The Capital Cycle Is Turning

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2:55Welcome to Meryn Talks Money, the podcast in which people who know the markets explain the markets. I am Meryn Somerset Webb, 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 Maren Talks Money. Great to be here.

3:29Thank you, Maren. Now, listen, Luke, I asked you one 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 to 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 Hosking and how does the investing style work?

4:07Great. Thanks, Maren. What we do at Hosking 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 400 stocks, 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.

4:47So now we need to explain exactly what it is that you mean by capital cycle investing. Okay. So the capital cycle is based on a very simple paradigm that 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. It's 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.

5:30We're looking for high return companies where capital can't get in. So those are sort of Warren Buffett-y, 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 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.

6:15That'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. So in a sense, you're looking at investing through the lens of supply rather than through the lens of demand. 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 stockbroker in 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, or when they look expensive is when you should be buying them.

6:49Because given the way the capital cycle works, you want to be selling them when they are incredibly popular and making piles of money and hoards 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, sorry, yes, when they're not making any money, that's when you want to be buying them because there's very limited amounts of capital in the market, right? Yeah, yeah, you're completely right. Two points. Yes, it's about supply rather than demand. So we're sort of able to observe those things which are observable.

7:21We 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? When we see poor returns, which are hated and neglected by everybody else, we ask ourselves, well, could they be wrong?

7:58And is there an opportunity for returns to recover because capital has been withdrawn from this particular sector. So as investors, taking contrarian 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 favour. Yes, well, that's why we always say that good fund management is much as that character of strategy, don't we? Yeah, I think that's very true. 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 DRAM memory thing?

8:35Was that you? No, yeah, I did. I did write that. Yeah. Sorry about that. Well, it's excellent. Of course you wrote it and it's excellent. This is the area where we're talking about the capital cycle. We look at companies such as these. You talk about Micron and SK Hynix and Samsung. And obviously there's been a lot going on in Korea over the last couple of weeks while I've been on holiday. So the Kospi is now down from its peak back in June, right? And some of these 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.

9:13Yeah, it's a fascinating subject because we've been investing in the memory semis, by which I mean the manufacturers of DRAM in particular. Those are the two Korean companies, Samsung and SK Hynix. as well as Micron in the US. But we've been investing in them since inception, which for us is 2014. It's a really interesting sector because to understand it, you really need to go back to the discovery of DRAM, which was by Intel, funnily enough, in 1970. And despite being the pioneer in this industry, it actually exited 15 years later in 1985 to focus on logic chips, where it saw itself having a greater advantage.

9:53And 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 memory chips, which were all interchangeable and which were suffering from excess investment as 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 a constant need to keep investing with the latest technology before you'd even really made a return on the previous investment cycle. And this led what had been 30 DRAM companies around 1985, when Intel exited, to fall to just three 20 years later in 2013, 2014, say.

10:42And 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 DRAM companies until there were just three left. 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.

11:20And we can come on to the Chinese companies later. Oh yes, that's the plan. But in the meantime, it allowed them to generate a return on capital rather than return of capital. And so the chip industry is still cyclical. It's based on end market cycles and chip companies need to run their kit at 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 return on capital in each high got higher and in each low as well, which was a fairly attractive phenomenon.

12:02So as long-term investors, we were able to trim at the peaks and add at the bottoms, which we did fairly successfully up until 2022 in November when ChatGPT 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 today, seeing their 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. 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.

12:53So when you say that that's a challenge, your previous approach, I mean, you still refer to this as a cycle. This is not a permanent increase in demand constantly. It's still a cycle. It's just a matter of figuring out what sort of cycle it is and how long a cycle it is. Totally. And there are wheels within wheels here. There's this sort of capital cycle I've been describing. There are inventory cycles, there are product cycles, there are economic cycles. But we've got to try and keep an eye on the bigger picture in terms of the capital cycle. And And I think the thesis remains intact. There are still just three DRAM companies, but we've got to recognize that there is exuberance in prices.

