any discount associated with the low credit rating of these layers</p><p>is more than offset by the discount on the purchase of the aircraft, thereby</p><p>creating an immediate profit and cash inflow on delivery of the aircraft.</p><p>Such are the wonders of modern financial alchemy.</p><p>Under good, even normal, business conditions, the airline makes lease</p><p>payments to the securitization vehicle. But in a recession or a bankruptcy</p><p>filing, when payments are suspended, the owners of the senior strata are</p><p>able to seize the collateral. The junior participants in the securitization have</p><p>no rights, and any such assets on the airline’s balance sheet must be written</p><p>down to zero, further increasing the airline’s losses. By this clever piece of</p><p>financial engineering, the airline gets shiny new planes for an extremely low</p><p>cost of funds –</p><p>recently as low as 6 per cent – while equity shareholders carry</p><p>nearly all of the business risk. That an industry which has rarely earned an</p><p>acceptable return on capital should have access to such cheap capital is quite</p><p>astonishing.</p><p>Similar feats of financial engineering, facilitated by securitization, are</p><p>apparent in a backwater of the US mortgage market. GreenPoint Financial</p><p>originates through a broker network mortgages that fail to meet mortgage</p><p>standards set by Fannie Mae and Freddie Mac. These risky loans, known as</p><p>Alt-A mortgages, generate on average a yield of about 100 basis points above</p><p>the typical conforming mortgage. A casual observer might assume that this</p><p>yield pick-up was a commensurate compensation for the increase in credit</p><p>risk. So we were amazed to learn that GreenPoint are able to sell these loans</p><p>whole, retaining absolutely no credit risk, while keeping 95 basis points of the</p><p>yield premium over the agency rate as a one-off gain on sale.</p><p>According to GreenPoint, this windfall is possible because the buyers,</p><p>usually investment banks or specialists in mortgage servicing, take the loans</p><p>and repackage them as securitizations attracting what GreenPoint describes</p><p>as money that “doesn’t care a hoot” about the underlying economics of</p><p>the mortgage. By keying off recent default statistics which are unbeliev-</p><p>ably benign (at less than 5bps of losses annually), the buyers of the senior</p><p>CAPITAL RETURNS122</p><p>tranches have been lulled into thinking the risk-reward characteristics are</p><p>in their favour and accept a tiny spread over the rate available from a con-</p><p>forming loan. Those buying the more risky junior notes are happy to earn</p><p>a significant yield premium while putting off the (inevitable?) write down</p><p>of this highly leveraged instrument. GreenPoint has taken full advantage of</p><p>this market madness by doubling the volume of mortgage originations and</p><p>whole loan sales over the past couple of years.</p><p>The eagerness of aircraft and Alt-A securitization buyers to accept a</p><p>“reliable” stream of income, while deferring possible losses, is not surpris-</p><p>ing in this age of financial myopia. Securitizations have been an effective</p><p>way of obscuring the real economics of these activities, while facilitating the</p><p>inflow of more and more capital.4 As for the airlines, only when manage-</p><p>ments’ growth ambitions are restricted by greater rationing of finance will</p><p>the industry’s returns on capital move towards a more acceptable level.5</p><p>4.4 CARRY ON PRIVATE EQUITY (DECEMBER 2004)</p><p>The buyout boom has entered a bubble phase</p><p>Paul Achleitner, investment director at Allianz, recently commented that: “The</p><p>traditional strategy of buying and holding [listed investments] worked well for</p><p>decades but it doesn’t work in a modern regulatory environment ... . Private</p><p>equity holdings don’t swing about in value like publicly listed companies.”</p><p>He is not alone in his enthusiasm. Europe is now the world’s largest private</p><p>equity market by transactions, accounting for some 60 per cent of global</p><p>private equity M&A activity, according to various industry estimates. In the</p><p>UK, one fifth of the UK private sector workforce is reportedly employed</p><p>by private equity firms. In the month of November, four major European</p><p>private equity bids with a total transaction value of $20bn were announced,</p><p>including a possible $14bn bid by a consortium of private equity firms for</p><p>Auna, Spain’s number three mobile phone operator. If successful, this latter</p><p>bid would constitute the largest ever private equity deal in Europe. Private</p><p>equity firms are doing more deals with more debt and have come to resemble</p><p>4 Losses on Alt-A mortgages after the Global Financial Crisis were estimated by Goldman</p><p>Sachs to be $600bn on a total stock of $1.3tn (The Economist, February 2009.) In February</p><p>2004, GreenPoint Financial was acquired by North Fork Bancorporation for $6.3bn. In</p><p>December 2006, Capital One acquired North Fork. A year later, Capital One shut down</p><p>GreenPoint, after suffering losses on its mortgage book.</p><p>5 Since this piece appeared, there has been a spate of North American airline bankrupt-</p><p>cies, including United Airlines (December 2002), Air Canada (April 2003), US Airways</p><p>(September 2004), Northwest (September 2005), Delta (September 2005) and American</p><p>Airlines (November 2011).</p><p>ACCIDENTS IN WAIT ING 123</p><p>the 1960s conglomerates like LTV, Litton and ITT in the breadth of their</p><p>activities. So will today’s private equity firms suffer the same fate as the con-</p><p>glomerates of the past, or are they here to stay, playing an essential role that</p><p>cannot be fulfiled by public capital markets?</p><p>There are a host of factors working in favour of private equity. In an age</p><p>obsessed with quarterly earnings, ownership of unlisted assets allows private</p><p>equity firms to take longer-term decisions than would be acceptable to stock</p><p>market “investors.” Corporate restructuring under private equity ownership</p><p>is also probably easier to achieve. Consider how difficult it is for Siemens to</p><p>reduce the workforce at any of its 900 consolidated subsidiaries. Managers</p><p>in private equity firms are not encumbered by the increasing bureaucracy</p><p>for listed firms, called forth by the Sarbanes-Oxley legislation. Furthermore,</p><p>management compensation escapes the public prurience associated with</p><p>executive pay at public firms. In theory, the principal-agent problem is</p><p>reduced via greater control by owners (whereas in practice, buyouts bring</p><p>with them a host of new fee-hungry agents).</p><p>We have a number of concerns, however, about the current private equity</p><p>boom. For a start:</p><p>1. The boom appears to be fuelled by the willingness of banks and</p><p>other financial institutions to fund deals on more lax terms to</p><p>private equity firms. The ratio of net debt to earnings before</p><p>interest, tax, depreciation and amortization (EBITDA) – a cash</p><p>flow measure of how much debt banks are willing to lend for a</p><p>corporate acquisition – has been rising. Deals with multiples of</p><p>6–7 times EBITDA are now not uncommon. “Seven is the new</p><p>five,” as one observer put it, raising the spectre of a credit bubble.</p><p>Banks, awash with capital, justify their enthusiasm for private</p><p>equity deals on the grounds that interest rates are low and that</p><p>there have been few defaults on historical private equity loans</p><p>(a “driving-via-the-rear-view-mirror” argument). We also sense</p><p>that slippage is occurring with regard to the security and loan</p><p>covenants demanded by creditors. Lax lending encourages pri-</p><p>vate equity to take on more leverage. Given that buyout loans</p><p>are non-recourse to the private equity sponsor, the risk is less</p><p>with private equity firms and more with the suppliers of debt –</p><p>namely, the banks or whoever has acquired the loans from the</p><p>banks. However, increased debt capacity increases the probabil-</p><p>ity that private equity deals will be overpriced.</p><p>CAPITAL RETURNS124</p><p>2. Higher levels of debt could be justified if the underlying busi-</p><p>nesses have sufficiently predictable cash flows to support higher</p><p>leverage. Yet in a number of recent cases, large amounts of debt</p><p>are being applied to highly cyclical businesses. In the case of</p><p>Rexel, a French distributor of electrical parts, the €3.7bn buy-</p><p>out has been funded on a debt to EBITDA multiple of almost</p><p>7 times. Or take the case of Celanese, a bulk chemical com-</p><p>pany, where the $1.2bn purchase was funded on a multiple of</p><p>5.5 times.6</p><p>3. The private equity firms themselves are awash with cash. There</p><p>are now said to be over 100 buyout firms with funds of more</p><p>than $1bn. According to the British venture capital firm 3i, three-</p><p>quarters of all capital ever raised by private equity firms has been</p><p>raised in the last five years. With so much money to invest in a</p><p>relatively short time (most funds seek to be fully invested within</p><p>three years of capital raising), competition among private equity</p><p>firms, skilfully stoked up by investment bankers in auctions, may</p><p>become excessive.</p><p>4. There are reasons to be sceptical</p><p>who bought into shipping in the summer of 2007, before the onset of the</p><p>global financial crisis, would have lost two-thirds of his money. Shares in</p><p>global shipping companies, such as Denmark’s Maersk Group, were down</p><p>a similar amount. New ships, which had been ordered during the boom</p><p>years, continued to be delivered long after the downturn. At the time of</p><p>writing, the shipping industry is still suffering from poor capacity utiliza-</p><p>tion and low rates.</p><p>Rising house prices after 2002 prompted another capital cycle in the US</p><p>homebuilding industry. By the time the US housing bubble peaked in 2006,</p><p>the excess stock of new homes was roughly equal to five times the annual</p><p>production required to satisfy demand from new household formation.</p><p>Spain and Ireland, whose real estate markets had even more pronounced</p><p>upswings, ended up with excess housing stocks equivalent to roughly 15</p><p>times the average annual supply of the pre-boom period. Whilst under way,</p><p>housing booms are invariably justified by references to rosy demographic</p><p>projections. In the case of Spain, it turned out that recent immigration had</p><p>largely been a function of the property boom. After the bubble burst and the</p><p>Spanish economy entered a depression, foreigners left the country by the</p><p>hundreds of thousands.</p><p>3 See “Waves in Ship Prices and Investment,” by Robin Greenwood and Samuel Hanson,</p><p>NBER Working Paper, 2013.</p><p>4 “Shipping Sector Report: Supply Finally Conquered but will Spot Rates be Liberated?,”</p><p>DNB Markets, 8 April 2013.</p><p>CAPITAL RETURNS6</p><p>Several well-known “value” investors who ignored capital cycle dynam-</p><p>ics were blindsided by the housing bust. In the years before US home prices</p><p>peaked in 2006, homebuilders had grown their assets rapidly. After the bub-</p><p>ble burst, these assets were written down. As a result, investors who bought</p><p>US homebuilders’ stocks towards the end of the building boom when they</p><p>were trading around book value – towards their historical lows – ended up</p><p>with very heavy losses.5 From a capital cycle perspective, it’s interesting to</p><p>note that although UK and Australia experienced similar house price “bub-</p><p>bles,” strict building regulations prevented a supply response. Largely as a</p><p>consequence, both the British and Australian real estate markets recovered</p><p>rapidly after the financial crisis.6</p><p>THE COMMODITY SUPERCYCLE</p><p>The commodity “supercycle,” as the brokers called it, took off in the period</p><p>of low interest rates following the dotcom bust of 2002 (see below, 1.3 “This</p><p>time’s no different” and 1.4 “Supercycle woes”). Rising prices for commodi-</p><p>ties were propelled by China, whose investment-heavy economy was expe-</p><p>riencing consistent double digit annual GDP growth. After the financial</p><p>crisis, China’s investment share of GDP rose even further to some 50 per</p><p>cent of GDP, a higher level than seen before in any other economy. By 2010,</p><p>China accounted for more than 40 per cent of global demand for a number</p><p>of commodities, including iron ore, coal, zinc and aluminium. China’s share</p><p>of incremental demand for these commodities was even higher.7 The prices</p><p>of these commodities and several others were far above their historic trends,</p><p>arguably at bubble levels.8</p><p>5 For instance, the large US homebuilder KB Home experienced a 28 per cent compound</p><p>annual growth in assets between 2001 and 2006. By summer of 2006, its shares were trading</p><p>at 1.2 times book. From that point, KB’s book value declined by 85 per cent, and its shares,</p><p>already well below their peak, fell a further 75 per cent.</p><p>6 The fact that UK housing supply didn’t respond to the British housing bubble is reflected</p><p>in the superior performance of UK homebuilding stocks relative to their US counterparts</p><p>over the last decade.</p><p>7 Sanford C. Bernstein estimates that China contributed 92 per cent of total growth in iron</p><p>ore consumption between 2000 and 2013. See “US Metals and Mining: Super-cycle ... Where</p><p>is the Super-Cycle?,” July 2014.</p><p>8 At the Boston-based investment firm GMO, my former employer, we defined an asset</p><p>price bubble as a two-standard deviation from trend. By 2010, iron ore was 4.9 s.d. above</p><p>trend, copper 3.9 s.d., coal 4.1 s.d., zinc 1.9 s.d. and aluminium 1.4 s.d. See Jeremy Grantham,</p><p>“The Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever,”</p><p>GMO, April 2011.</p><p>INTRODUCT ION 7</p><p>As the price of commodities rose, the profitability of global mining com-</p><p>panies took off. Their return on capital employed rose from around 7.5 per</p><p>cent at the turn of the century to peak at nearly 35 per cent in 2005, rebound-</p><p>ing after the financial crisis to around 20 per cent.9 Even after the Lehman</p><p>bust, most analysts extrapolated recent commodity demand growth into the</p><p>distant future on the grounds that China’s economy was destined to con-</p><p>verge with, and eventually overtake, the mighty US economy. This combi-</p><p>nation of high commodity prices, strong profitability and robust expected</p><p>future demand spurred the miners to increase production.</p><p>Annual global mine production (in USD terms) rose by 20 per cent annu-</p><p>ally between 2000 and 2011, more than half of this growth coming from iron ore</p><p>and coal.10 In volume terms, iron ore production doubled over the same period.</p><p>Mining capital expenditure climbed more than fivefold, from around $30bn a</p><p>year at the turn of the century to peak at over $160bn.11 Changes in iron ore sup-</p><p>ply materialize after a long lag – it takes up to nine years to develop a greenfield</p><p>site. New supply is particularly lumpy owing to the huge size of some of the new</p><p>mines – Vale’s Serra Sul project in Brazil, which had a capex budget of nearly</p><p>$20bn, is expected to add nearly 5 per cent to global iron ore production.</p><p>During the years of rocketing commodity prices, supply also came on</p><p>stream from non-traditional producers, including Iran and parts of Africa.</p><p>Although the global mining industry is concentrated among a handful of</p><p>major players, competition has been fierce – Australia’s Fortescue Metals</p><p>Group, a relative newcomer, expanded aggressively to become the 4th largest</p><p>iron producer by 2011. Many smaller mining companies came to the market,</p><p>including a number of rather dubious foreign outfits floated on the London</p><p>Stock Exchange.12 High prices also increased the supply of scrap metal.13</p><p>The commodity supercycle appears to have turned in 2011, roughly</p><p>coincident with a slowdown in China’s growth rate. By April 2015, the price</p><p>of seaborne iron ore was down roughly 70 per cent from the peak (in USD</p><p>terms). New mining capacity, commissioned when prices were high, is des-</p><p>tined to come on stream for the next several years, contributing further to</p><p>9 “A Long Lasting Mining Capex Correction,” UBS, June 5, 2014.</p><p>10 See Bernstein, op. cit.</p><p>11 The ratio of the miner’s capex to depreciation, which rose from 1.1x in 2001 to peak at</p><p>3x in 2012, UBS, ibid.</p><p>12 On a 12-month basis, global junior and mid-tier equity raisings in the mining sector</p><p>went from just $1bn in 2005 to $30bn by mid-2011, falling back to around $2bn by early 2014</p><p>(Bernstein, ibid.).</p><p>13 Scrap metal consumption rose from 401m to 573m metric tonnes, between 2000 and</p><p>2011.</p><p>CAPITAL RETURNS8</p><p>overcapacity.14 The profitability of the global miners has declined in tandem</p><p>with commodity prices, and their shares have underperformed.15 Thus, the</p><p>great commodity supercycle bears the hallmarks of a classic capital cycle: high</p><p>prices boosting profitability, followed by rising investment and the arrival of</p><p>new entrants, encouraged by overly optimistic demand forecasts; and the</p><p>cycle turning once supply has increased and demand has disappointed.</p><p>THE CAPITAL CYCLE ANOMALY</p><p>So much for some recent anecdotal evidence in support of the capital cycle</p><p>approach. What do the finance professors have to say? When I wrote the</p><p>introduction to Marathon’s Capital Account just over a decade ago, little aca-</p><p>demic work had been published on this subject. More recently, however, a</p><p>number of papers have appeared,</p><p>about the private equity indus-</p><p>try’s ability to replicate historical returns achieved during the</p><p>long bull market. David Swensen, the manager of Yale’s endow-</p><p>ment, pointed out in his book, Pioneering Portfolio Management,</p><p>that private equity funds produced annual returns of 48 per cent</p><p>between 1987 and 1998, compared with the annualized 17 per</p><p>cent return of the S&P 500 over the same period. This appears</p><p>impressive. But, as Swensen points out, if an investment in the</p><p>S&P had employed the same leverage as private equity, then</p><p>annual returns would have compounded at 86 per cent.</p><p>5. Private equity firms are outbidding trade buyers. This is now a</p><p>very frequent complaint at our meetings with companies. At a</p><p>recent meeting with Associated British Foods, the CFO com-</p><p>plained about the difficulty of competing for deals with private</p><p>equity firms. For instance, Hicks Muse recently paid 16 times</p><p>operating profits to acquire the venerable Weetabix breakfast</p><p>cereal business. (In this particular case, there may be syner-</p><p>gies with Hicks Muse’s other food businesses.) When asked</p><p>how they could afford to pay more than trade buyers, a senior</p><p>6 Celanese had an initial public offering in January 2005, and its private equity sponsor,</p><p>Blackstone, reportedly made five times its investment in the US chemical company.</p><p>ACCIDENTS IN WAIT ING 125</p><p>figure at 3i recently commented that they were “smarter” than</p><p>corporate buyers and did “more work” on deals. Not terribly</p><p>convincing.