The Capital Cycle Is Turning

0:02Speaker 1:Bloomberg Audio Studios, Podcasts, Radio News.

0:17Speaker 2:Welcome to Marin Talks Money, the podcast in which people who know the markets explain the market. I am Maren Somerset Web and this week I am speaking with Luke Bridgman, Senior partner and portfolio manager at Hosking Partners. I invited Luke on because they are a very interesting group of investors. At Hosking. They invest based on the capital cycle. We're going to talk about that, what it means, how it works, and at the same time we talk about everything from why they're invested in Japan to oil and in particular about dram memory and about shipping. Luke, Welcome to Marin Talks Money.

0:50Speaker 1:Great to be here. Thank you, Mary.

0:52Speaker 2:Well listen, Luke. I asked you on because I think a lot of our listeners are quite interested in capital cycle investing. We've written and spoken about it a few times in the past, and looking at the massive levels of capital spending going on, particularly of course in the AI area, it seems like something we probably should begin to focus on. So that's the reason that I thought I want to talk someone involved in a capital cycle style of investing, and you came to mind so I wonder if we could just start by me asking you what exactly is it that you do at Hoskin and how does the investing style work?

1:29Speaker 1:Great? Thanks Marin. What we do at Hosking is is very simple. We have a single strategy and that's global equities. We do that with a team of five portfolio managers, and we are slightly different from other firms in that we are all global generalists investing across the whole world without specialization, using this capital cycle approach, and we do this with a very diversified portfolio of about four hundred stocks.

1:56Speaker 2:If that answers the question, it begins to answer the question. But the second bit is to explain because we do not have a fully expert audience. We have educated amateurs at our audience in the main. So now we need to explain exactly what it is that you mean by capital cycle investing.

2:14Speaker 1:Okay, so the capital cycle is based on the very simple paradigm. The high returns tend to attract capital, and that capital competes away those returns to the point that the returns fall due to obsolescence or bankruptcy or merger. And then in the absence of competition, the returns recover and the cycle begins again. And that's not rocket science. Is very simple. It's a simple observation about business and economics. As capital cycle investors, we're really focused on where that doesn't work, and that means we're really looking for two types of situation. Broadly speaking, we're looking for high return companies where capital can't get in. So those are sort of Warren bufferty Moti barriers to entry. Situations where there's some reason why capital can't come in to compete and the returns can be sustained for higher than the market recognized in the price. They're able to beat the fade and show persistence. And then we're also interested in situations where returns have been beaten up and capital has been withdrawn, and that gives us the confidence to make the bet that the returns are going to pick up sooner than

3:23Speaker 1:the market is given credit for. And so the benefit of the capital cycle approach is that it's able to plot all companies somewhere in this sort of view of the world, but it makes it incredibly versatile. That's the governing principle, the lens through which we see the world, which allows us all to be generalists trying to take advantage of this huge opportunity set.

3:47Speaker 2:So in a sense, you're looking at investing through the lens of supply rather than through the lens of demand. I mean, I was actually on a podcast the other day talking to someone about this and saying that one of the very first things that I learned when I first started as a stop in Tokyo was to look in particular at semiconductor stocks and to say, when these things look cheap is when you shouldn't be buying them, and when they look expensive is when you should be buying them, because given the way the capital cycle works, you want to be selling them when they are incredibly popular, making powers of money and holds more capital that's coming into the market, because that's when you know that prices will soon fall, whereas on the other end, when they look very expensive, they're not. But sorry, yes, when they're not making any money, that's when you want to be to be buying them, because there's very limited amounts of capital in the market.

4:34Speaker 1:Right, Yeah, Yeah, you're completely right. Two points. Yes, it's about supplier rather than demand, So we're sort of able to observe those things which are observable we can count factories being opened, we can look at job hires, we can see the reverse in terms of bankruptcies or failures. We can see the amount of debt being raised or the amount of equity being issued, rather than trying to predict how many widgets are going to be sold in North America in two years time. But you're also right that it's something which is inherently contrarian. And if we see high returns as capital cycle investors, our first thought is, you know, how likely are those returns to be competed away?