13:31There 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. 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 are 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 yeah so you're not too worried about the chinese competition coming through?

14:18I 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. Yeah. And you say at the end that, of course, super profits will eventually bring on new supply because they always do with inevitable consequences for returns and ultimately for share prices. But that's a way off. Yeah. I mean, it's interesting speaking to the companies themselves.

14:57They 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. 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 has looked cheap, regardless of the fact that it's had an extraordinary share price run, you look at the PE and you go, oh, four times, six times, that looks very cheap.

15:30But actually, historically, that has been the time to sell. 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, price-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. Yeah. Okay, well, we'll watch that one and we'll keep feeling sorry or worrying about the Korean retail investors.

16:07I've been on holiday and one of the things that has stood out to me on my return is this number that 3 % of adults in Korea received a margin call. It seems extremely worrying. 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 familiar with. And a reminder that diversification is super useful.

16:45right what else is interesting at the moment for you i mean i see looking at the fund fact sheet for the hosking global equity fund that japan is still the the top exposure yeah i mean that's really um one of the themes in the portfolio trying to interpret the the 400 stocks in our portfolio and grouping them into themes. And Japan is one of those, but there are different ways to slice the portfolio. We've been overweight Japan for about four years. And like I'm sure many of your other guests, Japan has gone from, or 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.

17:30And valuations have been very cheap. And there's been a massive tailwind from the combination of activism by overseas investors 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. And the interesting question is, which other countries are going to be next? Whether it's Korea, Malaysia has a value up program as well. Yeah, well, Korea has a program now very similar to the Japanese one, pretty much copied, right? So you may begin to see things broaden out in Korea. Yeah. And I mean, an interesting thing in Korea 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.

18:17And these super profits are going to result in, I think, a huge amount of wealth filtering down into the Korean population, which should have, pretty strong ripple effects on the rest of the Korean stock market. Yeah, which would be interesting. Let's go back to Japan then. And what sectors have you got exposure to in Japan, or is this just across the board? We 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 idiosyncratic 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.

19:10We 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 illiquid because of a family shareholder or something. Because we have over 50 stocks in Japan, we're not reliant on any one situation paying off within a certain timeframe. And so we can manage that liquidity risk, 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.

19:50And it's interesting, isn't it, that Japan is one of the places where small caps have started to outperform 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 outperforming to the small and medium-sized companies outperforming in the last couple of quarters. 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.

20:19Whereas some of the more successful world-beating Japanese companies are still trading at really quite phenomenal valuation multiples, which haven't yet derated. And so there's a degree of rotation and mean reversion there. And then there's, even though the market has performed very well recently, there's also the possible additional kicker from a strengthening yen. Yeah, careful what you wish for. But I mean, I think certainly Japanese financials are well position to benefit from that, in particular the large banks. But the pace at which that will happen, the manner in which it will happen, is unclear.

20:54And so that, again, having a diversified portfolio in the context of a larger global portfolio gives us some sort of comfort. And careful what we wish for. What should we be worrying about with the strengthening yen? 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.

21:31So it's really interesting times to be investing in Japan. I suspect that almost everyone who listens to this podcast is invested in Japan because we have been going on about it for a very long time. A very long time. There's a wonderful chart. I like this chart enormously in the fact sheet 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. 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 thinks is likely.

22:14And mining and shipping are two examples of that latter. Mining went through its super cycle when when China really opened up and everyone started selling resources to China. And naturally human biases being what they are, this results in massive investment buys mining companies which resulted in terrible returns, which resulted in punishment and capital starvation until mining companies were trading 10 years ago at big discounts to what they should be valued at, discounts to 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.

23:00And they've been a feature of the portfolio for a while. Obviously, the time taken to bring on a new mine is measured in the years, if not decades. And again, rather like memory semis, 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.

23:34You 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 raise the capital to put in an order for a ship, resulting in massive overordering. Financial crisis happens with Lehman, yet the ships continue to be delivered from the shipyards even after the financial crisis. Massive oversupply, collapse in shipping rates, bankruptcies, and then a full storm in Arance of 2016 when private equity felt that it could get involved and take advantage of the distress, which resulted simply in more ordering in the deferral of the recovery.