</p><p>6. The lack of transparency in the private equity world, frequently</p><p>cited as a significant benefit, is double-edged. After all, it is easy</p><p>to forget that demands for increased transparency in public mar-</p><p>kets arose from a reaction to specific cases of corporate malfea-</p><p>sance. If such behaviour goes “under cover” in the private equity</p><p>arena, the problem does not go away. Raiding a pension fund</p><p>or overstating the value of assets or any other dubious practice</p><p>seems to us much more likely to occur in the private equity world</p><p>than in public markets where the spotlight of regulation shines</p><p>far brighter.</p><p>7. There are anecdotal signs of a private equity bubble, including</p><p>the entry of hedge funds into the private equity field, the obses-</p><p>sion with EBITDA valuation measures (which remind us of the</p><p>mania for “pro forma” earnings during the tech bubble) and the</p><p>proliferation of complex finance structures, including the use of</p><p>“special purpose vehicles.” Private equity has become one of the</p><p>most sought after career options for MBA graduates – a reliable</p><p>contrarian indicator.</p><p>8. Given the lacklustre market for IPOs, private equity firms have</p><p>been looking for other more incestuous exit routes. There’s been</p><p>a spate of “secondary buyouts” – the practice of one private equity</p><p>firm selling its investee company to another buyout firm. It is hard</p><p>to see that the new owner can generate huge gains if the previous</p><p>owner, who presumably thinks in a similar way, has exploited all</p><p>the value creation opportunities. An alternative exit is provided by</p><p>leveraged re-capitalizations in which equity is returned through</p><p>special dividends funded with debt. If things go bad, this risk is</p><p>more likely to land up with the banks than with the private equity</p><p>sponsors.</p><p>9. Private equity firms generate billions of dollars of fees for</p><p>investment and lending banks, lawyers, accountants, and sun-</p><p>dry other hangers-on in the world of finance. In the world of</p><p>“integrated” corporate finance, we see the potential for conflicts</p><p>of interest. One obvious potential conflict comes from a bank’s</p><p>desire to generate transaction fees (advisory, origination, etc.)</p><p>and its need to ensure the security of the loan principal. We sup-</p><p>pose the transaction-hungry investment bankers have the upper</p><p>CAPITAL RETURNS126</p><p>hand over the traditionally more sober-minded lending officers.</p><p>One dubious new practice is “staple lending,” whereby the bank</p><p>advising the vendor on the sale offers a loan to the purchaser, “sta-</p><p>pled” to the purchase and sale agreement. This occurred in the</p><p>sale of VNU’s directories business in which Goldman and CSFB</p><p>both advised the bidder and provided finance to the acquirer.</p><p>As adviser, one would expect the banks to seek the highest price,</p><p>but would it not be reasonable for the bank as lender to want the</p><p>lowest price?</p><p>10. Finally, Allianz’s bullishness about private equity should be</p><p>enough to make the most determined optimist shudder. When</p><p>it comes to capital allocation, Allianz deserves a special booby</p><p>prize. One thinks back to the German insurer’s 2001 acquisition</p><p>of 80 per cent of Dresdner Bank for €25bn or its sale of €12bn</p><p>of equities near the market trough in late 2002! That a director</p><p>of investment at Allianz cannot tell the difference between price</p><p>and value does little to inspire confidence (hint: the latter doesn’t</p><p>fluctuate with the daily moods of the market). In short, there is</p><p>a good chance that the capital cycle in private equity, as in hedge</p><p>funds, is about to turn nasty.7</p><p>4.5 BLOWING BUBBLES (MAY 2006)</p><p>Several indicators of speculative activity suggest a market peak has been</p><p>reached</p><p>“I’m forever blowing bubbles, pretty bubbles in the air,</p><p>They fly so high, nearly reach the sky,</p><p>Then like my dreams they fade and die,</p><p>Fortune’s always hiding, I’ve looked everywhere,</p><p>I’m forever blowing bubbles, pretty bubbles in the air.”</p><p>Chant of West Ham football supporters</p><p>The recent crack in the markets had to some extent been foreshadowed</p><p>in recent months by signs of excessively confident behaviour from market</p><p>7 In retrospect, Marathon failed to anticipate the extent to which private equity firms</p><p>would be bailed out by unconventional monetary policies following the financial crisis.</p><p>They remain some of the largest and least deserving beneficiaries of ultra-low interest rates</p><p>and quantitative easing.</p><p>ACCIDENTS IN WAIT ING 127</p><p>participants. Given the capital cycle focus of our firm, we have always had</p><p>a strong interest in identifying bubbles. Recent speculative activity in com-</p><p>modities, emerging markets, hedge funds, IPOs and, of course, private</p><p>equity all suggest a market peak has been reached. Current evidence of mar-</p><p>ket froth can be found in:</p><p>1. Commodity bubbles</p><p>The gold price has recently touched a 25-year high, while the prices of cop-</p><p>per, zinc and other base metals have all risen vertically for several months.</p><p>Most recently, however, commodity prices seem to have gone into overdrive</p><p>as natural strong user demand (mostly from China) has been exacerbated by</p><p>speculative demand from financial market participants. Copper is trading</p><p>at a premium to the face value of the coinage. It now pays to melt down pre-</p><p>1992 British pennies, as well as US cents and nickels. The steep rises in com-</p><p>modity prices in recent weeks remind us of the intraday spikes in Internet</p><p>stocks in the last few weeks of the 2000 tech bubble. It is rather ominous</p><p>that the pink paper launched a new supplement, entitled “FT Copper,” on</p><p>May 10, two days before copper touched an all-time high only to plummet</p><p>subsequently by 14 per cent.</p><p>2. Private equity mania (I)</p><p>In the last few months, some large and well-established private equity groups</p><p>– namely KKR and Apollo – have taken advantage of abundant market</p><p>liquidity and the allure of their own historical track records to list funds that</p><p>invest in their own funds. Needless to say, these funds charge management</p><p>fees on top of the fees already charged by the underlying funds. KKR initially</p><p>aimed to raise $1.5bn, but interest was so strong they increased the amount</p><p>to $5bn. After Citigroup and other bankers took $270m (5.5 per cent of net</p><p>asset value) for placing fees, KKR’s fund is now trading at a discount to the</p><p>issue price. Nice money if you can get it! Incidentally the Apollo fund is set</p><p>to pay away 6 per cent in fees to Goldman Sachs and friends.</p><p>3. Private equity mania (II)</p><p>A few weeks ago, Blackstone, one of the world’s largest private equity groups,</p><p>invested €2.7bn for a 4.5 per cent stake in Deutsche Telekom, the German tele-</p><p>phone operator. Deutsche Telekom is a publicly traded company that index</p><p>funds (no fee) and many long-only (low fee) managers are free to invest in. Yet</p><p>CAPITAL RETURNS128</p><p>Blackstone paid a 2.6 per cent premium for its stake and has agreed to be locked</p><p>up for two years – its consolation prize being the possibility of getting a board</p><p>seat on a 20-person German board. The shares are trading 11 per cent below</p><p>Blackstone’s purchase price. This is by far the largest investment made by a pri-</p><p>vate equity outfit in a listed equity. Why their private equity clients should pay</p><p>exorbitant fees for this kind of investment is difficult to comprehend. To us, the</p><p>DT deal suggests that buyout groups now have more money than ideas.</p><p>4. IPO frenzy</p><p>The IPO calendar has suddenly exploded. Marathon’s proprietary IPO</p><p>indicator – namely the size of the pile of issue prospectuses by our desks</p><p>– which worked so well in the TMT bubble, is flashing a strong warning</p><p>sign. Interestingly the industry composition of the IPOs has shifted mark-</p><p>edly from the last bubble, and now the main areas of capital raising include</p><p>the energy, commodity, utility and specialist financials industries.</p><p>In the case of the latter, specialist fund management groups and fund of</p><p>fund managers are opportunistically raising money or selling out. One list-</p><p>ing last March that caught our interest was that of a Swiss-based entity, called</p><p>Partners Group, which manages funds of funds in private equity and hedge</p><p>funds. At the year end, Partners had assets under management (AUM) of SFr</p><p>11bn and 2005 revenues of SFr 125m. After the first day’s trading, in which</p><p>the shares popped 25 per cent, Partners was valued at SFr 2.1bn, a staggering</p><p>19 per cent of AUM and nearly 17 times revenue.</p><p>At around the same date, Charlemagne Capital went public on the</p><p>London Stock Exchange. This fund management business was founded by</p><p>some of those who had been behind the Regent Pacific group and the now</p><p>defunct Regent Eastern European leveraged debt fund. Charlemagne special-</p><p>izes in investing in the hot Eastern European emerging markets. Its AUM has</p><p>grown from $250m in 2000 to $5bn today. The current share price values the</p><p>fund manager at some 10 per cent of AUM. Two-thirds of last year’s profits</p><p>came from performance fees. The IPO provided the opportunity for insiders</p><p>and directors to sell between 25 per cent and 33 per cent of their holdings in</p><p>the company. Following the emerging market turbulence of the last few days,</p><p>Charlemagne’s stock is down 32 per cent in the seven weeks since listing.</p><p>5. M&A Mania (I)</p><p>Another indication of market froth is the return of animal spirits in the merg-</p><p>ers and acquisition world, where activity has moved back up to levels last</p><p>ACCIDENTS IN WAIT ING 129</p><p>experienced in the 1999–2000 technology bubble. According to Thomson</p><p>Financial, announced M&A volumes in Europe in Q1 2006 amounted to</p><p>some $437bn, which is 240 per cent above the same period last year. It is</p><p>conventional wisdom that M&A destroys value over the long-term, which</p><p>is why the share price of an acquiring company normally falls when a deal</p><p>is announced. Yet we’ve recently observed several cases when the acquirer’s</p><p>stock has climbed on the announcement of a bid, even it is paying a large</p><p>premium for the target company. For instance, when Ferrovial, a Spanish</p><p>infrastructure group, announced it was buying the somewhat larger British</p><p>airports group, BAA, at a 28 per cent premium to the undisturbed share</p><p>price, Ferrovial’s own share price climbed by nearly 6 per cent. Likewise</p><p>when Mittal Steel announced a bid for rival steelmaker Arcelor, its shares</p><p>rose by 14 per cent over a 48-hour period.</p><p>6. M&A Mania (II)</p><p>M&A deals devoid of strategic logic or potential cost savings is a strongly devel-</p><p>oping theme. We have recently witnessed an Australian infrastructure fund</p><p>buying a national telecom operator in Ireland and a similar Singapore entity</p><p>buying a UK ports operator in combination with the private equity arm of an</p><p>investment bank. In both cases, large acquisition premiums were paid, despite</p><p>the absence of synergies. The tax savings from leveraging these companies after</p><p>they’ve been taken private can hardly justify these hefty takeover premiums.</p><p>7. Retail exuberance</p><p>No discussion of stock market excess would be complete without reference to</p><p>the antics of the retail investor. After the debacle of their day-trading experi-</p><p>ences at the turn of the century, retail investors have finally recovered their</p><p>appetite for equities, their spirits lifted by US house prices at record levels</p><p>and an equity market that has been rising steadily for over 18 months. In</p><p>the US, Charles Schwab recorded triple the commission income in February</p><p>versus three years ago. The retail crowd is currently behind some 60 per cent</p><p>of option trades on the NYSE, where turnover has been rocketing. It comes</p><p>as no surprise that emerging markets have caught the eye of Main Street,</p><p>given emerging’s strength over the last few years (from its low in 2003 to the</p><p>recent peak, the MSCI Emerging Index rose by 240 per cent, while S&P 500</p><p>is up only 63 per cent from its 2003 trough). In the first ten weeks of this year,</p><p>emerging market funds attracted more in-flows from US investors than for</p><p>the whole of 2005, which itself was a record year.</p><p>CAPITAL RETURNS130</p><p>8. Insiders out</p><p>Directors’ dealings have also been sending some strong signals of late. The</p><p>level of insider selling has risen steadily over the last several months. The</p><p>most recent monthly statistics for the UK show that directors sold 16 times</p><p>as many shares as they bought in April. This compares with a ratio of lower</p><p>than four times a year ago. Although the ratio of insiders’ purchases to sales</p><p>is almost always skewed towards selling, as directors tend to accumulate free</p><p>or cheap shares from options and incentive plans over the years, the current</p><p>level of insiders exiting is pronounced.</p><p>All of the above, combined with the usual anecdotal signals transmit-</p><p>ted in meetings with companies and sell-side practitioners, suggests that</p><p>May 2006 has represented something of a market peak.8 It is always difficult</p><p>to predict market turns, but the signs of excessive and hubristic behaviour</p><p>should serve as a warning. The period of easy money which has fuelled much</p><p>of this speculative activity may be coming to an end, and if easy money con-</p><p>tinues it will probably be for bad reasons.</p><p>4.6 PASS THE PARCEL (FEBRUARY 2007)</p><p>The securitized debt markets are responsible for the private equity mania</p><p>Rarely a day goes by without some rumour of an imminent private equity</p><p>bid. The size of the prey has risen to include companies which are perceived</p><p>as national institutions (in the UK, they include BAA, the airports group,</p><p>and Boots, the high street chemist). This has led to public complaints against</p><p>asset stripping and tax evasion by private equity “locusts.” In the UK, ire is</p><p>now being directed at the principals of the private equity firms, who, being</p><p>rich and foreign, make perfect scapegoats.</p><p>We suspect, however, that the real villain of the piece, if there has to be</p><p>one, is the debt market. Debt provides most of the firepower for buyouts.</p><p>Lower spreads and more lax lending terms are the magic inputs that make</p><p>the high projected returns in private equity deals still materialize despite</p><p>ever giddier transaction prices. In short, the key to understanding the pri-</p><p>vate equity business lies in what is going on in the credit world.</p><p>First, credit spreads have compressed. This is a global rather than</p><p>European phenomenon, which a senior Moody’s analyst at a recent</p><p>8 Calling stock market peaks is a perilous activity. As it turned out, the S&P 500 contin-</p><p>ued to climb until October 2007, at which point the S&P 500 was some 22 per cent higher</p><p>than its level at the time of writing.</p><p>ACCIDENTS IN WAIT ING 131</p><p>conference</p><p>ascribed to the “savings glut” coming out of Asia and the Middle</p><p>East. Too much money has been chasing too few “quality” financial assets.</p><p>In the European credit markets, there has also been a decline in the propor-</p><p>tion of buyout finance provided by commercial banks. The banks’ share</p><p>of leveraged loans has declined from over 90 per cent at the start of the</p><p>decade to less than 60 per cent today. In place of banks, a growing share of</p><p>the European buyout debt market has been taken by the securitized credit</p><p>vehicles – namely, collateralized debt obligations (CDOs) and collateral-</p><p>ized loan obligations (CLOs) – and by hedge funds. This development in</p><p>the credit markets occurred in the US many years earlier. In Europe, the</p><p>recent trend has been more exaggerated in the riskier tranches of acquisi-</p><p>tion finance where traditional bank lenders have largely disappeared over</p><p>the past 18 months.</p><p>Gone are the days when European banks hung onto loans because they</p><p>prized the associated corporate relationships, not to mention the net interest</p><p>income. There are a number of implications to these developments. First,</p><p>there is the moral hazard aspect. As banks hold on to less of the debt that</p><p>they originate, they are bound to have less concern about longer-term credit</p><p>quality. A recent survey by the UK’s Financial Services Authority found that,</p><p>on average, banks distribute 81 per cent of their exposure to their largest</p><p>buyout transactions within 120 days of finalizing the deal. Anecdotal evi-</p><p>dence suggests to us that this originate-then-distribute model is leading to a</p><p>decline in the quality of lending.</p><p>For instance, Svenska Handelsbanken, a prudent institution and the only</p><p>Swedish bank to come through the early 1990s banking crisis unscathed, is</p><p>currently experiencing a loss of market share in the corporate loan market in</p><p>Sweden. The bank has a policy of not entering into a loan agreement unless</p><p>it is prepared to keep the loan on its books. It is tempting to conclude that</p><p>its recent loss of market share is due to competing banks adopting the “pass-</p><p>the-parcel” business model and the resultant lowering of credit standards.</p><p>We’ve noted elsewhere the appearance of off-the-shelf loan packages to fund</p><p>private equity deals offered by fee-hungry investment banks. Staple finance</p><p>is no doubt used to extract the highest possible price from potential bidders.</p><p>One can have little doubt that the investment banks which provide such debt</p><p>don’t hold on to it for long.</p><p>More evidence of declining credit standards was provided by a recent</p><p>article in the Financial Times, where a City lawyer bemoaned that nowadays</p><p>no one seems to be negotiating over intercreditor arrangements relating to</p><p>potential corporate defaults. After sending out a draft agreement on a loan to</p><p>some 50 funds, the lawyer received no comments on the terms of the default</p><p>CAPITAL RETURNS132</p><p>arrangements. In the past there would have been a tussle over every clause.</p><p>A recent survey undertaken by Standard & Poor’s, the credit ratings agency,</p><p>found that the proportion of senior corporate debt being fully amortized had</p><p>fallen from 41 per cent in 2002 to 25 per cent in 2006. Another finding was that</p><p>the proportion of excess cash flow swept into debt amortization for LBO firms</p><p>has declined, leaving more money available for dividends to buyout sponsors.