5:13Speaker 1:Where we see poor returns which are hated and neglected by everybody else, we ask ourselves, well, could they be wrong? And is there an opportunity for returns to recover because capital has been withdrawn from this particular sector. So, as investors, taking contrariy decisions is emotionally very very difficult, and if we have some sort of intellectual or rational tool which helps us to make emotionally difficult decisions, then that's got to be something in our favor.

5:41Speaker 2:Yes, well, that's why we always say that good fund management as much as that character of strategy, don't.

5:46Speaker 1:We Yeah, I think that's very true.

5:48Speaker 2:Right, So let's move that on to talking about did you write this piece about the share prices of the three companies which dominate the global deram membory thing was that you?

5:57Speaker 1:Noh, yeah, I did. I did write that.

5:59Speaker 2:Yeah, worry about that?

6:00Speaker 1:Well?

6:00Speaker 2:Excellent, of course you wrote it, and it's excellent. This is the area when we're talking about the capital cycle. We look at companies such as the easy you talk about Micron and Skhiinex and Samsung. And obviously there's been a lot going on in career over the last couple of weeks while I've been on holiday, so the cost bit is now down from its peakback in June, right, and some of these big, big companies have had rather nasty negative momentum moves recently. But nonetheless, the conversation is about the extent to which these companies that currently dominate the memory market will be subject to an old fashioned capital cycle.

6:34Speaker 1:Yeah. It's a fascinating subject because we've been investing in the memory semis, by which I mean the manufacturers of DRAM in particular, and those are the two Korean companies Samsung and sk Heinex, as well as Micron in the US. But we've been investing in them since inception, which for us is twenty fourteen. It's a really interesting sector because to understand that, you really need to go back to the discovery of DRAM, which was by In funnily enough in nineteen seventy and despite being the pioneer in this industry, it actually exited fifteen years later in nineteen eighty five to focus on logic chips, where it saw itself having a greater advantage. And the reason why it exited DRAM despite having been the pioneer is that it just saw more and more competition coming into this highly commoditized market for memoryships, which were all interchangeable and which we're suffering from excess investment. There was a constant progress in what's called Moore's law. The number of transistors you can get onto a chip shrinks at a fairly regular pace every two years, broadly speaking, and so the constant need keep

7:44Speaker 1:investing with the latest technology before you'd even really made a return on the previous investment cycle. And this led what had been thirty DRAM companies around nineteen eighty five when Intel exited, to fall to just three years later in twenty twenty thirteen, twenty fourteen s and that was because they couldn't keep up with that pace of investment, and so the lack of a return on capital meant that they were either forced into bankruptcy or gobbled up by other d round companies until there were just three left.

8:17Speaker 1:And then what happened at that point was the physics really reached its natural limit and it became more and more difficult to shrink the number of transistors on these chips, and that gave the three surviving companies the breathing space to slow down. And the capex was still very high, which was a significant barrier to entry, preventing other companies really from coming in. And we can come onto the Chinese companies.

8:44Speaker 2:Later, Oh yes, that's the plan.

8:47Speaker 1:But in the meantime it allowed them to generate a return on capital rather a return of capital. And so the chip industry is still cyclical. It's based on and mark cycles, and chip companies need to run their kit at a full capacity, so you get a mismatch between supply and demand. But that's just a normal inventory cycle. But because the market had consolidated because no new capital was coming in from outside, what we found was that through each cycle, the reternal capitul in each got higher and in each low as well, which was a fairly attractive phenomenon. So as long term investors, we were able to trim at the peaks and add at the bottoms, which we did fairly successfully up until twenty twenty two in November when chatchpt first launched itself on the world, and we saw the beginning of a huge demand cycle which we're still in and that has turned these companies into trillion dollar companies. I'm not sure where they are to dating. The share prices are moving very violently because of all of the retail participation and momentum in the market, and so that's really put our previous approach to the test.

10:01Speaker 1:And what we're trying to do is actually keep doing what we have been doing, which is trim as the prices get higher and higher while retaining exposure, so that we probably will be adding at some point in the future if prices fall dramatically further from where they are.