24:12But the great thing about ships is that they have a finite life. Typically for a blue chip customer, 20 years is the limit, which from an investment point of 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, started to come out of Chapter 11 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.

24:54And 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 construction of new LNG carriers and container carriers. But relatively little supply coming into tankers or dry bulk or into those categories. Okay, so that's an area that's got a bit to run, you think? Well, as I say, we're out of LNG carriers, we're out of containers, and we have been taking profits in tankers and some of our dry bulk.

25:37So, 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. Interesting. I would have thought the barriers to entry in the shipping industry would be huge. That's not a simple thing to get into. A VLCC costs$150 million, say, but other types of shipping are cheaper.

26:15And there is an entire industry of financiers and brokers and owners and yards who can help you order a ship. 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 an 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.

26:51Yeah, 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 arbitrage 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 that traditional fossil energy is going to stop being consumed in a very short period of time. And there has, 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 companies, for example.

27:39So we are very conscious that we're no better than anyone else at predicting the price of energy. But there is a whole load of activities around energy which have suffered from underinvestment and therefore we're confident we're going to see improving returns. Look, when you look at the portfolio, 400 stocks is quite a lot to keep an eye on. Obviously, there's a team of you, but what worries you? What keeps you up at night? 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-correlated nature of the ideas within the portfolio.

28:19And 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. So, yeah, it's... So, nothing to worry about. 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 2 % of the portfolio. I mean, market crush as a whole, I mean, as we were saying earlier, or you were saying earlier, there's a lot of excitement in the market, there's a lot of momentum, there's a lot of retail participation. The sharp rises in the stock market in, say, not just Korea, but also maybe the US have participated to a fairly healthy wealth effect across the board.

29:03If there is a reversal in global stock 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 of a follow through impact than you might have had previously. I don't know, a lot of things keep me up at night. 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 care for what you wish for. And when it does happen, there will be all sorts of second and third order consequences, which will impact all of us.

29:41I am hopeful that we will do better than most other participants in the equity market. But if everything is crashing, then we will suffer with everybody else. Yeah, I mean, you wouldn't need to hope that. I don't think I've ever had anybody on the stock market who said that their expectation is that things should go wrong. They'll do worse than everybody else. They'll be a bad beginning for a conversation or end for a conversation. That's fair enough. Listen, Luke, I don't know if you've 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 finally head to the beach or perhaps you've already been to the beach.

30:21What are you taking with you? 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 Greene 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 325 years of economic history in the US and the UK.

31:02And 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 that has to be the case. and recessions come along for almost random reasons. They're a function of not bubbles getting too, 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. Not really. I think we've got strong chances of all those things right now. There's a lot of geopolitics going on at the moment, whether you're talking about Russia, Ukraine.

31:53El Nino and harvests. Iran, Taiwan, all of that. And then also, I mean, oil and energy prices are, you know, they are within historical bounds at the moment. But that may not stay the case. That may not stay the way forever. 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 romance novels in there too, or something. Yeah, there's a book by Ben Lanner as well, which I've got in my bag, but I haven't managed to read it. it. All right, good.

32:36We've had some excellent recommendations this year, actually. I'll send you a list. Should you be going on holiday again or is it all over for this year? Yeah, that'd be great. Yeah, I am actually going off to a patent model at the end of the month, so that'd be fun. Okay, brilliant. Luke, thank you so much for joining us today. That was all really interesting. Thank you, Marine.

33:06Thanks for listening to this week's Merrin Talks Money. If you like our show, rate, review and subscribe wherever you listen to podcasts and keep sending your questions or comments to merrinmoneyatbloomberg.net. You can also follow me and John on Twitter or X. I'm at MerrinSW and John is John underscore Stepik. This episode was hosted by Nima and Somerset Webb. It was produced by Samasadi and Moses Andem. Sound design by Blake Maples. And special thanks to Luke Bridgman.

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