</p><p>For the banks engaging in this pass-the-parcel game, there is always the</p><p>risk of being caught at the point when the credit market turns. Furthermore,</p><p>it may be that the banks have not been as clever as they claim in getting rid of</p><p>potentially toxic credit risks. Once offloaded, the securitized debt may end</p><p>up back at the same bank’s proprietary trading desk. A recent FSA survey</p><p>of banks found that only 50 per cent of respondents were able to provide an</p><p>indication of where they believed the debt had been distributed to. Andy</p><p>Hornby, chief executive of HBOS, has said that the matter of where leveraged</p><p>lending risk ends up is one of the biggest issues currently facing UK banks.9</p><p>For private equity players, the attitude of making hay while the sun</p><p>shines seems wholly appropriate, although a scenario of rising defaults is</p><p>unlikely to leave them unscathed. From the standpoint of an investor in</p><p>listed equities, however, it appears sensible to maintain a cautious stance</p><p>towards the European financial sector. Bank assets continue to reach new</p><p>highs despite the widespread adoption of originate-then-distribute bank-</p><p>ing practices. Passing on risk, however, may prove easier than passing on</p><p>blame.</p><p>4.7 PROPERTY FIESTA (FEBRUARY 2007)</p><p>Over the past few years the Spanish have gone property mad</p><p>“A tree that grows crooked will never straighten its trunk”</p><p>Spanish proverb</p><p>Our attention was drawn recently to Astroc Mediterraneo, a Spanish real estate</p><p>developer, which IPO’d in the early part of last year to little fanfare. Even by the</p><p>standards of the current bull market in Spanish equities, the share price perfor-</p><p>mance of Astroc has been nothing less than spectacular. Its stock has climbed</p><p>more than tenfold since flotation, giving the company a market capitalisation</p><p>9 Hornby might have spent his time looking for risks closer to home. HBOS eventually</p><p>failed as a result of “reckless lending policies pursued by HBOS Corporate Division,” accord-</p><p>ing to a UK Parliamentary Report.</p><p>ACCIDENTS IN WAIT ING 133</p><p>of some €8–9bn, which makes it the fifth largest property company in Europe</p><p>by value. Chairman and founder Enrique Banuelos, who has a 51 per cent stake,</p><p>has suddenly become one of the richest men in Spain. Management is taking</p><p>advantage of this strong market performance to issue another €2bn of shares.</p><p>Other Spanish property companies are similarly hot. Metrovacesa,</p><p>Europe’s largest office landlord, currently trades at 100 per cent premium</p><p>to its net asset value – a pretty hefty premium to other European property</p><p>companies, although one partly explained by a battle for control of the com-</p><p>pany between its two largest shareholders. Rising share prices in the sector</p><p>have attracted new capital. There were four IPOs of the Spanish property</p><p>companies last year, which equals the total number of listings in the sector</p><p>over the previous four years.</p><p>These stories illustrate a feature of Spain which will be obvious to any</p><p>recent visitor – over the past few years the country appears to have gone</p><p>property mad. Cranes abound and every major city centre has turned into a</p><p>huge building site. Depending on which estimate one believes, construction</p><p>comprises between 15 per cent and 20 per cent of Spain’s economic output,</p><p>compared to a European average of well below 10 per cent. And though it has</p><p>less than 15 per cent of Western Europe’s population, Spain now accounts for</p><p>fully half of the Continent’s annual cement consumption.</p><p>One reason for the construction frenzy is that Spain has been the</p><p>grateful recipient of some two-thirds of the Cohesion Funds doled out by</p><p>the European Union over the past few years, alongside smaller economies</p><p>such as Greece, Portugal and Ireland. This money has been spent on roads,</p><p>bridges, airports and other big ticket infrastructure projects. As the Spanish</p><p>share of the EU funds begins to wind down in favour of worthier recipients,</p><p>the Spanish government plans to increase its own infrastructure budget to</p><p>take up some of the slack.</p><p>Then there’s the booming market for residential construction. The sheer</p><p>scale of building in Spain is fairly breathtaking: some 800,000 housing starts</p><p>a year accounting for around one-third of the new houses being built across</p><p>Europe. The Spanish housing stock has doubled since 1997. This partly reflects</p><p>external demand, notably the number of second homes purchased by Britons,</p><p>Germans, and Scandinavians, and strong immigration. Spain’s economic boom</p><p>has attracted large numbers of workers from outside the EU, and immigrants</p><p>have risen from 2 per cent of the population in 2000 to over 9 per cent today.10</p><p>10 As it turned out, much of this immigration was related to Spain’s housing boom. After</p><p>the bubble burst, this migration trend reversed course and in 2013 more than half a million</p><p>foreigners left the country.</p><p>CAPITAL RETURNS134</p><p>With confidence high and immigrants still flooding across the bor-</p><p>ders, is there any reason to believe the boom cannot continue? For a start,</p><p>the house price inflation seems to be slowing. Household debt has reached</p><p>130 per cent of disposable income, up nearly 50 percentage points since</p><p>2001, and one of the highest levels in Europe. Since Spain is locked into the</p><p>euro, interest rates are well below what would appear appropriate for such</p><p>a strongly growing economy. While debt service costs remain relatively</p><p>affordable, there comes a point when households simply do not want to take</p><p>on any more debt. Another concern is that Spanish property is no longer</p><p>such good value for foreigners looking to buy holiday homes – many might</p><p>prefer cheaper alternatives in the Mediterranean, as can be found in Greece,</p><p>Turkey and Croatia.</p><p>A slower pace of housing construction would be bad news for many</p><p>of Spain’s municipalities, which derive a significant chunk of income (no</p><p>one seems to know quite how much) from selling building permits to eager</p><p>developers. While most of this is above board, this is big business with some</p><p>murky dealings – when a scandal broke over illegal development in the</p><p>southern city of Marbella a couple of years back, the authorities’ investiga-</p><p>tion ended with the arrest of the mayor. A country in which it seems difficult</p><p>to get anyone to accept a €50 or €100 note is said to host around quarter of</p><p>the entire €500 note issue. No doubt most of this cash is floating around the</p><p>construction industry in one way or another.11</p><p>Spain’s economy has become dependent on the construction industry,</p><p>which employs around 22 per cent of the workforce. Unlike Ireland, the</p><p>other formerly peripheral European economy which has seen very strong</p><p>growth for the past few years, Spain hasn’t enjoyed anything like the same</p><p>productivity gains. While immigration has kept a lid on wage rises to some</p><p>extent, unit labour costs are still climbing at twice the Eurozone average,</p><p>11 The collapse of Spain’s property boom has opened a can of worms, which have writhed</p><p>for several years under an increasingly hostile public glare. Several corruption scandals came</p><p>to light in October 2014. That month, Spain’s bank bail out fund approached prosecutors</p><p>regarding €1.5bn worth of apparently irregular real estate and debt operations at two local</p><p>savings banks (known as “cajas”). At around the same time, dozens of persons were arrested</p><p>across Spain following an investigation into local government corruption involving coun-</p><p>cillors, civil servants, builders and sundry others. Adding to an already turbulent month, a</p><p>former chairman of Bankia (a financial conglomerate created in 2010 out of several failed</p><p>savings banks) and a former CEO of one of the cajas folded into Bankia were summoned</p><p>before a judge to answer questions about a scandal involving dozens of Bankia executives –</p><p>all political appointees of local parties and trade unions – who had allegedly spent millions</p><p>of euros of the bank’s money, using so-called “black credit cards.” Public disgust with cor-</p><p>ruption in Spain has contributed to the rise of the radical left-wing party, Podemos.</p><p>ACCIDENTS IN WAIT ING 135</p><p>which is making Spain an increasingly uncompetitive place, especially given</p><p>the lack of productivity growth. One indication of this is the fact that foreign</p><p>direct investment has more than halved from 4 per cent of GDP in 2000 to</p><p>less than 2 per cent in 2005, as foreign companies look for more competitive</p><p>places to invest. If Spain had a floating currency, one would expect this com-</p><p>bination of relatively high inflation and low productivity growth to be offset</p><p>by a decline in the exchange rate. Spain, of course, is stuck in the euro and</p><p>can’t devalue to restore its lost competitiveness.</p><p>While Spain’s economy continues to grow at well above the European</p><p>average, increasingly the growth has been funded by borrowing on the part</p><p>of both corporations and households. The effect of this is that Spain’s cur-</p><p>rent account deficit – which measures the amount an economy consumes</p><p>and invests relative to what it produces and saves – has ballooned, reaching</p><p>a fairly remarkable 8.8 per cent of GDP at the end of 2006, higher even than</p><p>the US in percentage terms (the US current account deficit is 6.8 per cent). In</p><p>absolute dollar terms, Spain’s current account deficit is the second largest in</p><p>the world, worsted only by that of the US.</p><p>As European interest rates edge upwards, servicing Spain’s debt burden</p><p>is becoming more painful. It is difficult to see how it is sustainable. A soft</p><p>landing scenario is possible, but that would require a long period of below</p><p>average inflation and wage growth without overly damaging consumer and</p><p>business confidence, a combination which is difficult to envisage. It may well</p><p>be that much tougher times lie ahead for the Spanish economy, and indeed</p><p>for Señor Banuelos.12</p><p>4.8 CONDUIT STREET (AUGUST 2007)</p><p>The fragmented nature of the German banking system makes it especially</p><p>accident prone</p><p>There is a rather weary inevitability in the fact that the two primary European</p><p>casualties (so far) of the current turmoil in the credit markets have been</p><p>German banks, and mid-sized ones at that. Both IKB Deutsche Industriebank,</p><p>a listed specialist lender to the mid-market corporate segment, and Sachsen</p><p>LB, one of Germany’s accident-prone Landesbanken, have had to be bailed out</p><p>by a combination of the larger German banks and state institutions. The fault</p><p>12 Shortly after this article appeared, shares in Astroc Mediterraneo plunged by 70 per</p><p>cent in a week following an auditor’s report which suggested that Mr Banuelos had purchased</p><p>property from his own company equivalent to 65 per cent of annual turnover (Reuters, 26</p><p>July 2007).</p><p>CAPITAL RETURNS136</p><p>lines of German banking appear to lie in the fragmented nature of the industry,</p><p>together with the tendency of German bankers to be duped by City slickers.</p><p>At the beginning of the decade, several German banks faced substantial</p><p>losses on their property lending. Only a few years before that, one of the</p><p>largest Landesbanken, WestLB, was forced to write down its private equity</p><p>investments. This time around, the problems are related to investment vehi-</p><p>cles called conduits, which sat mostly off the banks’ balance sheets. Here’s</p><p>how they got into trouble. IKB and Sachsen financed their conduits in the</p><p>asset-backed commercial paper market. Such funding is usually cheap and</p><p>short-term, typically 90 to 180 days maturity. The loan proceeds are then</p><p>invested in higher-yielding, longer-term assets, such as collateralized debt</p><p>obligations or asset-backed securities, with the sponsoring bank only having</p><p>to post a small amount of collateral to repay the commercial paper holders</p><p>in case of problems. So as long the commercial paper could be rolled over at</p><p>a cost of funding below the income generated from the longer-term assets,</p><p>these conduits generated sizable profits for the banks.</p><p>Over the past four to five years, a number of European banks have been</p><p>very active in this market, with some $510bn of asset-backed commercial</p><p>paper sitting in European conduits, up from only $200bn five years ago and</p><p>accounting for nearly half of the $1.2tr asset-backed commercial paper mar-</p><p>ket. Sachsen and IKB were enthusiastic adopters of the conduit model. IKB’s</p><p>conduit, Rhineland Funding, started in 2002 and was expanded rapidly,</p><p>reaching €14bn in assets by the middle of this year. At this point, IKB’s own</p><p>exposure to Rhineland was €8bn, compared to its combined Tier 1 and 2</p><p>capital of only €4bn and a peak market capitalisation of less than €3bn. The</p><p>story was similar at Sachsen, whose Ormond Quay conduit, originated in</p><p>2004, grew to €17bn</p><p>or a quarter of the bank’s total assets of €68bn and as</p><p>much as 11 times their equity capital.</p><p>While things were going well, this level of exposure didn’t seem problem-</p><p>atic. The credit merry-go-round, however, stopped abruptly a few weeks ago</p><p>when concerns surfaced about just how much of the “investment grade” securi-</p><p>ties held in the conduits had exposure to the US subprime mortgages, which</p><p>themselves might not be quite as secure as their ratings suggested. Suddenly the</p><p>renewal of funding in the commercial paper market became impossible and,</p><p>with liabilities many times what they could afford to pay, both banks would</p><p>have defaulted on the spot had it not been for the hastily-arranged bail-outs.</p><p>Although IKB and Sachsen LB are the most extreme examples, they</p><p>are by no means isolated cases in Germany. Indeed the German state banks</p><p>appear to have taken the conduit model particularly to heart. None of the</p><p>eight largest Landesbanken is among the 30 largest banks in Europe, yet</p><p>ACCIDENTS IN WAIT ING 137</p><p>they all figure in the top 30 when it comes to the use of conduits. Sachsen</p><p>LB’s Ormond Quay was one of the largest European conduits of all, which</p><p>is astonishing given that Sachsen is a small bank even by German, let alone</p><p>European, standards.</p><p>So what is it about the German market structure which makes it suscep-</p><p>tible to these pitfalls? Part of the problem lies with the fragmented nature of</p><p>the German banking system. Unlike most other European markets, where</p><p>a small number of highly profitable nationwide banks have emerged, in</p><p>Germany even the largest private sector banks have only single digit market</p><p>shares. The ability to compete in corporate lending became harder for the</p><p>regional Landesbanken after the ending of state guarantees which allowed</p><p>them to borrow more cheaply in the wholesale markets and undercut private</p><p>sector banks when lending to corporations. The European Union put a stop</p><p>to this in 2005, squeezing margins.</p><p>Sachsen, the only Landesbank in former East Germany, has had a</p><p>particularly tough task trying to grow a lending business in what is still a</p><p>depressed region. Growing the loan book in other parts of Germany, as well</p><p>as an aggressive expansion into investment products, such as conduits, may</p><p>have seemed like a sensible solution. Similarly, IKB’s growth was constrained</p><p>by the willingness of its 38 per cent shareholder, the state-owned bank KfW,</p><p>to stump up additional funds for conventional expansion. Instead, it turned</p><p>to growth through off-balance sheet vehicles which was not supervised by</p><p>domestic regulators and required little capital apart from a small back-stop</p><p>loan facility (which itself could be syndicated).</p><p>German banks are also exposed to moral hazard – the ability to take risk</p><p>at other people’s expense. This may explain why they continue to make such</p><p>gross blunders. It must have been very tempting for the Landesbanken and</p><p>other public sector banks, such as IKB, to take on substantial risks, know-</p><p>ing that the German state, which is concerned about availability of credit for</p><p>Mittelstand businesses, would never have allowed them to fail.</p><p>Furthermore, managers had little or no equity stake in their banks.</p><p>Management incentives at IKB were geared around an annual return on</p><p>equity target. This only increased the attraction of conduits which could</p><p>manufacture profits using only small amounts of bank capital. In its most</p><p>recent financial year, over 40 per cent of IKB’s profits came from its Structured</p><p>Finance Division which, among other things, contained conduit activities as</p><p>well as assets in structured investment vehicles (SIVs) that are constructed</p><p>along much the same lines as the conduits. The profitability of this arm of</p><p>the bank was more than twice that of its other banking lines.</p><p>CAPITAL RETURNS138</p><p>Nor must we overlook the possibility that German bankers were simply</p><p>ignorant – they did not understand the complex risks that they were taking</p><p>on. In the case of IKB, which had been securitizing and selling on books</p><p>of their loans to the Mittelstand companies since the end of the 1990s, the</p><p>conduit business must have seemed familiar. This bank actually prided itself</p><p>on its risk management – 25 pages of its most recent annual report are dedi-</p><p>cated to showing how various risk committees supervised banking activities</p><p>to ensure that risk was minimised and much was made of their expertise in</p><p>the area of securitized finance.</p><p>The perception that the risk was being tightly controlled was doubtless</p><p>encouraged by the investment banks, which generated substantial fees con-</p><p>structing products to put into Rhineland, Ormond Quay and its other con-</p><p>duits. Our suspicions in this respect have been alerted by the curious names</p><p>of some of the German conduits. For example, one goes by the rather dubious</p><p>title of “Poseidon.” Did someone think this vehicle might end up underwater?</p><p>Another conduit at the Landesbank Berlin rejoices in the name of “Check Point</p><p>Charlie.” To our mind, these suspect names appear to have been conjured up</p><p>by some Canary Wharf wit, rather than originating in Hamburg or Berlin.</p><p>While some might argue that German banks have improved in recent</p><p>years, (none of the largest listed banks so far seem to have been seriously</p><p>caught up in the mess this time around), as long as the industry structure</p><p>remains fragmented, it seems that German bankers are destined to play the</p><p>role of the patsies in the sharpers’ game of global finance.</p><p>4.9 ON THE ROCKS (SEPTEMBER 2007)</p><p>Northern Rock’s fickle funding source made the UK bank vulnerable to a</p><p>credit crunch</p><p>A run on a large Western European bank is not a usual occurrence – the last</p><p>one in the UK happened in 1866. So it seems a subject worthy of review both</p><p>from the perspective of the Northern Rock organization itself (what drove</p><p>people to do what they did?), and also in the context of Marathon’s long-</p><p>standing underweight in European financial stocks.13 Our banking expo-</p><p>sure currently stands at 14 per cent of the portfolio versus a sector weighting</p><p>of 29 per cent in the index benchmark.