“Typically, capital is attracted into high-return businesses and leaves when returns fall below the cost of capital. This process is not static, but cyclical – there is constant flux.” — Edward Chancellor, Capital Returns
Recently, I was introduced to capital cycle analysis, an investment philosophy that spurns the traditional “value” and “growth” distinction to focus on supply conditions within a given industry — capital allocation in the sector and structure of components that feed the value chain. From what I can gather, financial historian Edward Chancellor and London-based manager Marathon Asset Management have been the most vocal supporters of this framework for approaching the markets and asset classes. I’d like to see if and how capital cycle analysis maps on to the venture ecosystem and explore whether its underlying assumptions still apply in our modern economy.
Proponents of capital cycle analysis believe asset prices, demand forecasts, and investor sentiment towards a market (optimism or pessimism) are lagging or messy signals. Rather, they have a relatively straightforward point of view grounded in a world-view that markets move in cyclical fashions, rather than linear or exponential. If there is over-investment in an industry relative to cost of capital, goods, etc., stay away. If it’s under invested, now might be a time to buy.
“The common mistake is that investors are transfixed by growth prospects, whilst ignoring changes on the supply side. During the boom periods, they extrapolate past growth rates into the future. Value investors hoped that the low multiples on US housing stocks before 2008, and global miners several years later, would protect them against capital losses. They were badly mistaken. In both instances, stocks in these sectors later fell on average by more than 50 per cent.” — Edward Chancellor, Capital cycle matters for investing
I found this way of thinking intuitive, yet refreshing. It makes sense, but I feel as if I rarely see it come into practice. I could drill deeper and further into what constitutes the capital cycle analysis framework, but won’t bore the reader with those details. On the contrary, I’d like to see if the features of this world can be mapped to venture.
A Framework for Venture?
Capital cycle analysis works with mature industries that have well-defined supply chains and diversified capital sources. For example, one look at iron ore prices as an indication of whether to short or long global mining stocks. But that exercise becomes a little trickier with information-driven businesses. What are the supply components of Figma or Notion? How do you measure them?
Furthermore, companies have three stages of life (value-seeking —> growth —> maturation), and capital allocation tactics may only matter in the growth and maturation phases. Venture typically doesn’t play in those. Capital cycle analysts also look at measures like # of IPOs, M&A, and high yield debt issuance. Companies are staying private longer, so data on other forms of capital allocation activities may be hard to wrangle.
With all this in mind, here’s how I see venture borrowing lessons from the world of capital cycle analysis:
Traditional investors focus 90% of their time on looking at demand, and 10% on supply. Capital cycle-driven investors flip this on its head. Despite demand being next-to-impossible to forecast in consumption and non-consumption markets, VCs still try to do it. As software continues to eat the world, investors could instead look at capital supply across industries during company evaluation to get a sense of emergent opportunities.
Take truly idiosyncratic bets other investors aren’t willing to pursue — areas like Planet+. Every VC likes to say this, but few do it. Those in the industry know it’s a psychological battle. For example, and based out of necessity, many emerging managers have to optimize for fundability of their portfolio companies by big name funds. If you’re a venture investor who buys in to a form of the capital cycle argument, you not only wouldn’t go to YC Demo Day, you wouldn’t even think about it.
Look for businesses that can build moats or systems impervious to the machinations of the capital cycle, escaping its grasp. Nick Sleep of Nomad (and formerly of Marathon) has gained fame in investment circles due to his big bet on Amazon and scale economies shared. With this framework, it makes sense that Ben Thompson believes those who rule the markets of the present and future will commoditize supply.
For Another Time
One of the primary tenets of capital cycle analysis is mean-reversion. What goes up must come down. It should be noted that this philosophy has come under attack in recent years — proponents of a new economy believe in a world guided by increasing returns and network effects. There are a lot of nuances within an attempt to reconcile this pushback on mean reversion with capital cycle analysis — bear / bull cases for the SoftBank Vision Fund, the proper taxonomy of companies — and I’ll save it for a later post.