Below will summarize takeaways from the following book: https://www.amazon.com/Capital-Account-Manager-Turbulent-1993-2002/dp/1587991802. The post will be “living” and will be updated/elongated as soon as possible.
Chapter One Takeaways:
A key component of Marathon’s investment theory is based on the inverse correlation between profitability and levels of competition. Capital Account at 45. Their thinking goes something like this: if competition declines, then future profitability is likely to increase, which should result in higher stock market values. Id. Often, investment analysts miss how competition (the supply side) drives profitability and shareholder returns. Id at 47.
If, during the course of a business cycle, the competitive environment of an industry changes dramatically, then we can expect peak to trough profits to change correspondingly. Id. at 48. The actions of management are extremely important as well. When a mature company operates from a smaller asset base (ie: ROIC improves), it can boost shareholder value even if cyclically adjusted profits stay the same. Id.
What might determine the direction of normalized profits? “The first important factor is the change in competition between one cycle and another. This needs to be tempered by an assessment of the firm’s position in the corporate life cycle and whether its product life cycles are lengthening or shortening. The latter is particularly important because shortening product lives are rarely caught by reported earnings. Indeed, the appearance of rising profits from a new product may be offset by a shorter product life.” Id.
In order to get clues into management behavior, look to proxies and incentives. As far as valuation in concerned, be mindful of market value to replacement costs. (NOTE – Market value to replacement costs applies to most companies. However, the types of companies Bruce Greenwald refers to as franchise companies are likely untethered from replacement costs. In those instances, an investor should think more about yield on cost than replacement values). Long periods of companies trading at discounts to replacement cost tends to result in profitability improving. Id. at 49. This is because sustained low valuations exert downward pressure on capital spending. Id. Eventually, some form of underinvestment leads to product shortages and improved profitability. Id. (NOTE – Be mindful to analyze this on a geographic basis. For instance, the US steel industry could be rational but foreign companies could expand production and ruin the benefits of US rationality).
Conversely, when companies are valued in the stock market at premiums to replacement costs there is a strong incentive to increase capital spending. Id. at 50. This is a form of multiple arbitrage where the company can spend $1 and have it valued at far more than $1. “All too often this encourages undisciplined expansion, which in turn leads to excess capacity and falling profitability. Id. Generally speaking, industry capex to depreciation is a decent clue for determining whether an industry is over or under investing. Id.
Be mindful of the impact asset lives can have on capital cycle analysis. For instance, paper processing plants have longer lives than semiconductor fab facilities. Id. at 57. Therefore, it can take a longer time for capital cycle analysis to flow through the paper processing industry. Id. It’s equally important to study the extent to which new technologies can wreak havoc on capital cycle analysis. Id. In today’s terms, be mindful of potentially disruptive technologies and how quickly they can enter the market.
Chapter 2 Takeaways
“When we examine a company as a prospective investment, we analyse both the industry in which it operates from a capital cycle perspective and make an assessment of the individual firm’s management. We attempt to judge whether the sector is attractive, whether our prospective portfolio company is positioned favorably within its sector and what are the likely returns a company will earn from reinvesting its profits. Since by definition half of all companies must be reinvesting at below average returns, they should ideally be retrenching. However, by our estimate, around 90 per cent of firms continue to invest for growth, regardless of their profitability.” Id. at 65.
Although not news, remember to be mindful of growth for growth’s sake. Moreover, pay some attention to where the company is located. In Chapter 2.3, Marathon highlights France (in 1994) as a country housing corporations with particularly egregious corporate structures and incentives. Perhaps today’s version is the energy MLP industry in Texas.
Throughout Chapter 2, Marathon argues that management compensation via long term options is a good thing. At least up to a point. In short, options compensation, while not a one for one incentive structure, does focus management on share price. Thus, management teams are more willing to make reasonable capital allocation decisions.
With respect to buybacks, Marathon argues a number of conditions should be met:
- The company must be able to afford the buyback without putting itself in jeopardy. Watch leverage and liquidity.
- Buybacks are most suitable for businesses that are mature and generating plenty of cash.
- Generally it’s the adoption of new performance measurement systems, rather than share repurchases themselves, that benefit investors.
- Be very wary of buybacks that drive EPS targets. According to Marathon, buying in shares to improve ROIC or another rational investment metric is a far superior capital allocation decision than driving EPS.
- Share repurchases should be done below intrinsic value. Above intrinsic value repurchases are no better than cash dividends.
- Consistent share repurchases instill discipline.
Chapter 3 Takeaways
The more things change, the more they stay the same. Much like today, the 1990s saw extreme outperformance in the “growth” segment of the stock market.