</p><p>Our meetings with Northern Rock over the years had left us baffled,</p><p>rather than particularly apprehensive about the sustainability of its business</p><p>13 In September 2007, Northern Rock suffered a bank run and was forced to turn to the</p><p>Bank of England for liquidity. The following February, Northern Rock was nationalised.</p><p>ACCIDENTS IN WAIT ING 139</p><p>model. No investment was ever made in the company. The fact that the</p><p>bank was borrowing short and lending long and exploiting the latest finan-</p><p>cial innovations (a.k.a. pass-the-hot-potato) did not strike us as particularly</p><p>abnormal in the context of current banking norms. Innovation in capital</p><p>markets and the pursuit of fee-driven approaches which shift risk to those</p><p>least capable of evaluating it is a widespread phenomenon, not one isolated</p><p>to a North of England mortgage originator.</p><p>Consider that Deutsche Bank generates almost 80 per cent of its income</p><p>from non-interest sources, compared with a figure of 49 per cent 12 years</p><p>ago. Our meeting note from the October 2006 Deutsche Bank annual inves-</p><p>tor day recorded the opinion that “any blow up in CDOs, securitization, dis-</p><p>tributed debt (the areas where they claim to have a competitive advantage)</p><p>is likely to be extremely damaging from a credit and ongoing fee generation</p><p>perspective, since the bank appears to be positioned as the scrum half in the</p><p>pass-the-hospital-pass game of modern debt markets.”</p><p>What did strike us in our meetings with Northern Rock was how</p><p>atypical the young, shaven-headed CEO [Adam Applegarth] was com-</p><p>pared with one’s image of a traditional banker. After a one-on-one meet-</p><p>ing, the writer of our meeting note mused that the “main fear is that he is a</p><p>Illustration 4.1 Northern Rock headquarters</p><p>Source: Getty Images International.</p><p>CAPITAL RETURNS140</p><p>bit too clever by half.” The alarm bells might also have been set off had we</p><p>seen plans</p><p>of the company’s new £35m head office. Perhaps a photograph</p><p>of every company’s HQ should be studied before making an investment</p><p>to see how it compares with the high-water mark set by Tesco’s shabby</p><p>HQ in suburban Cheshunt, England. One could also point to what are</p><p>nowadays politely described as governance issues – for example, the fact</p><p>that the chairman of Northern Rock is best known as writer of popular</p><p>science books.</p><p>With hindsight, the extreme dependence on a fickle source of fund-</p><p>ing and lack of business diversification made Northern Rock vulnerable to</p><p>the new scenario which played out in August 2007. There are a number of</p><p>financial institutions which have stayed on the sidelines during the period</p><p>of credit excess and now stand to benefit from current market conditions.</p><p>This is particularly true for European regional retail banks, like Svenska</p><p>Handelsbanken, which has been losing market share in corporate lending.</p><p>Other possible winners are companies whose business models in some way</p><p>resemble that of Northern Rock and are currently being unfairly marked</p><p>down by association. An example of this, in our view, is Provident Financial,</p><p>the dominant player in the UK home credit market. The company is tainted</p><p>in the first instance with the subprime moniker and by virtue of the fact that</p><p>its funding profile is relatively short duration. The reality is of a reverse carry</p><p>trade, in the sense that Provident’s lending profile is very short-term com-</p><p>pared with its borrowing profile, the exact opposite of the Northern Rock</p><p>case.14</p><p>While there are some individual instances worthy of attention, our over-</p><p>all sense is that underweighting of the financial sector is the correct position</p><p>to maintain at this point in time. A number of commentators have drawn the</p><p>distinction between liquidity risk (lack of wholesale funding) and solvency</p><p>or the credit quality of the underlying collateral (whether the mortgage is</p><p>ever repaid). The current crisis is limited to liquidity risk, so the argument</p><p>goes, and one has nothing to fear regarding the asset side of banks’ balance</p><p>sheets. Yet the correlation between ever more abundant liquidity and asset</p><p>price appreciation over the past decade suggests to us that asset prices are</p><p>vulnerable in the absence of generous support from lenders. From this per-</p><p>spective, it is better to wait for the rise in non-performing loans and asset</p><p>write-downs, before raising our exposure.</p><p>14 From September 2007 to December 2014, Provident Financial’s share price rose by 109</p><p>per cent in US dollars, while the MSCI Europe Banks Index declined by 64 per cent.</p><p>ACCIDENTS IN WAIT ING 141</p><p>4.10 SEVEN DEADLY SINS (NOVEMBER 2009)</p><p>How a Swedish bank sailed through the financial crisis unscathed</p><p>“Money, money, money, must be funny, in the rich man’s world,” chanted</p><p>Abba. Besides this famous band, Sweden has given the world that deadly com-</p><p>bination – dynamite and the safety match. Sweden even managed to detonate</p><p>its own banking system in the early 1990s. One large European financial</p><p>institution, however, which didn’t blow up during the Global Financial Crisis</p><p>is Svenska Handelsbanken, Sweden’s largest bank and a long-term Marathon</p><p>holding. Over the years we have gotten to know the bank quite well. Our</p><p>meetings with management have often provided timely insights into the folly</p><p>of their European banking competitors. A recently published book about the</p><p>bank, entitled A Blueprint for Better Banking, by Niels Kroner, describes the</p><p>history and culture of the bank and, as the title suggests, argues that many of</p><p>the recent problems of the financial system could have been avoided if other</p><p>banks were run in the “Handelsbanken way.”</p><p>Handelsbanken is a very conservatively run, branch-based retail bank</p><p>which was the only major Swedish bank not to break in the Nordic bank-</p><p>ing crisis of the early 1990s. This time around, Handelsbanken has pulled</p><p>through yet again, avoiding the need to raise fresh capital or receive gov-</p><p>ernment support. That puts it on a short list of only three major European</p><p>banks. Handelsbanken’s decentralised business model encourages branch</p><p>managers to make loans based on local, face-to-face knowledge of customers</p><p>rather than relying on centralised credit scoring techniques, as their com-</p><p>petitors do. The bank consistently has the best customer service ratings in</p><p>the industry and the lowest costs (as demonstrated by a low cost to income</p><p>ratio compared with other banks). A few years ago, we asked management</p><p>why (as we had been told) there were holes in the carpets at many of its</p><p>branches. “Carpets don’t make money,” was the reply.</p><p>Having avoided the disasters of its peers, since the beginning of 2007</p><p>Handelsbanken shares have outperformed those of all other major European</p><p>banks. According to Niels Kroner, Handelsbanken has succeeded by not com-</p><p>mitting what he calls the Seven Deadly Sins of Banking. These are as follows:</p><p>First deadly sin: Imprudent asset-liability mismatches on the balance sheet</p><p>Obviously there are many cases around the world of how borrowing short</p><p>and lending long can go wrong for banks. Recent examples in Europe</p><p>include Northern Rock in the UK and the Irish banks. During the boom</p><p>years, the Irish banks financed household mortgages that had a contrac-</p><p>tual maturity of two decades or more, with commercial paper of less than</p><p>CAPITAL RETURNS142</p><p>one year’s duration. Handelsbanken is acutely conscious of the risks posed</p><p>by asset-liability mismatches. The bank uses a central treasury function to</p><p>match and price deposits and loans according to their respective maturities.</p><p>In this way, branches cannot report a profit by simply engaging in maturity</p><p>transformation.</p><p>Second deadly sin: Supporting asset-liability mismatches by clients</p><p>The classic example here is foreign currency lending to households in Central</p><p>European countries. Not long ago, European banks were providing low inter-</p><p>est euro and Swiss franc mortgages to Hungarian and Latvian consumers. It</p><p>was unlikely these customers understood the foreign exchange risk they were</p><p>running. Handelsbanken does not engage in such lending, mainly because</p><p>the primary incentive of the branch managers is to eliminate default risk.</p><p>The worst thing a branch manager can do is to run up bad loans. Internally,</p><p>branches are ranked on this measure to shame the underperformers.</p><p>Third deadly sin: Lending to “Can’t Pay, Won’t Pay” types</p><p>Here one immediately thinks of banks lending to subprime borrowers and</p><p>private equity firms. Handelsbanken’s approach is rather to “lend to people</p><p>with money.” Theirs is a niche lending approach rather than a mass mar-</p><p>ket one. In company research meetings over the years, Handelsbanken</p><p>told us that the banking industry had become obsessed with earning a few</p><p>extra basis points of spread each quarter, while losing sight of credit risk,</p><p>namely the chance that borrowers might never be in a position to repay the</p><p>principal.</p><p>Fourth deadly sin: Reaching for growth in unfamiliar areas</p><p>A number of European banks have lost billions investing in US subprime</p><p>CDOs (UBS has blown some $40bn in this manner), having foolishly relied</p><p>on “experts” who told them that these were riskless AAA rated credits, i.e.,</p><p>they outsourced the underwriting decision. In Scandinavia, many banks</p><p>pursued growth in the Baltic states and have suffered as GDP in the region</p><p>has contracted by 15–20 per cent this year (house prices in Latvia are now</p><p>down 70 per cent from the peak). Handelsbanken’s approach to foreign</p><p>expansion, by contrast, has always been one of cautious “organic incremen-</p><p>talism,” as they describe it. The bank largely eschewed the Baltic states as too</p><p>risky. Instead, Handelsbanken expanded its branch network in a number of</p><p>mature Western European markets – including UK, Germany, and Norway</p><p>– where it has been easy to recruit good branch managers among those who</p><p>have grown disillusioned with the centralising tendencies at their old banks.</p><p>ACCIDENTS</p><p>IN WAIT ING 143</p><p>In the UK, Handelsbanken hired local branch managers who brought with</p><p>them their best clients and most highly regarded colleagues.</p><p>Fifth deadly sin: Engaging in off-balance sheet lending</p><p>Recent examples of the cardinal banking sin of off-balance sheet lend-</p><p>ing include the use of conduits and SIVs by European banks. By contrast,</p><p>Handelsbanken’s approach is to accept only risks which it is prepared to hold</p><p>on its balance sheet until maturity and not to lend money to those that are</p><p>in the business of lending money themselves. Incidentally this principle also</p><p>restrained the bank from engaging in pass-the-parcel securitization schemes</p><p>which have had such a damaging effect on underwriting standards across</p><p>the European banking system.</p><p>Sixth deadly sin: Getting sucked into virtuous/vicious cycle dynamics</p><p>The sixth deadly sin is to be seduced by what might be termed Ponzi econom-</p><p>ics. Lending by Scandinavian banks in the Baltic states seemed like a good</p><p>idea for a long time partly because GDP was growing rapidly. The strong eco-</p><p>nomic growth, however, was a function of rapidly growing credit supplied by</p><p>the banks themselves. The fact that every bank was lending in the same mar-</p><p>ket made it feel safe, and for a while the virtuous cycle continued. Real estate</p><p>markets around the world were similarly characterised by the notion that asset</p><p>quality was independent of credit conditions. Handelsbanken prides itself on</p><p>its contrarian streak. It is less prone to high level “strategic” moves (which</p><p>normally entail engaging in happy groupthink) because of its reliance on the</p><p>branch network. The branches have a fairly consistent risk appetite through</p><p>the cycle and so tend to lose market share in frothy times (e.g., during the</p><p>2006–08 period) and gain share when others are unwilling or unable to lend.</p><p>Seventh deadly sin: Relying on the rearview mirror</p><p>A recent expression of this common financial vice includes the widespread</p><p>use of value-at-risk models. Such models tend to be based on a limited amount</p><p>of historic data, which in the years before the crisis were relatively benign.</p><p>True risk was understated. In its 2007 annual report, Merrill Lynch reported</p><p>a total risk exposure – based on “a 95 per cent confidence interval and a one</p><p>day holding period” – of $157m. A year later, the Thundering Herd stumbled</p><p>into a $30bn loss! After house prices have risen by 85 per cent in ten years, as</p><p>they had in the United States, was it realistic to expect a maximum decline</p><p>of 13.4 per cent (Freddie Mac’s worst case scenario)? Handelsbanken deter-</p><p>mined its capital requirements based on more pessimistic crisis scenarios,</p><p>such as a repeat of the Swedish banking crisis.</p><p>CAPITAL RETURNS144</p><p>There are many other ways in which Handelsbanken is different from its</p><p>peers. In its dialogue with investors, bank representatives refuse to engage in</p><p>the game of trying to estimate this year’s profit number. They have no other</p><p>choice, since divisional budgets were abolished in 1972. If managers have</p><p>budget targets, so the thinking goes, it becomes more difficult to stay out of</p><p>the market when pricing is unfavourable.</p><p>Management incentives are also unusual. The bank funds an employee</p><p>profit-sharing scheme called the Oktogonen Foundation, which receives</p><p>allocations when the group’s return on equity exceeds the weighted average</p><p>of a group of other Nordic and British banks. If this criterion is satisfied, and</p><p>it usually is, except at the peak of the cycle, one-third of the extra profits can</p><p>be allocated to Oktogonen subject to a limit of 15 per cent of the dividend to</p><p>shareholders. If the Handelsbanken lowers the dividend paid out to its share-</p><p>holders, no allocation is made to the profit-sharing foundation.</p><p>The foundation channels a large part of its resources into Handelsbanken</p><p>stock and currently holds 11 per cent of the bank’s equity. All employees</p><p>receive an equal part of the allocated amount (without the traditional skew</p><p>towards the upper echelons), and the scheme includes all staff in the Nordic</p><p>countries and, since 2004, in Great Britain. Disbursements are only made</p><p>once a member of staff has reached the age of 60. Employees who have been</p><p>working for Handelsbanken since 1973 have around $600,000 – which turns</p><p>out to be roughly half the value of a Nobel prize – due to them at retirement,</p><p>regardless of whether they have worked as the CEO or as a security guard.</p><p>The system undoubtedly contributes to the bank’s tribal culture and aligns</p><p>employee interests with shareholders.</p><p>Ultimately, Handelsbanken is a wonderful example of a bank with a</p><p>strong culture and management team that allocates capital in an intelligent</p><p>way, with the right incentives and a long-term approach. All of these quali-</p><p>ties appeal to Marathon’s investment philosophy. The valuation remains</p><p>attractive, trading at 1.4 times book value, a P/E of 14 times and a dividend</p><p>yield of 3 per cent. If only more banks were built this way.15</p><p>15 Handelsbanken’s share price rose by 87 per cent in SEK from the date of this article to</p><p>31 December 2014.</p><p>5</p><p>THE L IV ING DEAD</p><p>Capital cycle analysis is strongly influenced by J.A. Schumpeter’s notion of</p><p>creative destruction, namely that competition and innovation produce a</p><p>constantly evolving economy and spur improvements in productivity. From</p><p>this perspective, an economic recession serves a useful function as – to use a</p><p>rather hackneyed image – the forest fire burns away the dead wood and weaker</p><p>trees, allowing healthy young plants to grow and prosper.</p><p>The decline in equity prices following the global financial crisis pre-</p><p>sented a variety of investment opportunities. Some of the best appeared in</p><p>industries where capital was rapidly withdrawn after the bust and consolida-</p><p>tion took place. The experience of Ireland’s banking sector described below</p><p>is a good example of the capital cycle moving into a benign phase. It has not</p><p>been all good news, unfortunately. Several of the pieces in this chapter com-</p><p>ment on how European policymakers have prevented various industries –</p><p>in particular the employment-heavy auto sector and the politically sensitive</p><p>Continental banking sector – from consolidating. As a result, the operation</p><p>of the capital cycle has been arrested. This is bad news for investors as the</p><p>problems of excess capacity and weak profitability have not been addressed.</p><p>It also augurs ill for the eurozone economy, which appears doomed to low</p><p>productivity and weak economic growth. These problems have been exacer-</p><p>bated by the post-crisis policy of ultra-low interest rates which, by lowering</p><p>funding costs, have allowed weak businesses – the corporate zombies – to</p><p>continue limping along.</p><p>CAPITAL RETURNS146</p><p>5.1 RIGHT TO BUY (NOVEMBER 2008)</p><p>Now that signs of speculative excess have been dispelled, the markets look</p><p>attractive again</p><p>The stock market is in a very different place than it was back in May 2006</p><p>[see “Blowing bubbles”], when we observed clear signs of excess. Most of the</p><p>bubble indicators we pointed to then have now turned positive. In addition,</p><p>market valuations suggest that equities are very attractively priced for long-</p><p>term investors.</p><p>The inversion of the earlier bubble signs include:</p><p>1. Commodity price declines: Commodity prices have witnessed</p><p>a dramatic decline which will have beneficial effects on infla-</p><p>tion. At the company level, commodity-related firms are rapidly</p><p>shelving plans to expand capacity. For instance, ArcelorMittal</p><p>has announced significant cuts in output with the aim of stabil-</p><p>ising steel prices as demand evaporates.</p><p>2. Private equity valuations collapse: During the boom period,</p><p>Apollo, KKR and Blackstone all took advantage of record valu-</p><p>ation levels to launch their own private equity IPOs. How the</p><p>mighty titans of finance have fallen! Blackstone shares are down</p><p>81 per cent from the June 2007 IPO. KKR Private Equity Investors</p><p>is down around 90 per cent since listing in April 2006, in line</p><p>with the Apollo</p><p>fund (AP Alternative Assets LP has declined</p><p>86 per cent since May 2006). The Lehman Private Equity Fund,</p><p>which listed in July 2007, has fallen by 80 per cent.</p><p>3. Private equity losses: Back in May 2006, we questioned the wis-</p><p>dom of Blackstone’s purchase of a 4.5 per cent stake in Deutsche</p><p>Telekom. That stake is now registering a loss of around 20 per</p><p>cent on the purchase price (excluding any magnifying effect of</p><p>leverage). The collapse of Washington Mutual cost the TPG buy-</p><p>out group some $7bn in just over five months (of which the TPG</p><p>fund itself lost $1.2bn).