Expected growth in industry demand can be alluring. It points to increased earnings and an opportunity for investors – and it's a common mistake to extrapolate boom-time conditions into the future.
In such scenarios, investors can be lured into stocks that may be trading at relatively low multiples while achieving high profitability. But it may be a mistake. Focusing on growth prospects while ignoring the supply side has often resulted in poor returns for investors.
For many industries, growth and profitability are not static. Investment is attracted to, and increases, for businesses with high profitability, and generally dries up when returns are poor. There is a cyclical element to this process.
As Edward Chancellor, a noted investor and editor of Capital Returns, explains, investors would do well to adopt ‘capital cycle’ approach. The key is to ‘understand how changes in the amount of capital within an industry are likely to impact future returns’.
Chancellor makes an interesting point about the benefits of tracking supply, a proxy for capital:
'Supply actually can be forecasted because in most industries, it takes quite a while for the supply to come on stream. You can see how much assets have grown inside an industry, or inside any particular business. You can see it through any number of measures.’
Mining is one industry where a capital cycle approach can benefit investors. Surges in capital expenditure for much of the past 15 years contributed to a collapse in related commodity and stock prices a few years ago. In the boom phase, many industry analysts and miners were fixed on seemingly insatiable demand, mostly notably from China.
The best times to invest are often when investors are leaving, and capital is being withdrawn.
That’s what we did when industry prospects turned gloomy. As we noted in 2015 with our Buy recommendation on South32: ‘We aren’t particularly bullish about commodities or about mining. Industry profitability is clearly declining and will be doing so for many years, but universal neglect is creating bargains’.
South32 rose nearly 65% from our first buy recommendation in June 2015 before our first call for members to sell in November 2017. Returns for those that followed our repeated Buy calls at lower prices will have done better still. Changes in the industry’s investment levels weren’t our sole basis for recommending South32, but it certainly helped.
Investing is a discipline that requires continuous learning. Adding new tools to your investment kit is one way of boosting your odds of success. So next time you're looking at a company, remember the ‘capital cycle’ approach.
Our Intelligent Investor Equity Income Portfolio is now available as a listed fund. Holdings in the Fund will mirror our current Equity Income Portfolio, has the same low costs, but you can buy it on the ASX. You can save yourself the broking commission by applying during the initial offer.