The ‘trapped’ capital cycle spreads to energy

At Ardevora, we frame our views around two focal points. First we judge how the managers who run companies are behaving. We assume most managers tend to view the future too optimistically and are tempted into taking too much risk; either chasing growth too aggressively or resisting evidence of a more difficult environment too stubbornly.

We look for those where the views look realistic, conservative and safe. Our hunt for them helps us form a view on the overall stock market, from the bottom, up: where is risk building, where it is receding, where are management relaxed, where are they seemingly in denial?

Second, we judge how other investors are behaving. We have to take a lateral approach. Investors are a seething mass. We can only attempt to infer how the mass is behaving. We infer in two ways. Initially we look at stock prices in relation to both history and to attributes of the company they represent – such as sales, profit and cash flow. Some patterns imply anxiety or scepticism; others imply a feeling of calm or hope.

Then we watch how financial analysts are behaving; we can observe them more directly. They produce forecasts and they write reports. Their views can influence investors, so they give us a partial insight into the views of the seething mass. From analysts we can get a sense of where anxiety or hope is building and, where scepticism may be lingering.

For most companies it is getting harder to grow. This can make normal management behaviour risky. In our experience most managers like trying to grow their companies. They can be tempted into risky behaviour when plans do not fit reality. A fast growing company can miss growth targets and allow costs to run ahead of new sales. A slow growth company can be too slow to recognise disappointing sales or pricing is not fleeting, but long lasting. They hang on to old plans for too long. The herding of management behaviour can create industry-wide problems, like ‘trapped’ capital.

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We are attracted to investor anxiety. We think investors can overreact to bursts of intense bad news, and can be scarred by particularly unpleasant experiences. But judging whether investor anxiety is misplaced for stocks in tricky industries with trapped capital is difficult. The debate often collapses down to how quickly a business might fail, rather than how far it might recover.

Since 2013, we have been worried the natural resource industries had become trapped. Recently we have started to worry they are not alone. We now believe there may be three industries where investors are anxious, but where trapped capital makes it tricky to judge whether this anxiety is truly misplaced: energy, media and retail.

Energy is the industry that vexes us the most at the moment. The industry experienced an unusually benign environment from 2000 to 2013. The oil price quintupled, making life easy for almost every company involved in energy production and switching management focus from survival and efficiency, to growth. The oil price collapse in 2009 proved to be short lived, emboldening managers further.

As a result, a lot of existing companies invested for growth. This is the first ingredient for trapped capital. The second is the emergence of new businesses with new, better ways of doing things. They suck in new capital. With the development of US shale reserves, we have this second ingredient as well.

Huge strides have been made in transforming previously prohibitively expensive oil and gas reserves locked up in US shale formations into a low cost source of new oil and gas. Once uneconomic below $80 per barrel oil, now large areas of shale reserves make attractive returns at $40 per barrel. Capital has flooded in to take advantage.

Meanwhile, new sources of demand, like China, are slowing and new demand destroying technologies, like renewable energy, are shifting the previously benign environment. The industry got a nasty shock in 2015, as the oil price fell sharply again. For a short time investors and analysts worried about whether some oil businesses would survive. The industry responded, production was cut and the oil price has partly recovered. But no capital has really left the industry and now capital is coming back in as US shale producers, having cut costs further, begin to grow again.

The trapped capital cycle looks set: too much capacity, not enough desire to exit, most businesses locked into non-mean reverting low profitability, with investor anxiety ebbing and flowing around a slowly unfolding trap. The industry can offer opportunity, but most likely amongst the small number of carefully run disruptors or occasionally when investors worry about bankruptcies in the businesses that will survive, but not ultimately prosper.

Jeremy Lang is a partner and co-founder of Ardevora Asset Management.

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