</p><p>4. Sunken flotations: Activity in the IPO market has sunk to mul-</p><p>tiyear lows, although there has been significant distressed capi-</p><p>tal issuance, most notably from the financial sector. Flotations</p><p>which epitomised the late market excesses have been particularly</p><p>hard hit: Partners Group, a Swiss-listed fund of funds group, has</p><p>fallen by 60 per cent since its peak, while Charlemagne Capital,</p><p>an emerging market manager, is down 89 per cent.</p><p>THE L IV ING DEAD 147</p><p>5. M&A doldrums: M&A behaviour was another excess indicator</p><p>back in the heady days of 2006, when animal spirits ran wild. We</p><p>noted back then that Ferrovial’s share price had actually climbed</p><p>on the announcement of its leveraged bid for BAA. Ferrovial’s</p><p>stock has since slumped by 77 per cent, as access to credit is cut</p><p>off and the true cost of overpaying for assets is revealed. A recent</p><p>major reversal in the M&A world is the withdrawal of BHP</p><p>Billiton’s bid for Rio Tinto.</p><p>We also complained that many mergers in 2006 produced no</p><p>cost saving but rather appeared to be driven by leverage. We</p><p>now note that Babcock & Brown, the Australian infrastructure</p><p>company, which purchased shares in Eircom from investors,</p><p>including Marathon, has put that investment up for sale less than</p><p>three years after the acquisition at a minimum 40 per cent loss.</p><p>Babcock & Brown’s share price is down 76 per cent, as the market</p><p>has lost confidence in leveraged infrastructure funds.</p><p>6. Directors’ dealings: In the UK, insider purchases were running</p><p>at less than 10 per cent of sellers in April 2006. That has now</p><p>reversed dramatically. Directors’ share purchases in October</p><p>2008 exceeded sales by two to one.</p><p>7. Retail investors burnt: Retail investors injected record sums into</p><p>mutual funds in 2005 and 2006, with a bias towards emerging</p><p>market funds. Emerging markets have not “decoupled” and are</p><p>now 63 per cent lower than the October 2007 peak. Once bitten,</p><p>twice shy. On the retail side, there is a record $4tn reportedly</p><p>parked in money market funds.</p><p>Aside from the disappearance of earlier signs of market excess, market val-</p><p>uations are now compelling. For the first time in 50 years, the yield on US</p><p>Treasuries has fallen below the dividend yield of the S&P 500. The price of</p><p>European equities relative to their ten-year average earnings (a measure known</p><p>as the Graham and Dodd or Shiller P/E ratio) is close to a long-term trough.</p><p>Market liquidity has evaporated. There is a significant shortage of buyers (aside</p><p>from insider buying). Hedge funds face redemptions amounting to perhaps</p><p>one-third of their total assets. In anticipation, many hedge funds have been</p><p>selling assets to raise liquidity. At the corporate level, share buybacks, which</p><p>were running at record levels in 2007, have virtually ceased. Even companies</p><p>with apparently sound balance sheets are suspending their programmes, due</p><p>to the difficulty of accessing funds from banks and the closure of the debt</p><p>markets.</p><p>CAPITAL RETURNS148</p><p>Markets are now restrained by fear and conservatism. Tight liquidity is</p><p>producing great pricing anomalies. Although the macroeconomic outlook is</p><p>bleak, this is clearly discounted in equity prices and there would have to be a</p><p>significant shock to jolt markets further. There have not been such compel-</p><p>ling valuations for equities in a generation. From such a low base, it is diffi-</p><p>cult to believe that investors will not make good returns over any reasonable</p><p>investment time frame.1</p><p>5.2 SPANISH DECONSTRUCTION (NOVEMBER 2010)</p><p>Now that the empire-building antics of Spanish construction firms are over,</p><p>investment opportunities are appearing</p><p>Arriving at Terminal 4 of the Madrid-Barajas airport, a one-kilometre-long</p><p>building with a bamboo-lined gull wing roof and floors of limestone, one gets</p><p>one’s first view of the infrastructure boom enjoyed by Spanish construction</p><p>companies during the “magical years” of economic growth. Finally completed</p><p>by Ferrovial in 2006, the terminal cost of €6.1bn was €2bn over budget. The</p><p>design team of Antonio Lamela and Richard Rogers spared no expense, their</p><p>stylish touches putting in mind the adage about the quality of airport build-</p><p>ings being inversely proportionate to the economic development of a country.</p><p>The boom in expensive civil works has now ended. The Spanish govern-</p><p>ment has finally yielded to pressure to make cuts in its infrastructure budget.</p><p>European Union funding has more or less dried up. Most of the construc-</p><p>tion firms had foreseen the domestic slowdown and had spent a number</p><p>of years diversifying their activities and expanding abroad. Unfortunately,</p><p>the results have been woeful for investors. Share prices in the sector remain</p><p>depressed – in some cases, over 80 per cent below the peak levels. As deep</p><p>pessimism about all things Spanish now prevails, could there be some value</p><p>in the rubble from Spain’s construction bubble?</p><p>Fomento de Construcciones y Contratas (FCC) was one of the first com-</p><p>panies to diversify by assembling a large portfolio of street-cleaning con-</p><p>tracts. Others followed in more capital-intensive service activities, such as car</p><p>parks, water treatment and baggage handling. A number of companies built</p><p>up significant toll road businesses around the world (OHL, Ferrovial, and</p><p>FCC). Others invested in renewable energy (Acciona, ACS, and Abengoa).</p><p>Instead of selling the energy assets at completion, however, the construction</p><p>1 The stock market continued falling until March 2009, bottoming out around 20 per</p><p>cent lower than at the end of November 2008. By the end of 2014, however, the S&P 500 was</p><p>roughly 136 per cent higher than at the time of writing. A case of short-term pains, long-</p><p>term gains.</p><p>THE L IV ING DEAD 149</p><p>firms chose to operate them. They funded this activity largely through debt.</p><p>In fact, during the boom years, Spain’s construction companies became</p><p>a funding source for the government to build roads, airports and energy</p><p>infrastructure. They began to resemble banks, just at the time when Spanish</p><p>banks, with their expanding mortgage books and increasing exposure to</p><p>property developers, were looking more like property companies.</p><p>The ease with which projects could be funded encouraged many con-</p><p>struction companies to make overpriced acquisitions. The Spanish govern-</p><p>ment encouraged the folly by allowing firms to deduct goodwill amortization</p><p>from their taxable profits. A number of firms made spectacularly bad acqui-</p><p>sitions at the top of the cycle, including Ferrovial’s £10.5bn acquisition of</p><p>BAA, owner of London’s Heathrow airport, at a price of 1.3 times the regu-</p><p>lated asset base. Ferrovial today still has debt of €19.5bn, 70 per cent of which</p><p>relates to BAA, and the company’s share price trades 41 per cent below its</p><p>peak. Acciona, a Marathon portfolio holding, entered the bidding war for</p><p>Endesa, Spain’s largest electricity generator, acquiring a 25 per cent stake</p><p>and increasing its debt burden from €8.9bn to €18bn. Fortunately, it was able</p><p>to sell the stake to Enel for a healthy profit, with part of the consideration</p><p>in the form of Endesa renewable assets. Acciona’s share price is nevertheless</p><p>down by 78 per cent from the peak.</p><p>As they diversified and expanded, Spain’s construction companies accu-</p><p>mulated vast quantities of debt, justified on the basis that the companies</p><p>and concessions being acquired were stable enough to bear massive lever-</p><p>age. While this may have been true</p><p>in the early stages of the cycle, such</p><p>was the combination of debt and lofty valuations in later deals that only a</p><p>small decline in operating performance had catastrophic consequences for</p><p>the equity position. When the global financial crisis struck, the construc-</p><p>tion companies’ projections for steadily increasing toll and airport passenger</p><p>traffic looked optimistic. In some cases, the regulatory environment became</p><p>distinctly less benign: Ferrovial, acquirer of BAA, was forced to sell Gatwick</p><p>airport at the market trough, due to competition concerns.</p><p>Other acquisitions were of a more cyclical nature and have suffered</p><p>accordingly. Here, the booby prize is hotly contested. FCC’s €1.09bn pur-</p><p>chase of a majority stake in Barcelona cement company Uniland, increasing</p><p>its exposure to cement in Spain shortly before the implosion of the property</p><p>market, looks hard to beat. FCC’s share price has declined by 78 per cent</p><p>from the peak in 2007. Sacyr Vallehermoso upped its bet on Spanish prop-</p><p>erty rather late in the day and then sought to diversify into concessions and</p><p>services, with its Itinere subsidiary making ludicrous bids at the wrong time</p><p>in the cycle. Its share price is down by 91 per cent.</p><p>CAPITAL RETURNS150</p><p>Now that these empire-building antics are well and truly over, the main</p><p>objective of most Spanish construction companies is to deleverage their bal-</p><p>ance sheets. So far, some have been more successful than others. Ferrovial</p><p>has reduced its parent company debts (i.e., those debts which are non-re-</p><p>course) from €3bn to virtually zero via the sale of toll roads, car parks and</p><p>airport activities. These disposals have been achieved at prices comparable</p><p>with market valuations in June 2007, although one should probably not take</p><p>this to mean that retained assets are also worth peak levels, given that a</p><p>certain amount of cherry-picking of the most saleable assets has taken place.</p><p>Others have been slow to make disposals, hoping perhaps that an economic</p><p>recovery will improve their chances of getting a more reasonable sale price.</p><p>Since management change has not been a big theme at these often fami-</p><p>ly-controlled companies, one suspects that there is an element of denial at</p><p>work. After all, crystallising losses is an admission of failure which is easier</p><p>to achieve if the architects of failure are no longer in their posts.</p><p>From an investment perspective, the sector now warrants close scru-</p><p>tiny. Take the case of Acciona. The company has nearly €8bn of debt, of</p><p>which just over half is non-recourse, being tied to wind energy projects. In</p><p>total, Acciona has 8,000 MW of installed renewable capacity. Management</p><p>believes that this is worth between €1.5m and €1.8m per MW, implying a</p><p>value for this business of €12bn to €14bn. Not only does this comfortably</p><p>exceed Acciona’s debt level, but it is also significantly above the company’s</p><p>enterprise value of €11.4bn. If this figure is correct, then the rest of the group’s</p><p>portfolio – including the core construction business; a Mediterranean ferry</p><p>operation thought to be worth up to €650m; motorway and other conces-</p><p>sions with invested capital of €1.3bn; a water treatment business; and a fund</p><p>management company with €5bn of funds under management – has a nega-</p><p>tive market valuation.</p><p>Despite this apparent wealth of assets, the company is not without issues.</p><p>It has some €800m tied up in Spanish land for development, which is prob-</p><p>ably unsellable in the current property environment. There is also the thorny</p><p>problem of €1.5bn of Endesa-related debt needing to be refinanced in the</p><p>short-term, which is likely to prove expensive in the current febrile climate.</p><p>Still, Spain’s real estate collapse appears to have created a significant invest-</p><p>ment opportunity. Taking a three- to five-year view, the likelihood is that</p><p>Acciona and other Spanish construction firms will be able to work through</p><p>their current difficulties, implying attractive valuation upside.2</p><p>2 From the time of writing to 31 December 2014, Acciona shares rose by 4.5 per cent in</p><p>US dollars, underperforming the MSCI Europe Index. The company was negatively affected</p><p>THE L IV ING DEAD 151</p><p>5.3 PIIGS CAN FLY (NOVEMBER 2011)</p><p>In the wake of the financial crisis, the capital cycle has entered a positive</p><p>phase for certain Irish businesses</p><p>Marathon recently received a phone call from a Dublin-based broker, seeking</p><p>feedback on behalf of Irish corporate clients as to whether we believed that</p><p>being listed in Ireland was depressing the valuation of certain companies</p><p>and, if so, whether they should relocate to bump up their rating. Shortly after</p><p>this conversation, Ireland’s largest public company, the building materials</p><p>supplier CRH, announced that it was moving its primary listing to London.</p><p>This move was ostensibly for liquidity reasons – the shares already traded</p><p>over half their volume on the LSE – but one suspects that they also wanted</p><p>to remove the “Irish discount” being applied to a business which generated</p><p>only a small proportion of its sales in the Emerald Isle.</p><p>For many investors, Ireland has become a no-go. In the fixed income</p><p>world, we are told, managers are having their investment guidelines redrawn</p><p>by clients to prevent them investing in “peripheral” (PIIGS being too politi-</p><p>cally incorrect) Europe. Capital flight from Ireland, whether semi-symbolic</p><p>in the case of CRH or even actual in the case of some fixed income investor</p><p>mandates, is interesting in the context of two of our more recent European</p><p>investments, Bank of Ireland and Irish Continental Group. It would take a</p><p>name change for these companies to hide their Celtic origins.</p><p>Marathon was always very suspicious of the property-fuelled Irish eco-</p><p>nomic boom, in particular the incredible growth of that aggressive corporate</p><p>and property development lender Anglo Irish [see above]. Anglo prided itself</p><p>on its high margin, mostly wholesale-funded, lending model and its close rela-</p><p>tionships with key property developers. The buoyant market conditions also</p><p>benefited the two largest Irish lenders, Bank of Ireland and Allied Irish, which</p><p>traditionally had pursued a more conservative approach than the young upstart</p><p>but found themselves tempted into riskier lending as the cycle progressed. In</p><p>his entertaining book, Anglo Republic: Inside The Bank that Broke Ireland,</p><p>journalist Simon Carswell describes how the two Irish banking majors ini-</p><p>tially ignored the competition, but once Anglo had got beyond nuisance value,</p><p>sometime around the turn of the century, they established “win back” teams</p><p>for key accounts. In retrospect, this was at exactly the moment when the banks</p><p>should have been ratcheting down their Irish property exposure.</p><p>by changes to Spain’s wind farm subsidy regime. The position was sold in 2015. Marathon</p><p>would have been better off investing in Ferrovial whose shares rose by 108 per cent in US</p><p>dollars from the date of this article to the end of 2014.</p><p>CAPITAL RETURNS152</p><p>The strong demand for credit also attracted foreign lenders, notably</p><p>RBS, through its Ulster Bank subsidiary, and HBOS (now owned by Lloyds),</p><p>whose Irish business Bank of Scotland Ireland (BOSI) really took off in ear-</p><p>nest after the acquisition of a state-owned lender in 2000. The last to the</p><p>party was Danske Bank, which in late 2004 acquired the Irish operations of</p><p>National Australia Bank, and proceeded to triple the loan book over the fol-</p><p>lowing three years. So at the peak of the cycle, six players each had a market</p><p>share of around 10 per cent share, with Danske playing catch up.</p><p>Since those giddy days, the Irish property bubble has collapsed, taking</p><p>down the economy with it. The situation in Ireland’s credit markets could</p><p>scarcely be more different. After heavy losses, foreign banks have lost their</p><p>appetite for lending in Ireland, with Danske shuttering half its Irish branches</p><p>and Lloyds putting BOSI – which has written down an incredible 32 per cent</p><p>of its loan book – into run-off mode. The domestic</p><p>banks have not fared</p><p>much better – Anglo Irish is also in run-off after 50 per cent of its loan book</p><p>was written off. Allied Irish has been all but nationalised, as the government</p><p>now owns a 99 per cent shareholding.</p><p>That leaves Bank of Ireland, where large losses also obliged the Irish</p><p>state to come to the rescue. Following a capital-raising last summer, in which</p><p>a group of foreign investors (including Fairfax Financial and Wilbur Ross)</p><p>acquired a 35 per cent holding, the government’s stake is down to 15 per</p><p>cent. Marathon also participated in the share issue, since it seemed to us that</p><p>the depressed state of Irish banking had the makings for a decent capital</p><p>cycle upturn.</p><p>It is not yet clear what the competitive landscape will look like once the</p><p>dust has settled, but it certainly will not be anything like the situation before</p><p>Chart 5.1 Irish bank’s lending share (October 2011)</p><p>Source: Central Bank of Ireland.</p><p>Nationalised</p><p>In run-off</p><p>Nationalised</p><p>Retrenched</p><p>Retrenched</p><p>23%</p><p>21%</p><p>12%</p><p>9%</p><p>10%</p><p>9%</p><p>4.5%</p><p>Allied Irish Bank</p><p>Bank of Ireland</p><p>Anglo Irish Bank</p><p>Irish Life & Permanent</p><p>FTA & Ulster</p><p>BoSI (HBoS)</p><p>National Irish Bank</p><p>(Danske)</p><p>THE L IV ING DEAD 153</p><p>the crisis. The Irish government plans to run with a “two-pillar” bank sys-</p><p>tem, one of these pillars being Bank of Ireland and the other Allied Irish, now</p><p>merged with the EBS building society. The state-controlled Irish bad bank</p><p>(NAMA) has taken many of the problem development loans off the banks’</p><p>balance sheets, leaving Bank of Ireland with a loan book of some €107bn, of</p><p>which just over half are mortgage loans in the UK and Ireland, with most</p><p>of the rest non-property related SME and corporate lending. Unlike with</p><p>most other European banks, the loan book has been independently stress-</p><p>tested under tough conditions to ensure that it has sufficient capital. Bank</p><p>of Ireland now boasts a core Tier 1 ratio of 15 per cent, which is among the</p><p>highest in Europe.</p><p>In the short-term, the outlook for the Irish economy remains difficult.</p><p>House prices are still falling, although at a much reduced rate, unemploy-</p><p>ment remains high, and consumer confidence is weak. Further out, however,</p><p>it seems reasonable to assume that the pricing power afforded to Bank of</p><p>Ireland as the dominant institution in a far less competitive banking system</p><p>should enable it once again to earn a double-digit return on equity. That</p><p>makes the current valuation of less than 0.4 times book value appear very</p><p>attractive.