Excess Capacity: The Case for not Following the Money
Investors who overlook capital cycle analysis do so at their own risk. Companies don’t operate in a vacuum, and factors such as capacity can be the difference between winners and losers.
Energy is only the latest example of the impact capital cycle can have on a sector. The dynamic has played out in other industries, including real estate, utilities, mining, and manufacturing.
Even the best company in a struggling industry may face additional headwinds due to the behavior of its peers. Case in point: Oil. Technology advancements that allowed for cost-effective fracking also led to increased capital flowing into the sector and an eventual supply glut.
Too Much of a Good Thing?
Additional business spending can support greater sales for industries where product appetite is still expanding, but when the tide turns excess capacity can amplify negative effects.
We use capital cycle analysis as an additional check when examining opportunities to determine whether a company could benefit from a return to rationality in the industry in which it operates.
Metrics such as reported capital expenditures versus depreciation rates provide a starting point to assess areas that are seeing a flood of investment versus those where capacity is likely to be constrained in the future.
However, the data requires context. Its usefulness varies among sectors and at the industry level. This type of analysis is best for companies that operate in highly commoditized businesses, such as raw materials, semiconductors and manufacturing. Businesses with differentiated products, limited competition, or where brand loyalty is strong tend to be less effected by capacity.
Investors should also take a longer view of industry trends when forecasting supply imbalances. If excess investment has been building for years, a quarter or two of reduced corporate spending is unlikely to result in future pricing power.
In Search of Triple Plays
Given our value focus, we tend to prefer sectors and industries where market interest has ebbed and stocks have sold off, capacity is declining due to low capital investment, and product demand is nearing the low end compared to historical averages. Our process has led us to names in late-stage cyclical areas that have long been out of favor with investors.
For example, Metals and Mining companies are trading at their lowest levels relative to the S&P 500 in nearly 10 years. As you can see, capital investments in the space have also been depressed, and, for the majority of the past three years, have lagged the industry’s rate of depreciation and amortization.
Poor returns for the group and a lack of investment could set the stage for additional tailwinds for effectively managed businesses. With that in mind, we continued to hold Joy Global (JOY) during the depths of the bear market.
The Milwaukee-based mining equipment producer was off 64.8% during the second half of 2015 as commodity prices fell and some of its coal mining customers filed to reorganize under bankruptcy protection. The company reported disappointing orders and lowered guidance for the full year.
While these challenges were significant, we believed Joy’s exceptionally close relationships with clients, business services lines, and entry into new markets warranted more patience. Further bolstering our confidence was industry consolidation and the dearth of capital investment in the space, which we believed would translate into tighter capacity going forward.
Because the sector was flooded with capital spending for an extended period, we anticipate reduced investment will take a while to have a meaningful impact on customer demand. However, mergers and acquisitions among leading players has helped accelerate some supply rationalization. To date, our analysis has paid off and shares of the company are up nearly 68% year-to-date through the end of June.
Using capital cycle analysis can also highlight areas that may face pressures in the future. For example, as the chart shows, Airlines have been investing in their businesses almost twice as fast as capacity has been removed through depreciation. At the same time, stock performance of the group is at a 20-year high based on relative performance to the S&P 500. To us, the dynamic is setting the stage for potential pain when pricing pressure emerges.
The same dynamic is playing out in the luxury cruise market. We previously held a large ship operator in our portfolios. Valuations were attractive and we believed capacity was not keeping pace with increased demand for leisure travel. Success in the industry, however, unleashed a flood of investment and capacity outstripped demand growth. We exited the position before pricing power eroded and our shareholders benefited as the name has sold off.
Other areas that warrant additional examination based on our view of capital expenditures are: Oil & Gas Consumables, Energy Equipment, Machinery and Engineering & Construction.
We’ve highlighted how different stages of the capital cycle can lead to oversupply, but additional business spending can support greater sales when demand is expanding. Similarly, if an industry has yet to reach a trough in demand, reduced investment can point to eventual pricing power, but challenges may remain in the near-term.
Past performance does not guarantee future results.
Investing involves risk, including the potential loss of principal. There is no guarantee that a particular investment strategy will be successful.
Value investments are subject to the risk that their intrinsic values may not be recognized by the broader market.
As of 6/30/2016, Heartland Advisors on behalf of its clients held approximately 0.01% of the total shares outstanding of Joy Global Inc. Statements regarding securities are not recommendations to buy or sell. Portfolio holdings are subject to change. Current and future holdings are subject to risk.
The statements and opinions expressed in this article [or appearance] are those of the presenter(s). Any discussion of investments and investment strategies represents the presenter’s views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed above, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations are based on Heartland Advisors’ estimates. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change.
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