In 1998 Marathon wrote:
“Enthusiasm for highly profitable businesses has been a striking characteristic of the stock market over the last few years. Yet in theory there is no reason why growth stocks should outperform value shares, since the market is capable of adjusting share prices to reflect each individual companies’ prospects. In other words, as the share price should reflect the net present value of the cash flow a business is likely to generate over its life cycle, it matters little whether this is a modest amount, in the case of a steel company, for example, or a much greater amount, say in the case of Coca Cola.” Id. at 87-88.
Later in the year they revisited their growth vs. value observations:
“We have felt that price-earnings mutliples of 50x earnings might be a little rich for firms whose profits might be overstated and whose main investment strategy is acquisition of their own shares, regardless of price. Furthermore, the high levels of current profitability, from which further enhancements are already discounted, increases our concern…Shares defined by Wall Street as growth stocks have a high probability of failure. Over the last 33 years, only 19% of growth stocks have maintained that elevated status for a decade or more. For most of this period, growth stocks were not as highly rated or as profitable as they are today.” Id. at 91.
They go on to analyze whether growth stocks can grow into current valuations and propose the following decision tree:
In the decision tree above the business model is riskiest at the top of the tree. Id at 93. Importantly, companies with long runways and low risk growth paths are worth a higher multiple than those lacking those characteristics. However, just as oaks don’t grow to the sky, multiples eventually reflect unrealistic expectations. The investor’s job is to avoid the pitfall of believing hype at exactly the wrong time. Watch out for leading indicators of falling profitability, industry expansion, lower returns on capital, and accounting gimmicks that keep earnings elevated. These are all warning signs and demanding valuations require few warning signs.
Interestingly, Marathon bucks conventional wisdom saying they operate under the philosophy that the range of investment outcomes is characterized by “fat tails.” Id at 99. Most market participants assume there is a normal distribution of returns. Marathon, however, argues shares spend relatively little time at “fair value.” Id. Instead, shares spend lengthy periods of overvaluation followed by lengthy periods of undervaluation. Id.
That thesis carries important conclusions. First, it implies short term mean reversion is not likely. Id. Second, it implies extreme periods of misvaluation are not short lived and/or rare. Id.
Given what’s going on within the market, it’s interesting to revisit Marathon’s thoughts in the late 1990s. A couple excerpts:
“We believe the capitulation of the investment community [to chase high flying shares]…will have economic consequences long after the current trend is reversed. This is because valuations affect behavior. For instance, among firms in the value universe which fail to earn their cost of capital even the most diehard optimists in senior management now accept that asset expansion destroys value.” Id at 103-104.
On investor’s behaviors: “The high valuation of growth stocks might leave investors dangerously exposed should growth disappoint at any time. This has induced investors to buy shares in companies they believe will maintain growth. In the last few years, as growth slowed, the list of potential growth companies has narrowed considerably…Growth now has a scarcity premium attached to it.” Id. at 106.“
The more things change, the more they stay the same…
Chapter 5 Takeaways
Chapter 4 didn’t have much. So, here’s chapter 5.
In 1994 Marathon saw the market capitalization of telecom stocks as a signal that competition would likely enter the market. Moreover, Europe was deregulating many telecom markets and transitioning from state run to private enterprise telecom companies. Signals included the following:
“Equity market valuations [of telecom companies] have sky-rocketed. The market capitalization of the telecoms service sector in Europe now…represent[s] 13 per cent of the MSCI Europe Index. Compare this with the modest 2 to 3 percent of national income spent on telecom services in the major European economies. The challenge for investors in such a rapidly changing an complex industry is to understand the assumptions underpinning current valuations and identify those companies with sustainable competitive advantages...That the market values of telecoms firms are currently at a huge premium relative to invested capital reflects an expectation that the prices [economic profits will remain] long into the future.” Id. at 130.
They shared this image of industries beginning deregulation.
That framework appears applicable to industries in the midst of disruption as well. Such as media distribution in 2020.
An important quote to remember: “The laws of the capital cycle are such that in a [competitive] environment, the price of goods and services will drop to the marginal cost of production and even below for a while.’ Id. at 129. This is extremely important to remember. There must be a very good reason if underwriting deviates from this thesis. Don’t find “moats” where none exist if you want to protect capital for the long run.
On network effects: “Many segments of the telecom market [in 1999] display network effects, i.e., the value that a customer derives from a product or service is dependent on how many other customers also use the product. For the network operator, the more businesses a network connects to, the greater the value of being plugged into it. There are also more subtle network effects: advertising is attracted by high levels of subscription, which funds investment in improving quality to attract more subscribers, thereby completing the virtuous circle. However, the first mover advantage will probably be sustainable only when customer turnover is low.” Id. at 134. It’s important to remember that being first, in and of itself, is not a durable advantage. Companies and management teams must combine that with customer lockin.