</p><p>The situation at Irish Continental Group (ICG) is similar from a capi-</p><p>tal cycle perspective. This firm operates as Irish Ferries between Holyhead–</p><p>Dublin and Pembroke–Rosslare, the shortest sea routes between Ireland and</p><p>the UK. The crossing is quick enough for the operator to be able to offer a</p><p>daytime return service for passengers and a nighttime one for freight to max-</p><p>imize the utilisation of the ships. The only other competitor on these routes</p><p>is the privately owned Stena Line, as capacity constraints at the harbours</p><p>mean that there is no room for a third operator. Despite the disadvantages</p><p>of long-sea routes, the expansion in Irish trade over the last couple of dec-</p><p>ades encouraged additional capacity on the freight side, in particular, with</p><p>the likes of P&O and the Danish conglomerate AP Moeller/Maersk (what</p><p>is it about the Danes and Ireland?) among those adding long-sea capacity</p><p>in freight. Following the downturn in the Irish economy, freight volumes</p><p>dropped 4 per cent in 2008 and a further 14 per cent in 2009. Capacity on</p><p>these longer routes which use more fuel and attract less premium freight has</p><p>shrunk in response to losses.</p><p>The downturn has also affected ICG, with freight roughly halving from</p><p>a peak of 55 per cent of ferry revenues in 2007. Still, the company’s out-</p><p>sourced crewing arrangements give it a lower cost base, and volumes may be</p><p>boosted as some of the loss-making ferry capacity is taken out and Ireland’s</p><p>export-led economy begins to grow again. On the passenger side, where 60</p><p>CAPITAL RETURNS154</p><p>per cent of the car traffic comes from UK passengers visiting Ireland, ICG</p><p>saw only a small reduction in volumes last year, offset by higher yields. They</p><p>should benefit from Ireland’s newfound competitiveness as a tourist desti-</p><p>nation (there is plenty of oversupply in the hotel market), as well as from a</p><p>reduction in airline capacity: both Ryanair and Aer Lingus have scaled back</p><p>capacity growth plans.</p><p>ICG’s current fleet does not need renewing for another five to ten years,</p><p>so any pick-up in activity should flow straight through to cash flow. In the</p><p>meantime, ICG’s valuation looks extremely attractive, given its free cash</p><p>flow yield of 10 per cent, while the chief executive’s 16 per cent stake in</p><p>the business aligns the interests of management with shareholders. Roll on</p><p>Ireland.3</p><p>5.4 BROKEN BANKS (SEPTEMBER 2012)</p><p>The necessary cleansing process for the European banking sector is being</p><p>thwarted by politicians</p><p>Marathon looks to invest in sectors where competition is declining and</p><p>capital has been withdrawn, and where depressed investor expectations</p><p>produce attractive valuations. At first glance, the European banking sec-</p><p>tor would appear to fit the bill. Competition and capital are seemingly in</p><p>retreat, and credit is being repriced. Investors have been put off by impen-</p><p>etrable balance sheets and by the complexity of new banking regulations</p><p>(Basel III runs to thousands of pages). Then there’s sovereign default risk</p><p>to worry about. European banks are trading at a discount to tangible book,</p><p>making them considerably cheaper than their US counterparts. Yet from</p><p>a capital cycle perspective, the investment case for European banks is not</p><p>clear-cut.</p><p>First, take the question of whether capital is really in retreat. During</p><p>the boom years, banks gorged on cheap capital to fund asset growth. Since</p><p>1998, eurozone bank assets relative to GDP have climbed from 2.2 times</p><p>to 3.5 times (by the first quarter 2012). European bank assets have always</p><p>been higher than in the US, since mortgages are generally kept on their</p><p>balance sheets and European companies have limited access to the cor-</p><p>porate bond market. Yet despite all recent talk of deleveraging, the ratio</p><p>of bank assets to GDP hasn’t fallen. This is thanks largely to life support</p><p>3 From the date of this article to the end of 2014, the share prices of the Bank of Ireland</p><p>and Irish Continental Group increased by 203 per cent and by 106 per cent respectively in</p><p>US dollars.</p><p>THE L IV ING DEAD 155</p><p>from the official sector, notably the European Central Bank. In fact, in the</p><p>12 months to 31 July 2012, eurozone banks actually increased their assets</p><p>by €34bn. In short, European banks have accumulated a huge mountain of</p><p>debt, and so far little has been done to reduce it.</p><p>The banks are also short of capital. So far, banks have engaged in some</p><p>of the easier deleveraging, withdrawing capital from abroad and retreating</p><p>to home markets. As senior unsecured debt funding has diminished, so</p><p>ECB short-term funding has taken its place. This form of funding, along</p><p>with covered bonds, consumes a large amount of collateral. To attract new,</p><p>senior unsecured funding (a requirement of Basel III), European banks</p><p>will need to have more equity capital. McKinsey has estimated they will</p><p>need to raise €1.1tn by 2021 to meet all the new regulatory requirements.</p><p>One of the lessons from (bitter) experience of investing in banks in the</p><p>US and UK is that when something as fundamental as the ultimate share</p><p>count remains uncertain, the investment outcome is unpredictable.</p><p>Another contributor to improved returns in bombed-out industries is</p><p>consolidation, either through mergers & acquisitions, or through the fail-</p><p>ure of weak firms. Outside of Spain and Ireland, however, the Continental</p><p>European banking sector seems incapable of rationalising. One story illus-</p><p>trates this point. After the rogue trader, Jérôme Kerviel, lost Société Générale</p><p>some €4.9bn</p><p>observing an inverse relationship between</p><p>capital expenditure and investment returns. Firms with the lowest asset</p><p>growth have outperformed those with the highest asset growth, as the chart</p><p>from Société Générale strategist Andrew Lapthorne shows (see Chart I.2).</p><p>14 A recent research note from Sanford C. Bernstein (supra) suggested that potential new</p><p>capacity in the pipeline amounted to 50 per cent of current global iron ore production.</p><p>15 Fortescue’s share price fell 44 per cent in the five years to June 2015.</p><p>Source: SocGen.</p><p>2</p><p>4</p><p>6</p><p>8</p><p>10</p><p>12</p><p>High</p><p>asset</p><p>growth</p><p>2 3 4 5 6 7 8 9 Low</p><p>asset</p><p>growth</p><p>Deciles by asset growth</p><p>A</p><p>ve</p><p>ra</p><p>ge</p><p>a</p><p>nn</p><p>ua</p><p>l r</p><p>et</p><p>ur</p><p>ns</p><p>(</p><p>%</p><p>)</p><p>fo</p><p>r</p><p>gl</p><p>ob</p><p>al</p><p>s</p><p>to</p><p>ck</p><p>s</p><p>(1</p><p>99</p><p>0–</p><p>20</p><p>15</p><p>)</p><p>Chart I.2 Asset growth and investment returns</p><p>INTRODUCT ION 9</p><p>Modern finance theory is based on the notion that while markets are</p><p>efficient, certain “factors” – namely, size, value and momentum – have his-</p><p>torically beaten the benchmark index. Nobel laureate Eugene Fama and</p><p>his colleague Ken French have suggested adding two more factors to their</p><p>model: profits and investment.16 With regards to the capital cycle, Fama</p><p>and French observe that companies which have invested less have delivered</p><p>higher returns. This finding has been termed the “asset-growth anomaly.” A</p><p>paper in the Journal of Finance reports that corporate events associated with</p><p>asset expansion – such as mergers & acquisitions, equity issuance and new</p><p>loans – tend to be followed by low returns.17 Conversely, events associated</p><p>with asset contraction – including spin-offs, share repurchases, debt prepay-</p><p>ments and dividend initiations – are followed by positive excess returns. The</p><p>negative impact on shareholder returns from expanding corporate assets</p><p>was found to persist for up to five years.</p><p>The Journal of Finance authors conclude that firm asset growth is a</p><p>stronger determinant of returns than traditional value (low price-to-book),</p><p>size (market capitalization), and momentum (both long and short hori-</p><p>zon). Other finance economists have found that companies often accelerate</p><p>investment after their stocks have done relatively well and that these same</p><p>companies later underperform. This suggests that asset growth may explain</p><p>the phenomenon of momentum reversal.18</p><p>In short, recent research is edging towards the conclusion that the</p><p>excess returns historically observed from value stocks and the low returns</p><p>from growth stocks are not independent of asset growth. This leads to a key</p><p>insight of the capital cycle investment approach: when analyzing the pros-</p><p>pects of both value and growth stocks, it is necessary to take into account asset</p><p>growth, at both the company and the sectoral level. One researcher goes so</p><p>far as to claim that the value effect disappears after controlling for capital</p><p>investment.19</p><p>16 Eugene Fama and Kenneth French, “A Five-Factor Asset Pricing Model,” Working</p><p>Paper, September 2014.</p><p>17 Michael Cooper, Huseyin Gulen, and Michael Schill, “Asset Growth and the Cross-</p><p>Section of Stock Returns,” Journal of Finance, 2008. See also, Sheridan Titman, John Wei and</p><p>Feixue Xie, “Capital Investment and Stock Returns,”Journal of Financial and Quantitative</p><p>Analysis, 2004; Yuhang Xie, “Interpreting the Value Effect through Q-Theory: An Empirical</p><p>Investigation,” Working Paper, 2007; and S.P. Kothari, Jonathan Lewellen, and Jerold Warner,</p><p>“The Behavior of Aggregate Corporate Investment,” Working Paper, September 2014.</p><p>18 Christopher Anderson and Luis Garcia-Fijóo, “Empirical Evidence on Capital</p><p>Investment, Growth Options, and Security Returns,” Journal of Finance, 2006.</p><p>19 Xie, ibid.</p><p>CAPITAL RETURNS10</p><p>MEAN REVERSION</p><p>The “asset-growth anomaly” can be viewed from the perspective of mean</p><p>reversion.20 Mean reversion is not driven by the ebb and flow of animal spirits</p><p>alone. Rather, it works through differential rates of investment. Companies</p><p>which earn above their cost of capital tend to invest more, thereby driving</p><p>down their future returns, while companies which fail to earn their cost of</p><p>capital behave in the opposite way. This point is recognized by Benjamin</p><p>Graham and David Dodd in Security Analysis (1934), the bible of value</p><p>investing:</p><p>A business which sells at a premium does so because it earns a large</p><p>return upon its capital; this large return attracts competition; and</p><p>generally speaking, it is not likely to continue indefinitely. Conversely</p><p>in the case of a business selling at a large discount because of abnor-</p><p>mally low earnings. The absence of new competition, the withdrawal</p><p>of old competition from the field, and other natural economic forces,</p><p>should tend eventually to improve the situation and restore a normal</p><p>rate of profit on the investment.</p><p>Investment drives mean reversion for both individual companies and whole</p><p>markets. A researcher at the University of Arizona has demonstrated that</p><p>corporate investment in most developed economies (comprising US and</p><p>EAFE) is a significant negative predictor of aggregate profitability, stock</p><p>market returns, and even GDP growth.21 During the US stock market bubble</p><p>of the late 1990s, for instance, the investment share of GDP rose above aver-</p><p>age levels. After the bubble burst and the misallocation of capital of the boom</p><p>years was revealed, both aggregate investment and profitability declined and</p><p>the US economy went into recession.</p><p>All this suggests that asset allocators should consider market valu-</p><p>ation in tandem with the capital cycle. Normally, the two run together.</p><p>The US stock market in recent years, however, has proved something of</p><p>a conundrum. Since 2010, US stocks have looked expensive when viewed</p><p>from a valuation perspective (e.g., the cyclically-adjusted price-earning</p><p>ratio) largely due to the fact that profits have been above average. Yet US</p><p>corporate investment has been lacklustre since the global financial crisis.</p><p>20 For a discussion of mean reversion and the capital cycle, see Capital Account, p. 28.</p><p>21 Salman Arif, “Aggregate Investment and Its Consequences,” Working Paper, March</p><p>2012. The exceptions to this finding are Hong Kong, Switzerland and Sweden.</p><p>INTRODUCT ION 11</p><p>With the key driver of mean reversion missing, profits have remained</p><p>elevated for longer than expected, and the US stock market has delivered</p><p>robust returns.22 China provides an example at the opposite end of the</p><p>spectrum: stock prices have often appeared cheap from a valuation per-</p><p>spective, but investment and asset growth have been elevated resulting in</p><p>poor corporate profitability.</p><p>EXPLANATIONS FOR THE CAPITAL CYCLE ANOMALY</p><p>The market inefficiency observed by capital cycle analysis can be explained</p><p>in terms of the conventional findings of behavioural finance – namely, some</p><p>combination of overconfidence, base-rate neglect, cognitive dissonance,</p><p>narrow-framing and extrapolation appear to account for the fact that com-</p><p>panies with high levels of investment tend to underperform. These behav-</p><p>ioural factors are reinforced by agency-related problems. Skewed incentives</p><p>encourage both investors and corporate managers to adopt short-term per-</p><p>spectives which are inimical to capital cycle analysis. Rational investors are</p><p>unable to impose their views on the market as the capital cycle poses a num-</p><p>ber of “limits to arbitrage.”</p><p>OVERCONFIDENCE</p><p>Why do investors and corporate managers pay so little attention to the</p><p>inverse relationship between capital spending and future investment</p><p>returns? The short answer is that they appear to be infatuated with asset</p><p>growth. Corporate expansion fires the imagination of both managers and</p><p>shareholders. This mistaken fetishism for growth is reflected in the historic</p><p>poor performance of stocks with higher growth expectations (higher valu-</p><p>ations). Behavioural finance suggests that investors (and corporate manag-</p><p>ers) are prone to overconfidence when it comes to making forecasts. As Yogi</p><p>Berra says, “It’s tough to make predictions, especially about the future.” As</p><p>we shall see,</p><p>in 2008, the incumbent French finance minister, Christine</p><p>Lagarde, was asked whether SocGen could now become a takeover target.</p><p>She responded simply, “Ce n’est pas possible.” This attitude is symptomatic</p><p>of the unwillingness of Europe’s national authorities to allow takeovers of</p><p>the weak by the strong, especially if the latter are foreign. Many markets</p><p>remain plagued by excessive numbers of banks – there are over 6,800 banks</p><p>in Europe – and anachronistic structures. Even in Germany, that paragon</p><p>of economic virtue, the banking landscape is littered with hundreds of</p><p>unlisted local cooperative banks, savings banks (Sparkassen) and wholesale</p><p>Landesbanken. As a result of this fragmentation, the German banking sys-</p><p>tem generates little by way of profits.</p><p>In essence, the capital cycle is not working in the banking sector in</p><p>Europe, because the creative destruction that is required is politically unac-</p><p>ceptable. Under the cover that the banks face liquidity problems and not a</p><p>solvency crisis, eurozone governments are propping up their banks and are</p><p>likely to continue doing so for years to come. For investors in banks with</p><p>stronger balance sheets, returns are likely to be restrained by weak lending</p><p>growth and excessive competition. Schizophrenic policymakers, who on the</p><p>one hand exhort banks to lend more and on the other hand restrict lending</p><p>capacity via onerous capital and liquidity requirements, make matters even</p><p>CAPITAL RETURNS156</p><p>worse. The threat of abrupt deleveraging in Europe has been replaced by the</p><p>prospect of many years of slow and painful adjustment.4</p><p>5.5 TWILIGHT ZONE (NOVEMBER 2012)</p><p>Low interest rates are slowing the process of creative destruction</p><p>Media coverage of the European economy remains trapped in the hor-</p><p>ror genre, as fatigue over the long-running euro crisis has given way to an</p><p>equally depressing sequel about lost decades and Japan-style ossification.</p><p>Such reports are not limited to the eurozone periphery. News that 10 per cent</p><p>of British businesses are “zombies,” kept alive by ultra-loose monetary policy</p><p>and the reluctance of lenders to write off bad loans, coincided with a report</p><p>from the Bank of England suggesting that 5–7 per cent of outstanding mort-</p><p>gage debt was in various forms of forbearance. One of the striking takeaways</p><p>of our conversations with European business managers in recent years is</p><p>that excess capacity built up during the credit boom has yet to be purged to a</p><p>significant extent. This is particularly apparent in the more capital-intensive</p><p>and cyclical industries.</p><p>When credit was cheap and animal spirits ebullient, the desire to press</p><p>“go” on new capital projects was hard to resist, particularly when peers</p><p>were engaged in the same race and the stock market was rewarding growth.</p><p>Unfortunately, such “malinvestments” as were made during boom times</p><p>have proved hard to eradicate in a period when interest rates have remained</p><p>low, banks have been reluctant to call in bad debts to avoid losses, and politi-</p><p>cians across the eurozone have done their utmost to prevent unemployment</p><p>moving even higher.</p><p>The poster child of this failure is the European auto industry, which</p><p>appears incapable of reducing its capacity despite weak demand and dwin-</p><p>dling exports to emerging markets (which have been busy boosting their</p><p>own car production). The low equity market valuations of French car makers</p><p>– Peugeot trades at a tenth of book value – have limited appeal in the light</p><p>of political resistance to plant closures. Nor can the European automakers</p><p>resist new investment. Volkswagen has recently announced it will spend</p><p>€50bn over the next three years on capex! Given the limited options avail-</p><p>able, it is hardly surprising that auto managers resort to price cuts aimed at</p><p>raising capacity utilisation at the expense of profitability.</p><p>4 The MSCI Europe Bank Index underperformed its US counterpart by 20 percentage</p><p>points from the date of this article to the end of December 2014.</p><p>THE L IV ING DEAD 157</p><p>The situation in the European steel industry mirrors that of automakers.</p><p>Demand for steel in Europe remains 20 per cent below the (inflated) peak,</p><p>and a trade body estimates surplus capacity at 30–40m tonnes, enough to</p><p>make 25 million cars a year or nearly twice current European auto demand.