10:16Speaker 2:So when you say that that it challenged your previous approach, I mean you still refer to this as a cycle. This is not a permanent increase in demand constantly. Are still a cycle. It's just a matter of figuring out what sort of cycle it is and how long a cycle it is.

10:31Speaker 1:And there are wheels within wheels here, there's this sort of capital cycle life to've been describing their inventory cycles. There are product cycles, they're economic cycles. But we've got to try and keep an eye on the bigger picture in terms of the capital cycle. And I think the thesis remains intact that there are still just three d RAM companies, but we've got to recognize that there is exuberance in prices. There is the threat that the Chinese will catch up, and there is the risk that other ship companies may try to come into the memory market. Yeap.

11:03Speaker 1:Where we take some comfort for the time being is just the huge amount of capital and know how required to compete with these companies. And even if they themselves are going to lose discipline in terms of capex, and we're fairly confident that they are aware of their own sins in the past and determined not to repeat the same mistakes. Never say never, But nevertheless, the amount of time required to bring on new capacity is long in terms of building these new fabs and equipping them and getting them going, and so on, so we've got some time yet.

11:35Speaker 2:Yeah, so you're not too worried about the Chinese competition coming through.

11:40Speaker 1:I think at the moment the view is that as the Chinese advance, so too will the incumbents, and so catching up will always be difficult, and there's much less value in the previous generation of chips than the leading edge. But I think you'd be foolish to assume that the Chinese aren't capable of eventually catching up. So it may simply be a question of time.

12:03Speaker 2:Yeah, only say the end that, of course, superprofits will eventually bring on new supply, because they always do, with inevitable consequences for returns and ultimately for share prices.

12:13Speaker 1:But that's a way of Yeah. I mean it's interesting speaking to the companies themselves. They are so conscious of having screwed up previous cycles. They are now entering into so called long term supply agreements with their customers to try and keep everyone on the same page and make sure that supply matches demand. But very difficult to do them.

12:35Speaker 2:Yeah, because you have that vague feeling, don't you, that there may be an earnings bubble in here, and you look at the valuations going back to what we were talking about at the beginning, is that historically, when a company like this is look cheap, regardless of the fact that it's had an extraordinary share price run, you look at the p and you go, oh, four times six times, that looks very cheap. But I think historically that has been the time to sell.

12:54Speaker 1:Yeah, I mean, mid single digit pe looks very cheap. But on the other hand, much higher price to book multiples than we're used to. I mean, previously priced to book multiples peaked in this industry at about three times, and they are six, seven, eight times at the moment. And if you can put capital to work and the stock market's going to give a value to that capital six times what you just put in, then that's a great incentive to overinvest.

13:22Speaker 2:Yeah. Okay, well we'll watch that one and we'll keep feeling sorry or worrying about the Korean retail investors. I've been on holiday and one of the things that have stood out to me on my return has be this number that three percent of adults in career received a margin call. It seemed extremely worrying.

13:39Speaker 1:Yeah, I mean, that's human dimension to that, which is horrifying, But clearly there's a huge amount of exuberance in the market at the moment, and that's partly a phenomenon of momentum and indexation and all those phenomena we're.

13:52Speaker 2:Familiar with and reminded that diversification is super useful. Right, What else is interesting at the moment for you? I mean, I see looking at the fund fact cheap for the hosting Global Equity Fund that Japan is still the top exposure.

14:18Speaker 1:Yeah, I mean, that's really one of the themes in the portfolio. Trying to interpret the four hundred stocks in our portfolio and grouping them into themes, and Japan is one of those. But there are different ways to slice to slice the portfolio. We've been overway Japan for about four years, and like I'm sure many of your other guests, Japan has gone from all the purpose of corporate Japan has gone from providing full employment to the Japanese working population to providing returns on capital for the retired Japanese population as the demographics have aged and valuations have been very cheap, and there's been a massive tailwind from the combination of activism by overseason vesters and domestic institutions wanting to improve return on equity by Japanese corporates. So we've really been taking advantage of that, and I think that continues.

15:10Speaker 1:And the interesting question is which other countries are going to be next, whether it's career. Malaysia has a value up program as well.

15:17Speaker 2:Yeah, well Career has a program now very similar to the Japanese one, pretty much copied, right, so you may begin to see things broaden out in career.

