Capital cycles, business valuations and the macropicture

Welcome to The Mirandolan by me, Joseph Noko. The best newsletter on capital cycles, the macro picture and business valuations.

What are capital cycles? Here’s an excerpt from my first post, The Asset Growth Effect and Future S&P 500 Returns:

High returns on invested capital (ROIC) invite capital and new investment, bidding up asset prices to euphoric valuations while eventually creating excess capacity, plunging economic earnings below the cost of capital, sending a market lurching forward to what Joseph Schumpeter called, the ”gale of creative destruction”, the "process of industrial mutation that continuously revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one", forcing capital to exit, reducing prices, destroying excess capacity in its wake and reducing competition, until profitability recovers. The number of years that a business is expected to yield economic earnings is known as the growth appreciation period (GAP) and is defined by what Warren Buffett has referred to as its “moat”, the set of competitive advantages that support economic earnings, defying the tendency of ROIC to sink below the cost of capital in a process of mean reversion. Not only can some businesses or indeed asset classes “defend” their profitability, but, it is also true that there can be impediments to capital exiting a market, preventing the emergence of profitability, leading to “value traps”. 

The capital cycle is a concept pursued in Edward Chancellor’s book, Capital Returns, a compilation of reports written by Marathon Asset Management’s portfolio managers, and it is driven by a phenomenon known as the “asset growth effect”: the negative relationship between asset growth rates and subsequent abnormal returns.

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