Practical analysis for investment professionals
28 August 2016

Book Review: Capital Returns

Capital Returns: Investing through the Capital Cycle: A Money Manager’s Reports 2002–15. 2015. Edward Chancellor, ed.


A financial publication that is more unappetizing than a collection of company analyses is hard to imagine. Once one gets past the collected Berkshire Hathaway annual reports, the recommended list rapidly tapers.

Capital Returns: Investing through the Capital Cycle: A Money Manager’s Reports 2002–15 proves the exception for at least two reasons. First, it covers an important and underappreciated subject, the capital cycle. Second, it contains a superb introduction by one of the great financial writers of our era, Edward Chancellor. The rest of the book — a compilation of reports from various analysts at Marathon Asset Management — is uneven at best, as might be expected in a multiauthored volume. Chancellor’s gem-like exposition of the concept in the first few dozen pages, however, is by itself worth the price of admission.

Most finance professionals have a working grasp of the real estate cycle and the credit cycle, but they are less familiar with the credit cycle’s close — and arguably more important — cousin, the capital cycle.

Chancellor’s starting point is an imaginary manufacturer of obscure but profitable widgets with rapidly growing revenues and earnings. The company’s success lands its CEO on the front cover of Fortune, producing the inevitable attendant megalomania and overreach. Chancellor’s fictional executive, William Blewest-Hard, no longer imagines himself a hard-working bean counter but, rather, the second coming of Thomas Edison. Capital is raised from investors hungry for growth, a new plant is built, and capacity burgeons. At the same time, the company’s competitors, particularly in China, take notice, and as global widget production increases, profitability plummets. Plants shutter, bankruptcies ensue, and competition ebbs, setting the stage for renewed profitability among the survivors. Analysts, notes Chancellor, tend to focus excessively on the growth of demand for output rather than on the growth of the output itself, which is what drives the capital cycle. The rest of the book amply demonstrates that the companies that survive are the ones that best understand the cycle.

Chancellor steps back for a moment with several salient observations. First, at ground level, the capital cycle is particularly vigorous in certain industries, such as the semiconductor, construction, marine shipping, and airline industries. During the past few years, one does not have to move much beyond the headlines to add the petroleum industry to that sorry list. Second, this observation is backed up by loftier academic work demonstrating the negative impact of investment/asset growth on future returns. Chancellor labels this phenomenon the “capital cycle anomaly,” an effect so powerful that it may well subsume the value premium. This anomaly operates at all levels of the economy, from individual companies to sectors and right up to nations. It is no accident, for example, that Sweden, notoriously stingy with investment capital, has produced one of the world’s highest series of equity returns or that China, with near double-digit economic growth, has rewarded shareholders with dismal profit growth and negative long-term real equity returns.

During the 1990s, Gary Winnick’s Global Crossing built about a third of today’s submarine fiber-optic net with billions raised from credulous investors. In the end, his empire was scooped up by two Asian firms for literally a penny on the dollar, leaving the rest of us with instantaneous worldwide communication. This story is not new. During the 1920s, the development of radio, automobile, and aircraft technology fleeced millions while simultaneously improving the overall quality of life. It is not much of an oversimplification to observe that investors are often “capitalism’s philanthropists,” throwing money at ambitious schemes that, while benefiting society at large, do not do much for shareholders and bondholders.

The rest of the book is problematic. Analysts’ reports are all too often self-congratulatory and self-promotional, and the editor could have done a better job of filtering out those faults. In addition, the reports frequently delve far too deeply into the weeds of individual corporations’ accounting. On the moral side of the ledger, a particularly alarming passage extols the virtues of a hearing aid company that successfully marketed its overpriced wares to price-insensitive audiologists, who then prescribed them to underinformed patients.

From the analyst’s perspective, the most important point made is that meetings with corporate management should focus as much on executives’ awareness as on the financial data. Do the leaders understand just where in the capital cycle their company stands, and are they carefully husbanding their assets for the inevitable point in the cycle when capital becomes most scarce, precious, and profitable? Even more critically, do the managers demonstrate overconfidence and megalomania — the quicksand patches where capital goes to die?

The Marathon reports illustrate several amusing examples of “toxic management syndrome.” As one contributor puts it, “Appearances can be revealing. A CEO of an industrial company who wears expensive shoes, or a snappy suit, is more likely to enjoy the expensive company of investment bankers than spend his time visiting factories and customers.” But even Marathon’s sharp-eyed analysts occasionally get fooled; one report fills three pages with verbatim quotes from a favored executive that sport enough bromides to fill the storeroom of a university chemistry department.

More book reviews are available on the CFA Institute website or in the Financial Analysts Journal.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.


All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
William J. Bernstein

William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and also three volumes of history, The Birth of Plenty, A Splendid Exchange, and Masters of the Word, about, respectively, the economic growth inflection of the early 19th century, the history of world trade, and the effects of access to technology on human relations and politics. He was also the 2017 winner of the James R. Vertin Award from CFA Institute.

Leave a Reply

Your email address will not be published. Required fields are marked *