15:25Speaker 1:Yeah, And I mean an interesting thing in career is coming back to the memory semis. They've been making so much money that their unions have successfully negotiated profit participation in the pay of their employees. And these super profits are going to result in I think a huge amount of wealth filtering down into the Korean population, which should have, you know, pretty strong ripple effects on the rest of the Korean stock market.

15:52Speaker 2:Yeah, which would be interesting. Let's go back to Japan then, and what sectors have you got exposure to, entrepaneur is this just across the board, We.

16:01Speaker 1:Have pretty broad exposure. We have really been able to take advantage of the diversified nature of our portfolio to have quite a lot of more audiosyncratic risk, by which I mean really size and liquidity, so smaller cap Japanese companies where other people running more concentrated strategies would find it difficult to put money to work. Because we have this broader portfolio, we can invest in those companies and take advantage potentially of the work of other activist investors who may have been working with the company behind the scenes for several years in some cases, and also situations which might be relatively liquid because of a family sheholder or something. Because we have over fifty stocks in Japan, we're not reliant on any one situation paying off within a certain timeframe, and so we can manage that liquid risk.

17:01Speaker 1:I think a little better thanks to the diversification. But it tends to be more domestic companies, but we also have export facing companies as well. But yeah, across all sorts of sectors.

17:12Speaker 2:And it's interesting, isn't it that Japan is one of the places where small caps have started to auform larger companies rather like in the US. Not in the UK unfortunately as usual, but in Japan and the US you've started seeing a bit of a shift from very large companies at performing to the small and medium sized companies at performing at the last couple of quarters.

17:28Speaker 1:Yeah, I mean, you still find companies in Japan with negative enterprise values, and some of these small companies just have very inefficient balance sheets which result in just very cheap valuations, and they really have been overlooked, whereas some of the more successful world beating Japanese companies are still trading it really quite phenomenal valuation multiples which haven't yet derated. And so there's a degree of rotation and mean reversion there.

17:54Speaker 2:And then there's even though the market has performed very well recently, there's also the possible additional kicker from a strengthening Yan.

18:01Speaker 1:Yeah, careful what you wish for, but I mean I think certainly Japanese financials well positioned to benefit from that, in particular at the large banks, but the pace at which that will happen, a manner in which will happen is unclear, and so that again, having a diversified portfolio in the context of a larger global portfolio gives us some sort of comfort.

18:23Speaker 2:And careful what we wish for. What should we be worrying about with a strengthening yan.

18:27Speaker 1:Well, there is a huge amount of debt in Japan which is one of the reasons why interest rates haven't yet managed to rise to the level needed to stabilize the currency, and so there are those perennial fears that the BOJ will lose control of the exchange rate. On the other hand, there are huge amounts of assets belonging to Japan overseas, and if they would come back, then that would have the opposite effect. So it's really interesting times to be investing in Japan.

18:57Speaker 2:I suspect that almost everyone who listens to this podcast it's invested in Japan, because we have been going on about it for a very long time, very long time. There's a wonderful chart. I like this chart enormously in the fact cheap for the fund which has bubbles on it so we can see where the fund is allocated, and I'm interested to see there are quite big bubbles for both mining and oil.

19:20Speaker 1:Yeah, if you remember, I was saying, we're really looking for two sorts of situations, high return situations where those returns can be sustained, and lower return situations where we have confidence that the returns are going to pick up sooner than the market things is likely. And mining and shipping into examples of that. Latter mining went through its supercycle when China really opened up and everyone started is selling resources to China, and naturally, human biases being what they are, this results in massive having investment ad buys mining companies, which resulted in terrible returns, which results in punishment and capital starvation. Until mining companies were trading ten years ago at big discounts to well, they should be valued at discounts book value in some cases, and the return of capital discipline and the opportunity for investors like us to get involved in the large mining companies which had got religion again in terms of understanding capital discipline, and they've been a feature of portfolio for a while. Obviously, the time taken to bring on a new mine is measured in the years, if not decades, and again it'll