</p><p>ArcelorMittal, in which Marathon has an investment, described to us how</p><p>ten of its 32 European blast furnaces are temporarily shut, with staff under</p><p>contract but working shorter hours. Attempts to close two further blast fur-</p><p>naces at its French site in Florange, with the loss of 629 workers (3 per cent</p><p>of the company’s French workforce), have been met with a threat from the</p><p>left-wing industry minister of expulsion from the country due to the compa-</p><p>ny’s failure to “respect France,” as reported by the Financial Times. Arnaud</p><p>Montebourg, the anti-globalization industry minister, has also accused the</p><p>company, one of France’s largest industrial investors, of resorting to “black-</p><p>mail and threats” in relation to the Florange plant, something which the com-</p><p>pany denies. With the freedom of managers to manage capacity so severely</p><p>constrained, the outlook for ArcelorMittal’s European business (40 per cent</p><p>of the firm’s total output) appears much less attractive than its operations in</p><p>other parts of the world.</p><p>The problems of European auto- and steelmakers relate primarily to a</p><p>fall in demand as opposed to any recent overbuilding of domestic capacity in</p><p>more favourable macroeconomic conditions. Other industries have suffered</p><p>from disruptive new technologies or business models which have left legacy</p><p>companies struggling to cope. Flag-carrier airlines, saddled with outdated</p><p>employment contracts and national champion status, have suffered greatly</p><p>from the growth of unencumbered low cost carriers. The CEO of struggling</p><p>SAS in Scandinavia recently bemoaned the lack of a Chapter 11 process in</p><p>Europe. Perhaps he is jealous of a system which in the US has led to the anti-</p><p>Darwinian outcome of the survival of the least fit!</p><p>Other European industries have built up export capacity only to find</p><p>that their putative export markets have developed their own domestic supply</p><p>which threatens one day to lead to imports into Europe. Here one thinks of</p><p>the European paper and aluminium industries, besides the aforementioned</p><p>auto sector. A recent article in the Financial Times described how China has</p><p>gone from producing just under 3m tonnes of aluminium in 2000 to nearly</p><p>18m tonnes in 2011, or 40 per cent of world output. This has led to a surplus</p><p>of 10m tonnes of aluminium stacked up in warehouses around the world,</p><p>enough to make more than 150,000 Boeing 747s or 750bn soda cans.</p><p>From a capital cycle perspective, the above situations only become attrac-</p><p>tive when stock market valuations fall to a fraction of replacement cost and a</p><p>path opens up for dealing with the excess capacity. While the first condition</p><p>CAPITAL RETURNS158</p><p>is close to being met in many European sectors, the prospects for the sec-</p><p>ond appears dim. In previous downturns, capacity adjustment has come as</p><p>a result of interest rates rising to choke off inflation, leading to widespread</p><p>bankruptcies and industry consolidation. In the early 1990s, for example, our</p><p>portfolios benefited from UK investments which survived the shake-out and</p><p>prospered in the subsequent recovery, among them homebuilders (Taylor</p><p>Woodrow), conglomerates (Trafalgar House) and advertisers (WPP).</p><p>With interest rates low and set to remain so, and banks prepared to prop</p><p>up weak businesses for fear of crystallising losses, monetary policy looks very</p><p>unlikely to precipitate a major reallocation of resources. Indeed, it appears</p><p>designed to head-off such a denouement. Under such circumstances, sup-</p><p>ply side restructuring via industry consolidation also looks like a long-shot,</p><p>especially as many European industries are already quite consolidated and</p><p>face anti-trust barriers.</p><p>While the outlook from a shareholder</p><p>this is especially the case when it comes to predicting future</p><p>levels of demand.</p><p>COMPETITION NEGLECT</p><p>Overinvestment is not a solitary activity; it comes about because several</p><p>players in an industry have been increasing capacity at the same time. When</p><p>22 This is not to say that unorthodox monetary policies from the Federal Reserve have</p><p>played no part in recent years in inflating US stock prices.</p><p>CAPITAL RETURNS12</p><p>market participants respond to perceived increases in demand by increasing</p><p>capacity in an industry, they fail to consider the impact of increasing sup-</p><p>ply on future returns. “Competition neglect,” according to Harvard Business</p><p>School professors Robin Greenwood and Samuel Hanson, is “particularly</p><p>strong when firms receive delayed feedback about the consequences of their</p><p>own decisions.”23 The authors of a paper in the American Economic Review</p><p>sought to explain why so many new entrants into business frequently fail.</p><p>They found that managers so overestimate their own skills they neglect</p><p>competitive threats.24</p><p>This failure to pay attention to the outward shift in the supply curve</p><p>can be linked to another common behavioural trait, known as “base-rate</p><p>neglect.” Namely, the tendency of people not to take into account all avail-</p><p>able information when making a decision. With regards to the workings of</p><p>the capital cycle, investors focus on current (and projected) future profit-</p><p>ability but ignore changes in the industry’s asset base from which returns</p><p>are generated. At times, this tendency morphs into what psychologists call</p><p>“cognitive dissonance” – a wilful refusal to consider disconfirming evidence</p><p>once a course of action has been decided upon.</p><p>INSIDE VIEW</p><p>Such narrow-framing arises by decision-makers taking the “inside view,”</p><p>a term coined by the psychologist Daniel Kahneman.25 The inside view is</p><p>generated when individuals in a group focus on “specific circumstances and</p><p>search for evidence in their own experiences.”26 As investment strategist</p><p>Michael Mauboussin (formerly of Legg Mason) writes:</p><p>23 Robin Greenwood and Samuel Hanson, “Waves in Ship Prices and Investment,”</p><p>NBER Working Paper, July 2013. On the phenomenon of excess investment, Greenwood</p><p>and Hanson comment that “models in which market participants over-extrapolate exoge-</p><p>nously given cash flows are well understood in economics ... But in most industries, the cash</p><p>flows are not exogenous but are an endogenous equilibrium outcome that is impacted by</p><p>the industry supply response to demand shocks. It follows that firms may over-extrapolate</p><p>current profits either because they (i) overestimate the persistence of the exogenous demand</p><p>shocks facing the industry or (ii) fail to fully appreciate the long-run endogenous supply</p><p>response to those demand shocks.”</p><p>24 Colin Camerer and Dan Lovallo, “Overconfidence and Excess Entry: An Experimental</p><p>Approach,” American Economic Review, 1999.</p><p>25 See Michael Mauboussin, “Death, Taxes and Reversion to the Mean,” Legg Mason</p><p>Capital Management, December 2007.</p><p>26 Daniel Kahneman, Thinking Fast and Slow, 2011, p. 247.</p><p>INTRODUCT ION 13</p><p>An inside view considers a problem by focusing on the specific</p><p>task and the information at hand, and predicts based on that</p><p>unique set of inputs. This is the approach analysts most often use</p><p>in their modeling, and indeed is common for all forms of plan-</p><p>ning. In contrast, an outside view considers the problem as an</p><p>instance in a broader reference class. Rather than seeing the prob-</p><p>lem as unique, the outside view asks if there are similar situa-</p><p>tions that can provide useful calibration for modeling. Kahneman</p><p>notes this is a very unnatural way to think precisely because it</p><p>forces analysts to set aside all of the cherished information they</p><p>have unearthed about a company. This is why people use the out-</p><p>side view so rarely.27</p><p>Analysts with highly specialized knowledge of an industry are prone to</p><p>adopting the inside view. They assume that their own case is unique. When</p><p>it comes to investment analysis, looking for relevant historical parallels</p><p>(e.g., comparing the US real estate boom of the 2000s to the Japanese real</p><p>estate market in the 1980s) is an example of taking the outside view. “In</p><p>the inside view,” write the AER authors in their paper on new entrants’ fail-</p><p>ures, “there is no special role for anticipation of the number of competitors</p><p>or their abilities. In the outside view, the fact that most entries fail cannot</p><p>be ignored.”</p><p>EXTRAPOLATION</p><p>The inside view is linked with our tendency to extrapolate. Behavioural</p><p>finance – a branch of economics established by Kahneman and his late</p><p>colleague Amos Tversky – describes how we “anchor” on the information</p><p>placed in front of us and are overly influenced by our immediate experi-</p><p>ences (“recency bias.”) Another common heuristic is the tendency to draw</p><p>strong inferences from small samples. These weaknesses reinforce the pro-</p><p>pensity of investors to make linear forecasts, despite the fact that most eco-</p><p>nomic activity is cyclical – there are trade cycles, credit cycles, liquidity</p><p>cycles, real estate cycles, profit cycles, commodity cycles, venture capital</p><p>cycles and, of course, industry capital cycles. Our inclination to extrapolate</p><p>must be hard-wired.</p><p>27 Mauboussin, ibid. The failures of analysts who take an “inside view” is discussed below,</p><p>see 3.1 “Food for thought.”</p><p>C</p><p>ha</p><p>rt</p><p>I.</p><p>3</p><p>In</p><p>ve</p><p>st</p><p>or</p><p>o</p><p>ve</p><p>rr</p><p>ea</p><p>ct</p><p>io</p><p>n</p><p>an</p><p>d</p><p>th</p><p>e</p><p>ca</p><p>pi</p><p>ta</p><p>l c</p><p>yc</p><p>le</p><p>So</p><p>ur</p><p>ce</p><p>: M</p><p>ar</p><p>at</p><p>ho</p><p>n.</p><p>In</p><p>ve</p><p>st</p><p>or</p><p>s’</p><p>ex</p><p>pe</p><p>ct</p><p>at</p><p>io</p><p>ns</p><p>o</p><p>ve</p><p>rs</p><p>ho</p><p>ot</p><p>in</p><p>g</p><p>U</p><p>nd</p><p>er</p><p>sh</p><p>oo</p><p>tin</p><p>g</p><p>Ti</p><p>m</p><p>e</p><p>B</p><p>us</p><p>in</p><p>es</p><p>s</p><p>in</p><p>ve</p><p>st</p><p>m</p><p>en</p><p>t</p><p>de</p><p>cl</p><p>in</p><p>es</p><p>, i</p><p>nd</p><p>us</p><p>tr</p><p>y</p><p>co</p><p>ns</p><p>ol</p><p>id</p><p>at</p><p>io</p><p>n,</p><p>fi</p><p>rm</p><p>s</p><p>ex</p><p>it:</p><p>in</p><p>ve</p><p>st</p><p>o</p><p>rs</p><p>p</p><p>es</p><p>si</p><p>m</p><p>is</p><p>ti</p><p>c</p><p>Im</p><p>pr</p><p>ov</p><p>in</p><p>g</p><p>su</p><p>pp</p><p>ly</p><p>s</p><p>id</p><p>e</p><p>ca</p><p>us</p><p>es</p><p>r</p><p>et</p><p>ur</p><p>ns</p><p>to</p><p>r</p><p>is</p><p>e</p><p>ab</p><p>ov</p><p>e</p><p>co</p><p>st</p><p>o</p><p>f c</p><p>ap</p><p>ita</p><p>l:</p><p>sh</p><p>ar</p><p>e</p><p>p</p><p>ri</p><p>ce</p><p>o</p><p>u</p><p>tp</p><p>er</p><p>fo</p><p>rm</p><p>s</p><p>In</p><p>du</p><p>st</p><p>ry</p><p>c</p><p>ap</p><p>ita</p><p>l c</p><p>yc</p><p>le</p><p>R</p><p>et</p><p>ur</p><p>n</p><p>on</p><p>in</p><p>ve</p><p>st</p><p>m</p><p>en</p><p>t</p><p>N</p><p>ew</p><p>e</p><p>nt</p><p>ra</p><p>nt</p><p>s</p><p>at</p><p>tr</p><p>ac</p><p>te</p><p>d</p><p>by</p><p>pr</p><p>os</p><p>pe</p><p>ct</p><p>o</p><p>f h</p><p>ig</p><p>h</p><p>re</p><p>tu</p><p>rn</p><p>s:</p><p>in</p><p>ve</p><p>st</p><p>o</p><p>rs</p><p>o</p><p>p</p><p>ti</p><p>m</p><p>is</p><p>ti</p><p>c</p><p>ROI</p><p>R</p><p>is</p><p>in</p><p>g</p><p>co</p><p>m</p><p>pe</p><p>tit</p><p>io</p><p>n</p><p>ca</p><p>us</p><p>es</p><p>re</p><p>tu</p><p>rn</p><p>s</p><p>to</p><p>fa</p><p>ll</p><p>be</p><p>lo</p><p>w</p><p>c</p><p>os</p><p>t o</p><p>f</p><p>ca</p><p>pi</p><p>ta</p><p>l:</p><p>sh</p><p>ar</p><p>e</p><p>p</p><p>ri</p><p>ce</p><p>u</p><p>n</p><p>d</p><p>er</p><p>p</p><p>er</p><p>fo</p><p>rm</p><p>s</p><p>INTRODUCT ION 15</p><p>Value investors who buy cheap stocks with depressed earnings are pro-</p><p>tected against the extrapolation tendency. As the author of a recent invest-</p><p>ment text book writes:</p><p>The main behavioral explanation for value stocks’ long-run outper-</p><p>formance is excessive extrapolation by investors of multiyear growth</p><p>rates. In reality, growth mean reverts faster than the market expects,</p><p>making growth stocks more likely to disappoint.28</p><p>The capital cycle analyst would agree with these comments, adding crucially</p><p>that mean reversion is driven by changes on the supply side which value</p><p>investors who consider only quantitative measures of valuation are inclined</p><p>to overlook.</p><p>SKEWED INCENTIVES</p><p>Skewed incentives exacerbate these well-known behavioural weaknesses.</p><p>CEO compensation is often linked to short-term performance measures,</p><p>such as annual changes in earnings-per-share or shareholder returns. Stock</p><p>prices often react positively to announcements of major capital spend-</p><p>ing.29 Companies which invest more often attract premium valuations. The</p><p>stocks of high asset growth companies often exhibit positive momentum.30</p><p>Executive pay is also frequently linked to a company’s size, as measured by</p><p>revenue or market capitalization. The incentives are thus skewed for manag-</p><p>ers to favour growth and to downplay any adverse long-term consequences.</p><p>There is some evidence that managers with a large ownership stake are more</p><p>likely to shrink capital employed – through buybacks – if they see few profit-</p><p>able alternatives.</p><p>Investors whose compensation is linked to short-term performance are</p><p>also inclined to myopia. Investment bankers who drive the capital cycle –</p><p>raising money to finance investment with debt and equity issuance</p><p>and</p><p>launching IPOs – are compensated according to their fee generation rather</p><p>than the outcome their capital-raising activities may have for clients and</p><p>shareholders. Investment bank analysts serve as cheerleaders; their pay is</p><p>linked to brokerage commissions, generated by stock turnover. They too</p><p>have little interest in long-term outcomes.</p><p>28 See Antti Ilmanen, Expected Returns, 2011, Chapter 12.</p><p>29 See Titman et al., op. cit.</p><p>30 Ibid.</p><p>CAPITAL RETURNS16</p><p>PRISONER’S DILEMMA</p><p>Game theory can also explain overinvestment within an industry. Managers</p><p>in a business with high current profitability may face a problem akin to the</p><p>prisoner’s dilemma. Take a situation where future demand growth can prof-</p><p>itably accommodate expansion by a single player, but no more. If several</p><p>players simultaneously expand their operations, their aggregate profits will</p><p>decline at some future date. Under such circumstances, it’s collectively ratio-</p><p>nal for the incumbents to prevent any expansion – since gains only accrue</p><p>to one of their number. If the industry is competitive or has low barriers to</p><p>entry, there is an incentive for one player to break ranks and enjoy the fruits</p><p>of expansion. The remainder may feel obliged to follow suit, as they can’t</p><p>abide a competitor leaving them standing and may wish to protect market</p><p>share. Thus, excessive asset growth can result from a lack of cooperative</p><p>behaviour within an industry (see Section 1.1 “Evolution of cooperation”).</p><p>LIMITS TO ARBITRAGE</p><p>If high asset growth companies consistently underperform, why don’t smart</p><p>investors simply short these stocks? Or, if they are constrained from going</p><p>short, at least not go long? The answer is that the fast-growing companies often</p><p>have volatile share prices and going short volatility can be very expensive – as</p><p>short-sellers of Internet and technology stocks discovered to their cost in the</p><p>late 1990s. Furthermore, companies with strong asset growth often have large</p><p>market capitalizations – as was the case with many of the telecoms companies</p><p>in the 1990s and more recently with the global mining stocks. Investors who</p><p>avoid buying high asset growth stocks may be forced to take large bets against</p><p>the benchmark. Short-term underperformance may result in the only risk</p><p>which keeps professional investors awake at night, namely “career risk.”31 It</p><p>should also be noted that capital cycles vary in length, and nobody knows in</p><p>advance when they will turn. This uncertainty adds yet another limit to arbi-</p><p>trage. Marathon’s private ownership and longstanding client relationships</p><p>31 See Eric Lam and John Wei, “Limits-to-Arbitrage, Investment Frictions, and the Asset</p><p>Growth Anomaly,” Journal of Financial Economics, forthcoming. Harvard’s Andrei Shleifer</p><p>and Robert Vishny demonstrated that markets become inefficient when rational inves-</p><p>tors face high costs, which come, for example, from shorting volatile stocks. They coined</p><p>the phrase “limits to arbitrage” to describe this phenomenon (see eponymous paper in the</p><p>Journal of Finance, 1997). Lam and Wei argue that the inverse relationship between high</p><p>asset growth and subsequent returns is most pronounced for stocks that are difficult to arbi-</p><p>trage, because they have larger market caps, greater trading costs, or are more volatile.</p><p>INTRODUCT ION 17</p><p>enable the firm to adopt a long-term approach, more tolerant of benchmark</p><p>deviation, which is necessary to apply capital cycle analysis.</p><p>FUNDAMENTALS OF CAPITAL CYCLE ANALYSIS</p><p>Marathon’s approach is to look for investment opportunities among both</p><p>value and growth stocks, as conventionally defined.32 They come about</p><p>because the market frequently mistakes the pace at which profitability</p><p>reverts to the mean. For a “value” stock, the bet is that profits will rebound</p><p>more quickly than is expected and for a “growth stock,” that profits will</p><p>remain elevated for longer than market expectations.</p><p>FOCUS ON SUPPLY RATHER THAN DEMAND</p><p>Given that the future is uncertain, why should Marathon’s approach fare any</p><p>better? The answer is that most investors spend the bulk of their time trying</p><p>to forecast future demand for the companies they follow. The aviation ana-</p><p>lyst will try to answer the question: How many long-haul flights will be taken</p><p>globally in 2020? A global autos strategist will attempt to forecast China’s</p><p>demand for passenger cars 15 years hence. No one knows the answers to</p><p>these questions. Long-range demand projections are likely to result in large</p><p>forecasting errors.</p><p>Capital cycle analysis, however, focuses on supply rather than demand.</p><p>Supply prospects are far less uncertain than demand, and thus easier to fore-</p><p>cast. In fact, increases in an industry’s aggregate supply are often well flagged</p><p>and come with varying lags – depending on the industry in question – after</p><p>changes in the industry’s aggregate capital spending. In certain industries,</p><p>such as aircraft manufacturing and shipbuilding, the supply pipelines are</p><p>well-known. Because most investors (and corporate managers) spend more</p><p>of their time thinking about demand conditions in an industry than chang-</p><p>ing supply, stock prices often fail to anticipate negative supply shocks.33</p><p>32 See below, 2.1 “Warning labels” and 2.7 “Value in growth.”</p><p>33 Several accounting based measures provide insights into the capital cycle. As observed</p><p>above, stocks with the fastest asset growth tend to underperform. When a company’s capital</p><p>expenditure relative to depreciation rises above its average level it may be a sign that the</p><p>capital cycle is deteriorating (see 1.4 “Supercycle woes” and Chapter 1, “A capital cycle revo-</p><p>lution”). A rising gap between reported earnings and free cash flow is another warning sign</p><p>(see 1.7 “Major concerns”). The Herfindahl Index provides a statistical measure of industry</p><p>concentration which may reveal changes in competitive conditions. Anecdotal signs prove</p><p>just as useful in gauging the capital cycle. It’s generally a bad sign when a company starts</p><p>building a grandiose new head office (see 4.9 “On the rocks”).