What is the ‘Capital Cycle Effect’?

This is something you’ve mentioned in past newsletters and writings, but I’m not sure what this means. Can you explain what you mean by the ‘Capital Cycle Effect’ and what it means for investors?

One of the “laws” of economics is that capital flows into and out of industries based on the strength and weakness of investment returns. High returns attract more capital, while poor returns have the opposite effect. In other words, investors overpay for businesses when they’re at the peak of their industry cycle, and they underpay when the businesses are at the nadir of the cycle. That’s the Capital Cycle Effect.

It affects some industries more than others. Commodities tend to be particularly sensitive because supply drives pricing so directly. If you have oil prices at $120 per barrel, for example, you’ll see a lot of capital flowing into oil because investors want to chase that profit. However, one way or another, that excess capital will be used to create new supply that will eventually work to bring prices lower. Then shareholders move on.

We can see this phenomenon portrayed visually in the standard demand curve (see chart).

If you have a demand curve that's relatively constant, and supply (quantity) is low (less than demand), prices will move up. People want to lend to companies in that environment because they want to be part of that profit profile. But then all of that new lending and investment will work its way into creating new supply. When supply overtakes demand, prices will have to correct, and capital will move on to something else.

Can investors make money in cyclical environments? Definitely, but we don’t want to own them throughout the whole capital cycle. At best, we want to own them when prices are low, and they’re not making any money. If they have staying power and are low-cost producers, they have a good chance of giving you good returns with less risk of loss. Then, you want to get out of them when they’re printing money. In many ways, it’s the opposite of what you think is rational.

This capital cycle is less pronounced in areas that don’t have typical boom-bust cycles. In fact, that’s my own preference: I’m more interested in companies that aren't exposed to an intense capital cycle. For example, a lot of technology companies have a simpler value proposition, wherein their pricing power isn't driven so much by industry supply as by what they're doing under the hood to create engagement with customers.

In fact, if I were to invest in something like oil and gas, I would argue that I’d be paying an opportunity cost for that investment, because I have other investments that I could potentially ride for five to ten years rather than during a short cycle.

In general, I don't want money riding on capital cycles. Yes, I can make money that way, but it’s not core for me because other judgments are better, easier, and less volatile. (I also addressed this back in September when I answered a question about whether commodities are worth investing in). So, I’d rather get into a situation where the ability to create long-term success is driven more by what's happening inside the company, and that’s generally not in companies that are subject to intense capital cycle effects.