20:30Speaker 1:run like memory semmes. That gives us the confidence that that picture is not going to change too quickly and they're going to have the opportunity to sustain high returns for a while. Yet shipping is something similar. I mean, before the financial crisis, abundant liquidity and very very low barriers to entry. This is not a high quality sector. Meant that a huge amount of money flooded into shipping. You could borrow money from your bank, you'd get some sort of credit from the shipyard which didn't require money up front. You could raise money in the equity market fairly quickly, so anyone could could raise a capital to put in an order for a ship, resulting in massive over ordering. Financial crisis happens with Lehman, Yet the ships continue to be delivered from the shipyards even after the financial crisis. A massive oversupply claps in shipping rates bankruptcies, and then a full storm and around so of twenty sixteen when private equity felt that it could get involved and take advantage to the distress, which resulted simply and more ordering in the deferral of the recovery. But the

21:34Speaker 1:great thing about ships is that they have a finite life. Typically for a blue chip customer, twenty years is the limit, which from an investment point view is fantastic because it means we have visibility into the future. We can see not only how many ships are on the water today, but what their age is and when they're likely to need to be scrapped. And so we've been really investing in shipping since these companies came out and started to come out Chapter eleven and refloat and taking a basket approach with this sort of diversified portfolio, investing in a number of different shipping companies and in a number of different shipping asset classes. And more recently we've really focused on tankers and we've sold our shipping in container carriers LNG carriers in particular, as more capital has gone into those areas. And if you were to go to China or Korea today, you would see a large number of shipyards all very busy working on a construction of new LNG carriers and container carriers, but relatively little supply coming into inter tankers or dry bulkers or into those categories.

22:46Speaker 2:Okay, so that's an area that's got a bit to run.

22:48Speaker 1:You think, well, we were, as I say, we're out for LNG carriers, we're our containers, and we have been taking profits in tankers and some of our dry bulk, so you know, we are towards the end of that cycle. As I said, the barriers to entry and shipping are much lower than other areas, so you are really constrained by the availability of capacity in the shipyards. And the great thing is we have visibility into that. They do publish their order books, and you should never underestimate the ability of somebody to come in and take a view that the market could support more capacity.

23:23Speaker 2:Interesting, I would have thought the barriers that entry and the shipping industry would be huge. That's not a simple thing to get into.

23:30Speaker 1:The LCC costs one hundred and fifty million dollars, say, but other types of shipping, you know, cheaper, and there is an entire industry of financiers and brokers and owners and yards who can help you ordership.

23:47Speaker 2:Let's shift back to the energy sector. We've got holdings in oil and coal and all sorts of things. And one of the interesting things about the energy sector at the moment is that the transition, which I think a lot of people predicted at the beginning, has not turned out to be a transition, but to be in addition, so the whole energy infrastructure is expanding in every area, partly because going back to the beginning of our conversation, partly of course, down to the energy requirements of AI.

24:13Speaker 1:Yeah, I mean, and actually, funnily enough, with shipping, one of the common themes there is energy. I mean, with the exception of container shipping. Most shipping is about the transport of energy, whether you're talking about coal or oil or protein. Shipping is really something to enable you to ubcharge the price of energy in one place versus the price of energy in another. But yeah, all this enthusiasm for the energy transition has led some people to assume or that traditional fossil energy is going to stop being consumed in a very short period of time, and as a result, been under investment in traditional energy and related areas, one of which is shipping, another of which might be the offshore drilling company needs for example. So we are very conscious that well, we're no better than anyone else are predicting the price of energy, But there is a whole load of activities around energy which have suffered from under investment, and therefore we're confident are going to see improving returns.

25:18Speaker 2:Look, when you look at the portfolio, four hundred stocks has quite a lot to keep an eye on. Obviously that you have, there's a team of you. But what worries you, what keeps you up at night?

25:28Speaker 1:That's a great question. We do take great comfort from the diversification in the portfolio. I don't just mean the number of stocks, but I also mean the non non correlated nature of the ideas within the portfolio. And thanks to the versatility of this capital cycle approach, as I said, we are able to sort of map any company we come across through this capital cycle lens.

25:51Speaker 2:So yeah, it's nothing to worry about.