</p><p>CAPITAL RETURNS18</p><p>ANALYZE COMPETITIVE CONDITIONS WITHIN AN INDUSTRY</p><p>From the investment perspective, the key point is that returns are driven by</p><p>changes on the supply side. A firm’s profitability comes under threat when</p><p>the competitive conditions are deteriorating. The negative phase of the capi-</p><p>tal cycle is characterized by industry fragmentation and increasing supply.</p><p>The aim of capital cycle analysis is to spot these developments in advance</p><p>of the market. New entrants noisily trumpet their arrival in an industry. A</p><p>rash of IPOs concentrated in a hot sector is a red flag; secondary share issu-</p><p>ances another, as are increases in debt. Conversely, a focus on competitive</p><p>conditions should alert investors to opportunities where supply conditions</p><p>are benign and companies are able to maintain profitability for longer than</p><p>the market expects. An understanding of competitive conditions and sup-</p><p>ply side dynamics also helps investors avoid value traps (such as US housing</p><p>stocks in 2005–06).</p><p>CAVEAT INVESTMENT BANKER</p><p>The capital cycle analyst is particularly wary of the actions of investment</p><p>banks, and the work of their in-house propagandists, the brokerage analyst.34</p><p>Besides generating fees for themselves, the main economic function of the</p><p>investment bank is to supply finance to capital-hungry businesses – for which</p><p>they earn generous fees. Bankers are paid to drive capital cycles, not to worry</p><p>about the negative long-term consequences that capital expansion may have</p><p>for clients.</p><p>Brokers also pay little attention to the capital cycle which operates</p><p>beyond their short-term time horizon. Instead, they spend their time trying</p><p>to forecast the next quarter’s earnings, which is good for generating turno-</p><p>ver and commissions, and occasionally going “over the wall” to help their</p><p>banker colleagues market a new share issuance. In fact, brokers have never</p><p>been adept at anticipating movements in the capital cycle:</p><p>“Rarely does</p><p>one find a brokerage house study that point outs,”</p><p>wrote Benjamin Graham, “with a convincing array of facts, that a</p><p>popular industry is heading for a fall or that an unpopular one is</p><p>due to prosper. Wall Street’s view of the future is notoriously fal-</p><p>lible ... [especially when it] is directed towards forecasting the course</p><p>of profits in various industries.”</p><p>34 For a humorous take on this, see Chapter 7.</p><p>INTRODUCT ION 19</p><p>Yet the broker’s continual failure to analyse the capital cycle doesn’t mean</p><p>that all effort is futile! The good capital cycle analyst is a contrarian by nature</p><p>and always sceptical of the siren call of Wall Street.</p><p>SELECTING THE RIGHT CORPORATE MANAGERS</p><p>Marathon is fond of repeating two comments of Warren Buffett. The first</p><p>being to the effect that most chief executives have risen to the top of their</p><p>companies because they “have excelled in an area such as marketing, pro-</p><p>duction, engineering – or sometimes, institutional politics.” Yet they may</p><p>not have the capital allocation skills required of managers. Such skills are</p><p>essential, according to the Sage of Omaha, since, “after ten years on the job,</p><p>a CEO whose company retains earnings equal to 10 per cent of net worth</p><p>will have been responsible for the deployment of more than 60 per cent of</p><p>all capital at work in the business.” Capital cycle analysis involves keeping a</p><p>sharp eye on managers to assess their ability to allocate capital. Marathon</p><p>spends a lot of time meeting and questioning managers to this effect (see 3.8</p><p>“A meeting of minds”).</p><p>GENERALISTS MAKE BETTER CAPITAL CYCLE ANALYSTS</p><p>Industry specialists are prone to taking the “inside view.” Having got lost in</p><p>a thicket of detail, industry specialists end up not seeing the wood for the</p><p>trees. They may, for instance, spend too much time comparing the perfor-</p><p>mance and prospects of companies within their sector and fail to recognize,</p><p>as a result, the risks that the industry as a whole is running. Marathon pre-</p><p>fers to employ generalists who are less likely to suffer from “reference group</p><p>neglect” and better able to employ an understanding of capital cycle dynam-</p><p>ics across industries.</p><p>ADOPT A LONG-TERM APPROACH</p><p>Capital cycle analysis, like value investing, requires patience. It takes a long</p><p>time for an industry’s capital cycle to play out. The Nasdaq started bubbling</p><p>in 1995. Yet it wasn’t until the spring of 2000 that the dotcom bubble finally</p><p>burst. New supply comes with varying lags in different industries. As we</p><p>have seen, it can take nearly a decade for a new mine to start producing.</p><p>Marathon warned of the dangers of rising mining investment back in May</p><p>2006 (see 1.3 “This time’s no different” – yet after rebounding in the wake of</p><p>the financial crisis, the commodity supercycle didn’t turn down for another</p><p>CAPITAL RETURNS20</p><p>five years. Marathon’s long-term investment discipline, with its very low</p><p>portfolio turnover, is well suited to applying the capital cycle approach.</p><p>CAPITAL CYCLE BREAKDOWNS</p><p>Capital cycle analysis requires patience, a certain doggedness (willingness</p><p>to be wrong for a long period) and a contrarian mindset. Once the cycle has</p><p>turned and overcapacity in an industry has been exposed, the progression</p><p>of events appears inevitable. That’s hindsight bias. At the time, the out-</p><p>come never seems so certain. Besides, on occasion the normal operation of</p><p>the capital cycle breaks down. Over the last two decades, the Internet has</p><p>destroyed many long-established business models – in advertising (Yellow</p><p>Pages), media (newspapers), retailing (bookshops), and entertainment</p><p>(music industry and video rental). Investors who underestimated the dis-</p><p>ruptive impact of new technology have lost money.35 The capital cycle also</p><p>ceases to function properly when policymakers protect industries (see 5.4</p><p>“Broken banks” and 5.5 “Twilight zone”) and under conditions of state cap-</p><p>italism, as found in modern China (see Chapter 6, “China Syndrome”).</p><p>THE TENETS OF CAPITAL CYCLE ANALYSIS</p><p>The essence of capital cycle analysis can thus be reduced to the following key</p><p>tenets:</p><p>• Most investors devote more time to thinking about demand than</p><p>supply. Yet demand is more difficult to forecast than supply.</p><p>• Changes in supply drive industry profitability. Stock prices often</p><p>fail to anticipate shifts in the supply side.</p><p>• The value/growth dichotomy is false. Companies in industries</p><p>with a supportive supply side can justify high valuations.</p><p>• Management’s capital allocation skills are paramount, and meet-</p><p>ings with management often provide valuable insights.</p><p>• Investment bankers drive the capital cycle, largely to the detri-</p><p>ment of investors.</p><p>• When policymakers interfere with the capital cycle, the market-</p><p>clearing process may be arrested. New technologies can also dis-</p><p>rupt the normal operation of the capital cycle.</p><p>35 For Marathon’s experience, see footnote to 5.6 “Capital punishment.”</p><p>INTRODUCT ION 21</p><p>• Generalists are better able to adopt the “outside view” necessary</p><p>for capital cycle analysis.</p><p>• Long-term investors are better suited to applying the capital cycle</p><p>approach.</p><p>A BRIEF OUTLINE OF THE BOOK</p><p>I have arranged the essays from Marathon’s Global Investment Review in the</p><p>following order: Chapter 1 – Capital Cycle Revolution: This chapter looks at</p><p>the operation of the capital cycle in a number of industries, from fishing to</p><p>wind turbines. As noted above, the capital cycle enters a dangerous phase</p><p>when high profitability leads to rising capital spending, as has occurred in</p><p>both the mining and oil sectors in recent years. In these cases, increases in</p><p>miners’ capex to depreciation ratio and the decline in energy companies’</p><p>cash conversion rate served as red flags for investors. The capital cycle enters</p><p>a benign phase when low profitability results in industry consolidation, as</p><p>the global beer industry experienced at the turn of the century. Alternately,</p><p>the capital cycle takes a positive turn when industry players cease competing</p><p>virulently against each other and learn to cooperate.</p><p>Chapter 2 – Value In Growth: The essays contained in this chapter</p><p>eschew the conventional growth/value dichotomy. Marathon rejects the</p><p>label “value investor,” which is generally associated with buying stocks that</p><p>are cheap based on accounting measures. Instead, the aim is to look for</p><p>stocks which are selling below Marathon’s estimate of intrinsic value and</p><p>have strong competitive positions: such companies may benefit from net-</p><p>work effects, occupy secure niches, be firmly embedded an industry’s sup-</p><p>ply chain, or enjoy pricing power because their products are sold through</p><p>third parties more concerned with quality than price. Marathon argues that</p><p>high valuations are often justified for companies protected by deep moats.</p><p>Fast-growing companies with little or no profits and high valuations, such as</p><p>Amazon, can still make good investments provided their industry’s supply</p><p>side remains supportive.</p><p>Chapter 3 – Management Matters: Over the medium term, the perform-</p><p>ance of companies depends on how well managers allocate their assets. It’s</p><p>important therefore that investors meet with management in order to assess</p><p>their asset allocation skills. Marathon argues that much can be learned from</p><p>meeting CEOs – the ones who fly around in private jets, spend their time con-</p><p>structing lavish new headquarters, or are greedy and vain, generally deliver</p><p>poor returns for shareholders. The greatest managers, like Björn Wahlroos at</p><p>CAPITAL RETURNS22</p><p>Finland’s Sampo, understand their industry’s capital cycle and invest in a con-</p><p>trarian fashion.</p><p>Chapter 4 – Accidents in Waiting: The financial crisis took most of</p><p>the world by surprise. Yet banks can also be analysed from a capital cycle</p><p>perspective. When bank assets (loans) are growing strongly, this is gener-</p><p>ally a negative indicator. In the years prior to the Lehman bust, Marathon’s</p><p>investment professionals held meetings with a number of banks and became</p><p>increasingly concerned by what</p><p>they saw – particularly at the Anglo-Irish</p><p>Bank, whose failure imperilled the sovereign credit of Ireland. One European</p><p>bank, Sweden’s Handelsbanken, provides a model of how to overcome many</p><p>of the flaws inherent in modern banking, including asset-liability mismatch-</p><p>ing and chronic short-termism.</p><p>Chapter 5 – The Living Dead: Policymakers have responded to the finan-</p><p>cial crisis by lowering interest rates and supporting stricken industries, such</p><p>as European automakers. Their actions have interfered with the economic</p><p>process of creative destruction. Low return businesses are able to survive in</p><p>the era of ultra-low rates, creating the possibility that Europe is entering an</p><p>era of “zombie” capitalism – akin to Japan’s lost decades. Low rates have also</p><p>encouraged investors to chase yield, which poses the threat of capital losses</p><p>at some future date.</p><p>Chapter 6 – China Syndrome: Many investors believe that investment</p><p>returns follow economic growth. Yet the returns from the Chinese stock mar-</p><p>ket since it reopened in the early 1990s have been dreadful – notwithstand-</p><p>ing the occasional bubble. Poor returns from Chinese equities are largely the</p><p>result of Beijing’s investment-intensive growth model, which relies on cheap</p><p>capital, debt forgiveness and never-ending asset growth. The fact that many</p><p>Chinese IPOs have been carved out of larger state-owned enterprises and</p><p>dressed up with artificial profits has further damaged investors’ interests.</p><p>Chapter 7 – Inside the Mind of Wall Street: As outlined above, Marathon</p><p>is inherently suspicious of the modern investment banker, who prizes fees</p><p>(and bonuses) above all else. The book concludes with a satirical take on</p><p>Wall Street provided by the antics of a fictional banker, Stanley Churn, head</p><p>of the investment bank Greedspin. Any resemblance to real bankers and real</p><p>banks, living or dead, is purely coincidental!</p><p>PART I</p><p>INVESTMENT PHILOSOPHY</p><p>1</p><p>CAPITAL CYCLE REVOLUT ION</p><p>The following essays describe the operation of the capital cycle in a variety of</p><p>industries, from cod fishing to global brewers and wind turbine manufactur-</p><p>ers. A common theme linking these pieces is the importance of understanding</p><p>how competition – or the supply side – evolves over time, and the role it plays in</p><p>determining both industry and individual company returns on capital. In addi-</p><p>tion, some of the essays highlight the malign influence of regulation and the</p><p>potentially disruptive impact of technology on particular industry capital cycles.</p><p>An understanding of the capital cycle helps to identify and avoid speculative</p><p>bubbles. All too often, high returns attract capital, breeding excessive competi-</p><p>tion and overinvestment. In recent years, for instance, there has been an epic</p><p>burst of capital spending in the field of resource extraction. Four of the articles</p><p>presented below highlight the dangers posed to shareholders over the last decade</p><p>by ever rising levels of investment in the mining and the oil and gas sectors.</p><p>1.1 EVOLUTION OF COOPERATION (FEBRUARY 2004)</p><p>Instability within an industry can create the conditions for</p><p>improved future returns</p><p>In the 1980s, Robert Axelrod, an American political scientist and author of</p><p>The Evolution of Cooperation, invited game theory experts to participate in</p><p>repeated rounds of the best-known problem in their field – the prisoner’s</p><p>dilemma game.1 Axelrod found that a policy of “tit for tat,” or reciprocity,</p><p>1 The “prisoner’s dilemma” involves two prisoners, kept apart, who are separately offered</p><p>inducements to betray each other. If one betrays the other while the other stays silent, then</p><p>the squealer goes free and the one who stayed silent is harshly punished. If both prisoners</p><p>betray each other, they each receive harsh punishment. If both stay silent, they each receive</p><p>a lesser penalty. The rational solution to a single game is for both prisoners to betray each</p><p>other. When the game is played several times, a successful strategy of “tit for tat” evolves in</p><p>which each betrayal is met by retaliation.</p><p>CAPITAL RETURNS26</p><p>was the most successful strategy to adopt in the long-run. He pointed to</p><p>an intriguing example of “tit for tat” in the trenches of World War I. When</p><p>stationed for long periods opposite each other, unspoken truces emerged</p><p>spontaneously between British and German troops. If either side reneged on</p><p>the compact, revenge would be exacted by the injured party, after which the</p><p>truce would return.</p><p>From an investor standpoint, a similar kind of cooperation in basic</p><p>industries is crucial to shareholder value creation. The trick is to identify</p><p>conditions where cooperative behaviour can exist or may evolve, while</p><p>avoiding those industries where this is unlikely to happen. For contrarian</p><p>investors, a history of poor returns in an industry can represent a poten-</p><p>tial opportunity, since cooperative behaviour is more likely to break out if</p><p>companies are responding to the imperative of balance sheet repair. Just as</p><p>Hyman Minsky, the US economist and author of Stabilizing an Unstable</p><p>Economy, observed that financial stability is destabilizing since it leads</p><p>to all kinds of excessive behaviour, so instability can, from a capital cycle</p><p>standpoint, create conditions of stability.</p><p>The ideal capital cycle opportunity for us has often been one in which a</p><p>small number of large players evolve from a situation of excess competition</p><p>and exert what is euphemistically called “pricing discipline.” Having a small</p><p>number of players is important, since retaliation (say a price cut) is likely to</p><p>be a more powerful weapon in the hands of a dominant price setter, although</p><p>barriers to entry are also required to deter opportunistic entrants from tak-</p><p>ing advantage of any price umbrella.</p><p>Certain industries having evolved oligopolistic industry structures,</p><p>have a potentially favourable capital cycle, and yet persist in generating poor</p><p>returns. Partly, this is because “tit for tat” is only likely to work where the</p><p>strategy can be properly discerned. In the auto industry, for example, there is</p><p>too much noise in the everyday competitive battle. Carmakers have to decide</p><p>not just on price, but also on specification, customer financing terms, new</p><p>model launches, service and warranty terms etc., leading to the paradoxical</p><p>conclusion that product differentiation can be an impediment to achieving</p><p>supernormal returns. Contrast this with the steel or paper producer, whose</p><p>product is relatively undifferentiated.</p><p>Politics can also hinder the operation of the capital cycle. In the</p><p>European auto industry, for instance, Volkswagen has for many years</p><p>pursued a market share strategy. At VW, the agenda of the State of Lower</p><p>Saxony (the largest single shareholder, with 18.2 per cent) has more of a</p><p>stakeholder than shareholder bent, with an eye to local employment condi-</p><p>CAPITAL CYCLE REVOLUT ION 27</p><p>tions. In airlines, the habit of protecting “national champions” has not died</p><p>out in Europe as yet.</p><p>Transaction frequency is another feature that can confuse, such as in</p><p>the airline industry, where decisions on pricing have been devolved to front-</p><p>line managers, creating a competitive battleground akin to death by a thou-</p><p>sand cuts. Again, contrast this with an industry such as the automotive glass</p><p>industry in Europe, where the three remaining participants enjoy long-term</p><p>supply agreements and infrequent decisions on new capacity that are sig-</p><p>nalled clearly in advance.</p><p>Axelrod attributes the success of the “tit for tat” strategy in his repeated</p><p>prisoner’s dilemma game to what he calls the “shadow of the future,” which</p><p>has a bearing on decision-making in the current game. Participants are less</p><p>likely to defect in the current game if they think that a competitor will retali-</p><p>ate in the subsequent game. The generals of WWI, infuriated by the policy</p><p>of “live and let live” adopted by their troops realized that the way to change</p><p>behaviour was to remove the “shadow of the future.” This they did by reduc-</p><p>ing</p>
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