Offshore investing - Allan Gray
Offshore investing

Capital: Can companies have too much of a good thing?

In the centre of London, there is a market whose history stretches back to the first century. Built on the site of a Roman forum, Leadenhall was once the biggest market in Britain, with its merchants eventually selling poultry, cheese, meat, and fish.

If lots of people are clamouring for cheese, merchants can sell it at higher prices, and the buyers won’t get much for their money. The merchants may be tempted to bring more cheese to market, and even lower quality produce may find buyers. But if few people want to buy cheese, they’ll be able to buy at low prices, even if they insist on buying only the best bits. Merchants may bring less cheese to market, and mediocre cuts may go unsold.

At a high level, there isn’t much difference between a market like Leadenhall and a capital market, except that instead of a menu of brie and parmesan, imagine a menu of companies. In exchange for your money — your capital — you can buy a claim on a company — either a promise to be repaid with interest, or an ownership stake in the business.

The same relationships apply. If lots of people are clamouring to invest, companies can sell shares and bonds at higher prices, and the investors will get smaller claims for their money. The companies may be tempted to raise more capital, and even lower quality companies may find investors. But if few people want to invest, they’ll be able to buy at low prices, even if they insist on backing only the best firms. Companies may raise less money, and mediocre ones may struggle to attract any funding at all.  

 This is often how we think about managing the Orbis Funds, where our best investment ideas are constantly competing for the Funds’ capital. It is a reason we are contrarian. Better to be picky about prices than to join a throng of buyers in a cash-throwing contest.

This challenge is also similar to one faced by individual industries and companies. Over the years, we’ve found that analysing the investment patterns of companies in an industry can yield insights into its future profit potential.

Businesses make decisions all the time about whether to invest in different projects — a new factory here, a new store there, etc. The textbook version of this process is a list of potential projects ranked by the value that each will create for the business. At the top of the list are super profitable slam-dunk opportunities; at the bottom are projects with profits barely high enough to be worth considering. Projects at the top of the list get funding first, so as a company works its way down the list, it’s investing in less attractive projects. The same is true at an industry level. As we wrote in one of our Strategy commentaries last quarter, nothing kills return on capital like capital itself. On the other hand, if companies in an industry cut back on spending, funding only their top projects, returns on capital tend to rise. For this reason, industries starved of capital often go on to deliver nice profits.

For a historical example, consider technology and tobacco. In the early 1970s, the first commercial microprocessor was produced, planting the seed of the information revolution. In the same period, the US banned most cigarette advertisements. As an investor in the early 70s, which industry would you have invested in, tech or tobacco? Tech! But looking at Datastream sector indices, tobacco shares have delivered 10 times the return of tech shares since 1973. The reason? Investors poured an ocean of capital into exciting tech opportunities, which increased competition and depressed returns. Conversely, regulatory burdens scared investors away from tobacco, but left scant competition and handsome returns for the limited capital that remained.

In the current environment, we’ve observed an interesting trend in the investment levels of the energy and technology industries. Today, most investors regard energy as a risky, capital-intensive business. Pictures of skyscraper-sized tankers and city-sized refineries readily come to mind. Since the oil price crash in 2014, however, the global oil majors have cut back spending, and are now focused on only their best opportunities. And, as we have seen historically, depressed capital spending has been a good setup for attractive returns on capital, one reason why Total, BP, and Royal Dutch Shell are held in one or more Strategies.

On the other hand, most investors regard the FAAMGs (Facebook, Amazon, Apple, Microsoft, Google/Alphabet) as great, capital-light businesses. They have been, and we continue to find Alphabet and Facebook attractive, but the group has ramped up investment in recent years. Each of the FAAMGs runs a network of data centres—warehouses, sometimes as big as ten football fields, filled with computer chips. Building and equipping those data centres is expensive. Last year, the FAAMGs spent over US$75bn on capital investments, and are on track to spend more than the oil majors if recent trends continue. Much of that investment is in areas like cloud services where the biggest firms compete with each other, and intense competition is anathema to returns. Though the tech giants remain strong businesses, this spending warrants close attention, as it could cause their historically high returns on capital to fall.

Yet this trend in tech spending suggests opportunities for other companies, such as Taiwan Semiconductor Manufacturing, which makes many of the chips in those data centres. In a gold rush, selling shovels can be more profitable than joining in the digging.

Cycles of capital investing are far from the only consideration for a company’s fundamentals. But past experience suggests a decent rule of thumb for investors: go where the capital isn’t. 

Orbis will be presenting at the Allan Gray Investment Summit in Johannesburg and Cape Town in July 2019.

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