25:55Speaker 1:Many many things can go wrong, but hopefully as they go wrong, they're not going to dominate the portfolio. Our largest position is around two percent of the portfolio.

26:05Speaker 2:In market crist as a whole. I mean, as we were saying earlier, you were saying earlier, there's a lot of excitement in the market, there's a lot of momentum, and there's a lot of retail participation, the sharp rises in the store market, and say not just career but also maybe the US have participated to a fairly healthy wealth effect across the board. If there is a reversal in global store markets, maybe it really is led as long predicted by big tech, etc. Then you don't just get a market collapse, you also get a reverse wealth effect, and maybe you get much more ever of a follow through impact then you might have had previously. I don't know.

26:45Speaker 2:A lot of things keep me up at night.

26:46Speaker 1:You're completely right, and we do look at this sort of passive driven momentum in the market and keep anticipating its demise, which never seems to happen. But what you wish for, and when it does happen, there will be all sorts of second and third all the consequences which will impact all of us. I am hopeful that we will do better than most other participants in the equity market, but everything, if everything is crashing, then we will suffer with everybody else.

27:13Speaker 2:Yeah, I mean, you wouldn't need to hope that. I don't think I've ever had anybody on the stop market who said that their expectation is that things should go wrong, they'll do worse than everybody else. We have a bad beginning for a conversation or end for a conversation.

27:29Speaker 1:That's fair enough.

27:31Speaker 2:Listen, Lick. I don't know if you've had you been on holiday yet or not, but one of the things that we're asking everybody at the moment is what they're reading when you when you finally head to the beach, or perhaps you've already been to the beach, what are you taking with you?

27:44Speaker 1:I've just come back. I took one book which I didn't manage to open, but I'm looking forward to, which is The Mask of Demetrius by Eric Ambler, which is an old fashioned thriller which I've had recommended by a couple of people, set in Istanbul and apparently a writer admired by Graham Green and Ian Fleming. The book I did read on holiday most recently was Recession by Tyler Goodspeed, which is a really interesting piece of economic history, interesting not just for the thesis itself, but just for the wide ranging examination of three hundred and twenty five years of economic history in the US and the UK, and its basic thesis is that, contrary to most people thinking that economic expansions eventually collapse under their own weight or die of old age, that there's no reason why there has to be the case, and recessions come along for almost random reasons. They're a function of not bubbles getting two or economic expansions lasting too long, or economies getting too hot, but more external things like war, failed harvests, plagues, strikes, and energy shocks in a way that's reassuring.

29:05Speaker 2:Not really, I think we've got strong chances of all those things.

29:10Speaker 1:There's a lot of geopolitics getting on at the moment where you're talking about Russia, Ukraine.

29:15Speaker 2:El Nino and harvests.

29:17Speaker 1:Eran, Taiwan, all of that, and then also, I mean oil and energy prices are you know, they are within within historical bounds at the moment, but that may not stay the case. That that may not stay the way forever.

29:33Speaker 2:Yeah. Interesting, Okay, So I'm fascinated by the fact that you spent your holiday not reading a thriller that everyone loved, but reading a possibly rather too long book on recessions. I hope there are a couple of romantic nobles in that. It was something.

29:51Speaker 1:Yeah, that's a book by Ben Lerner as well, which I've got in my bag.

29:54Speaker 2:But all right, good. We've had some excellent recommended since this year. Actually, I'll send I'll send you a list. Should you be going on holiday again, is all over for this year?

30:06Speaker 1:That would be great And I'm yeah, I am. I am actually going on and getting off to your Pat Moss at the end of the month, so that would be fun.

30:12Speaker 2:Okay, brilliant, Luke, thank you so much for joining us today. That was all really interesting. Thank you, Marion, thanks for listening to this week's maryn Dogs Money If you like our show, Greek review and subscribe wherever you listen to podcasts and keep sending your questions or comments to Merrorn Money at Bloomberg dot net. You can also follow me and John on Twitter or ex I'm at marys w and John is John Underscorestepic. This episode was hosted by me marin Sunset Web. It was produced by Someersardi and Moses, and it sound designed by Blake Mabels and special thanks to Luke Bridgeman