The Ideal Investment: Companies That Don’t Invest

To spot the next bust, watch the capital cycle of corporate-investment surges followed by retrenchment

By JAMES MACKINTOSH
May 23, 2016 4:09 p.m. ET

From my desk I can count 44 construction cranes, as London’s boom in office and apartment towers transforms the city.

Building surges tend to end badly, and London’s grimy air already contains more than a whiff of concern about the number of new luxury flats coming to the market.

This is not only about London. Investors should study the city’s premium property market to learn once again a lesson all too often ignored: High prices eventually lead to supply, which leads to lower prices. London has among the highest prices for residential real estate in the world, but the lesson applies to any company, in any sector, when it gets its moment in the market spotlight.

The pattern is evident in markets time after time, yet investors repeatedly make the same mistake, arguing that this time is different, because this time demand is running ahead of the surge in supply. Mining and oil companies are suffering the effects of the biggest of these capital cycles, with holes in the ground still being dug years after commodity prices plunged. But even in these most cyclical of sectors, investors still got carried away with their projections of demand in the good times, ignoring the solid evidence of increasing supply.

In London, house prices have been rising for so long that it is treated as normal. In the 18 years since I bought a home in the city, the rise in the value of it and its successors have made me more money than my total after-tax pay. Many other London homeowners have done even better from soaring prices, thanks to bigger mortgages. This is, of course, an illusion: unless I sell up and leave London, I’ll never see that “value.”

Developers are demolishing the corroded chimneys of the Battersea Power Station in London and will replace them with replicas, as part of the re-development of the area. PHOTO: TOBY MELVILLE/REUTERS

Londoners occasionally need reminding that higher prices are not inevitable. It’s true that London has changed for the better, justifying higher prices as more people want to live here. But in recent years something else has changed too: restrictions on tower blocks were loosened, so construction could finally respond to those high prices. More than 35,000 new luxury homes are planned over the next decade, according to consultancy Arcadis, a 40% rise in less than two years.

Investors looking for the next bust should pay close attention to the capital cycle of corporate-investment surges followed by retrenchment. Edward Chancellor, an author and former fund manager, sets it out nicely in Capital Returns, a collection of essays by Marathon Asset Management LLP. “All too often,” he writes, “high returns attract capital, breeding excessive competition and overinvestment.”

The ideal management—from a shareholder perspective—would invest the absolute minimum, operate in an uncompetitive industry and return its fat profits to the owners.

Shareholders are terrible at recognizing their own interests, though. When they spot an opportunity, they tend to bid up the shares trying to take advantage of it to the point of excess: social media, shale oil, biotechnology, miners, anything China-related, and of course companies tied to London luxury homes, just in the past few years. With a focus on the predictions of rising demand which encouraged them in the first place, investors tend to be slow to notice that supply has now risen sharply. When demand proves disappointing, that rise in capital spending turns from a reason to buy to a reason to sell.

Spotting the capital cycle at work is quite different to profiting from it. Booms can go on longer than expected, and it is hard to define the point in the bust when investment excesses are in the past and management has truly learned their lesson.

The capital cycle doesn’t always work, particularly when governments protect companies from the consequences of their mistakes—state-owned industries in China continue to invest heavily despite plunging profits, for example. High prices do not always result in a self-defeating rush of supply, either: U.K house-building outside the London luxury segment remains far too low, probably due to land-use restrictions. But when shareholders cheer on corporate investment, it is worth paying close attention to the risk that they are merely driving up competition and so driving down future profitability.

Eugene Fama, winner of the economics Nobel, and his colleague Ken French, have expanded their famous “three-factor” model to include corporate investment as a driver of returns, alongside value, momentum and size (they also added profitability). Broadly speaking, companies which invest more tend to underperform those which spend little. But, as with the other factors, it may take years to profit from such an approach.

A plausible case can be made that the corporate caution induced by the 2008 financial crisis contributed to the wonderful returns made by shareholders in its aftermath. Companies were reluctant to invest despite elevated profit margins, instead returning spare cash via share buybacks. With the triple tailwinds of a low starting valuation, easy money and little wage pressure, margins remained high and stocks prospered.

All three of the tailwinds are now in question, and U.S. companies are investing more (outside the energy sector, the one place where money poured in, only to be poured into holes in the ground). Shareholders are also encouraging corporate capital spending: according to a regular Bank of America Merrill Lynch survey of fund managers, the clamor for U.S. companies to invest spare cash rather than pay it out is at record levels.

Timing the capital cycle is hard. But we can be reasonably sure that when shareholders push companies to invest, it will eventually lead to lower profitability for everyone. So count those cranes. And if you must buy a luxury London home, expect it to give you the chance to live in the world’s greatest city, not repeat the price gains of the past.