QUALITY CONTROL (May 2014)

Capital Cycle analysis helps to identify investments with high and

sustainable returns
The capital cycle approach to investing is often associated with stocks from the value
universe, where low and falling returns lead to capital flight, laying the foundations for an
eventual recovery in profitability and valuations. It is perhaps less well understood how the
capital cycle can also be applied to companies which have high and sustainable returns. This
class of business has produced some of Marathons best performers over the last ten years
Coloplast, Intertek, Geberit, Gartner, Kao and Priceline to name a few. How do such
investments fit in the capital cycle framework?

Pricing power has arguably been the most enduring determinant of high returns for these
investments. It has come from two main sources. The first being a concentrated market
structure, closely associated with effective management of capacity through the demand
cycle which encourages a rational approach to pricing. The second being intrinsic pricing
power within the product or service itself. Intrinsic pricing power is created when price is
not the most important factor in a customers purchase decision. Most often this property is
generated by the existence of an intangible asset. There are several classes of intangible
assets, examples of which can be found amongst Marathons holdings.

An obvious one is consumer brands. In the toothpaste category, private label penetration is
only 2 per cent, supporting Colgates excellent economics. An intangible asset can also
derive from a long-term customer relationship, as in case of the agency business models
(Legrand, Assa Abloy or Geberit) where the customer relies on intermediaries (electricians,
architects and plumbers respectively.) The agents interest is safety, quality, reliability,
availability and perhaps his own ability to earn a commission. Under such circumstances,
price is a pass-through to the end customer, for whom product costs represent a small part
of the total bill.

Sometimes a product is so embedded in a customers workflow that the risk of changing

outweighs any potential cost savings - for instance in subscription-based services like
computer systems (Oracle) or payroll processing (ADP, Paychex.) Networks, where the
customer benefits from a companys scale, as in the security business (Secom), industrial
gases (Praxair, Air Liquide), car auctions (USS) or testing centres (Intertek) are another
example. Finally, technological leadership (Intel, Linear Technology) can be another
important intangible asset although this is perhaps one of the less durable sources of
pricing power, unless combined with others. The very best economics appear when some of
the above characteristics combine in a situation in which the cost of the product or service is
low relative to its importance. For example, the analog semiconductor chip which activates
the car airbag, yet costs little more than a dollar.

The presence of intangible assets acts as a powerful barrier to entry. They are by nature
durable, difficult to replicate and tending to economies of scale. Importantly, these barriers
often strengthen over time as high returns on capital throw off abundant free cash flow
which is in turn reinvested in the business. For example, over the last five years, P&G has
spent over $40bn in advertising whilst Intel has invested over $40bn in R&D. This repels new
entrants, short-circuiting the destructive side of the capital cycle whereby excess profits
normally attract competitors, which over time erodes profitability. Thus, the presence of
intangible assets creates a virtuous cycle allowing intrinsic value to compound over
sustained periods at above average rates, an extremely powerful combination for the long-
term shareholder when allied with prudent use of free cash flow. (The importance of
management in this process is paramount high organic returns can be diluted quickly by
poorly conceived investment decisions or badly timed buybacks.)

Critically, this higher rate of compounding comes at a lower level of risk as the economics of
a high return business tend to be more resilient to adverse shocks. This is partly
mathematical a 1 per cent fall in margin has a greater impact on a 5 per cent margin
business compared to one that earns 20 per cent. Equally though, the factors which create
sustainably high returns intangible assets, strong market position and rational
management also make a business more robust in the face of adverse changes in the
business environment, whether of a macroeconomic or industry specific nature.

For investors with short-term horizons, the virtue of compounding at a higher rate can
appear insignificant. Over short time periods, share prices are generally driven by other
factors such as macroeconomic or stock specific news flow. Investing in a high quality
company can seem dull and unrewarding in the near term. The lower risk which comes from
investing in quality companies is only properly observed over the long-term. The fact that
investors are often focused more on the short-term is partly a function of psychology the
human brain is simply not attuned to multiyear planning, being far better at responding to
short-term threats and stimuli. This is seen in several behavioural heuristics notably
hyperbolic discounting1 and recency bias. Short-termism can be intensified in an
institutional setting. Performance-related pay for money managers at most investment
firms is weighted to annual performance, which discourages long-term thinking.

Finally, there is another more technical reason why the virtues of a high return business are
not always fully appreciated by investors. This is the tendency of investors to focus on the
income statement. This fosters a fixation on price earnings (P/E) valuation metrics and not
price free cash flow (P/FCF). Thus all earnings growth is seen as equal, even though it is
materially more value creative when return on capital and cash flow generation is higher.
Faced with a choice between invest in two companies with the same earnings growth, we
are prepared to pay materially more (in P/E terms) for the business with high returns on
equity and superior cash flow generation.

In short, there are any number of good reasons to invest in businesses with durable high
returns. Now appears an especially good time to do so. The rationale is simple across
nearly all sectors margins are close to peak levels. It is sensible, therefore, to consider
whether current profitability is sustainable given the historical tendency of margins to mean
revert. In addition, tail risks lurking in the background namely elevated debt levels in the
private and public sectors, and the uncertain consequences of the unprecedented degree of
monetary stimulus are likely to impact the profits of lower quality firms at some stage in
the future. Current valuation levels do not require investors to pay a premium for this
superior durability, hence the preponderance of higher return names in our global
accounts.2

1
There is evidence that investors discount rate increases for when cash flows are further out - a phenomenon known as
hyperbolic discounting. See for example Andrew Haldane, The Short Long, (Speech May 2011).
2
At the time of writing, Marathons top ten positions in its global accounts had an aggregate operating margin and return on
equity of 25 per cent, while trading on a similar trailing P/E multiple (18 times) to the MSCI World Index. The superior free cash
flow conversion of these businesses (92 per cent vs. 65 per cent) means that they trade at a discount on a price to free cash
flow basis.