Throughout the chapter Marathon demonstrates a strong understanding of competitive advantages. Where those advantages begin and end, to whom the real customer relationship belongs to, and whether the growth spend that telecoms underwent in the 1990s would prove economic. The firm also consistently focused on share turnover as an indication of whether a company like Level 3 had long term oriented shareholders (they didn’t and turnover was quite high).
On over indebtedness creating opportunity: “Just as during the technology bubble the ability to raise cheap capital led to ludicrously overvalued companies, the viscous cycle in the debt markets (in May 2002) is creating the opposite phenomenon. Many indebted companies now have share prices that are significantly below our assessment of a ‘clean balance sheet’ valuation. As the price of debt falls in tandem with the market value of the equity, the likelihood of debt-for-equity swaps rises to the point where distressed debt can often be viewed as equity in waiting. While traditionally, the upside for debt securities has been limited to face value, under the debt-for-equity swap model, distressed debt is beginning to look more like equity, both with regard to risk and potential rewards.” Id. at 147. Note – Remember that carnage creates opportunity and look across the capital structure for potential opportunities.
In June 2002 Marathon was following the tech and telecom industry closely. They tend to like situations where shares are trading below replacement cost because management teams have the option to purchase shares rather than spend on capex. They also look for firms in an industry buying debt back at discounts to par because that is another example of capital buying a part of the business in cheaply. However, the industry remained too fragmented for Marathon’s liking and they decided to watch and wait for consolidation.
Chapter 6 Takeaways
On why IPOs tend to be poor investments: Id at 157.
- First, new issued tend to be concentrated in fashionable sectors where a great deal of money has already been made.
- Second, insiders only sell at attractive valuations. Since shares tend to trade around intrinsic value in cyclical fashion, they are likely to be undervalued in the future if they are overvalued today.
- Third, investment banks are paid handsomely to sell a good story.
- Fourth, the company knows a lot more than the equity buyers.
“Despite the favourable reception accorded new flotations in 1995, it would be foolhardy to adopt anything other than a skeptical approach to new issues. We continue to prefer a policy of investing where the supply of equity is shrinking rather than rising, as such a situation is more likely to be consistent with reasonable valuations. Unfortunately, this means our portfolios will be disproportionately invested in the mundane rather than the glamorous. Over the long run, this may be no bad thing.” Id. at 159.
On investment banks and bankers: “An understanding of ‘how the game works’ provides us with an edge over the competition. We believe investment banks exploit weak CEOs; that fads and fashions are hyped to drive deals; that the power of investment banks is sustained by an industry cartel; that skulduggery is rampant; and that banks’ research encourages momentum strategies which produce ultimately futile stock trading.” Id. at 166. Note, that was written in 2000 and some things may have changed. Overall, the incentives identified are more likely to endure than not.
Chapter 7 Takeaways
Marathon is extremely good at focusing on incentives. In discussing economic value added (EVA) as a concept they question whether the incentives are actually counter to long term growth. Id. at 184. They are also extremely focused on looking at what is going to happen, not what happened. For instance:
“Proponents of EVA-type systems agree that it is not the level of profitability that’s most important but the direction in which it is heading. For this reason, we continue to believe that the best investment opportunities lie among companies in the value universe. Not only is it easier to improve corporate profitability from a low level, but expectations for value stocks are now extremely pessimistic, especially compared with so-called growth companies. The new corporate metrics (such as EVA) will surely be applied in the value universe…[which could prove quite profitable for investors].” Id. at 186.
On share repurchases: “Contrary to the widespread belief that highly-profitable and highly-valued businesses have all the opportunities, when it comes to share repurchases it is among the lowly valued business where returns are potentially highest. An out-of-favor company pays a low price for its shares (compared to assets and cash flow), and the size of its buyback can be meaningful relative to the number of shares in circulation. The opposite case is the case for the “nifty fifty” companies whose shares may be trading above intrinsic value. For these companies, the typical share repurchase is so small, relative to market capitalization, that it is largely offset by dilution from share options issued to employees. In some sectors, especially technology, share repurchases are only a drop in the ocean compared to the number of options outstanding.” Id. at 190. That was written in 1999 and remains true today. Tomorrow’s headlines are history’s stories.
They go on to say: “The future returns from repurchasing shares, seventeen years into the greatest bull market of all time, are likely to disappoint shareholders. In our view, the money would be better spent on doubling the research budget, or preferably on special dividends to shareholders…The looking glass world of buybacks is largely ignored by the investment community. At a recent company presentation, analysts bombarded Merck’s management with questions about the R&D pipeline, but none asked about the considerably larger sum being spent on share repurchase. If we capitalized as an investment the cost of company buybacks, then assets at Merck would rise by nearly 40% and return on capital decline proportionally. In our opinion, this represents a truer picture of the trend in returns at the company.”
On turnarounds: Look for businesses that have hit a temporary bump, but did so following big investments in R&D and/or marketing. Those businesses likely have good things going on under the surface.