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A tool to avoid market minefields

May 2021

Recently, investors have asked why we are not investing in certain sectors that are getting a lot of media attention, and seem to have very exciting growth prospects over the medium to long term. To answer the question, we refer to a framework called ‘the Capital Cycle’.

It’s an analytical framework developed in the 1990s that tries to identify which areas of the market to avoid at a particular moment in time. We would argue it is even more relevant today, given that with interest rates at rock bottom levels, capital is basically free and the likelihood of a misallocation of capital is high.

The key insight of the Capital Cycle framework is that investors focus too much on the growth in demand and not nearly enough on the supply-side response.

Slide 2 illustrates the four stages of the capital cycle, starting at the 12 o'clock position and going clockwise.

Source: Marathon, ‘Capital Returns’

When a new sector is opened up through technological innovation, many potential entrants rightly look to set up a business and claim their slice of the pie. The upside potential of the sector is marketed and the excitement generated leads to a lot of capital being invested in order to capture the opportunity. Everyone is optimistic. However, as more and more people look to enter the industry, competition begins to increase. Margins erode, price wars intensify, and almost everyone ends up losing money for a period. At this point, returns drop below the cost of capital and the equity tends to underperform. With time, the weaker players can no longer afford to compete. They exit the industry, or the more successful players buy them out to begin a process of consolidation. At this stage, investors who have been burned are likely exiting as well. This provides an attractive entry point to long-term investors who've analysed the industry dynamics and can see the consolidation playing out. The consolidation then leads to more rational competition, leading to returns improving to levels above the cost of capital. Equity owners are generally rewarded at this point.

Right now, we think we're somewhere between the investor optimism and rising competition phases. An enormous amount of capital has been invested to chase the opportunity in many hot sectors over the past 12 months. Without a defendable moat and rational competition, being able to forecast high levels of demand or a huge total addressable market is ultimately insufficient for investors, since the businesses in question may not be able to economically capture the opportunity to drive value in the industry.

Let's make this a bit less theoretical and a bit more practical. Where are we seeing this play out?

Real-world examples

It would seem a new buy now pay later service is being launched somewhere around the world every other month. Should one want to invest in BNPL, it is worth looking at it from many angles to fully understand the opportunities and competitive risks. In the next slide, we have taken a simple screenshot from the Officeworks website:

Source: website

There are three BNPL services listed. Other than brand recognition, there is nothing to differentiate the three shown here from each other. Given the intense competition between all the BNPL players, it is unlikely that all of them can win, meaning an investor should consider what will happen when one player starts pulling ahead of its peers. We doubt that players number two and three will go gentle into that good night, meaning that they will likely start to compete on pricing. Possibly they can cut the fees they charge merchants or try and extend the repayment profile to their consumer. It can very quickly become a race to the bottom.

We would argue the BNPL business model is also somewhat capital-intensive, in that merchants are generally paid prior to the BNPL provider being paid in full by their customer. To grow aggressively generally requires additional infusions of capital. What happens when capital providers either in the form of debt or equity demand a higher rate of return from the company? Access to cheap, external capital is in our view not a sustainable moat, particularly for companies that effectively run a single line of business, as many of the BNPL operators do.

Another area where we have concerns is in the food and grocery delivery space. As recently reported in the Financial Times, there has been an inflow of roughly $14 billion of capital into this sector in recent months. Established businesses, such as Just Eats, Delivery Hero, Uber Eats and Deliveroo are all seeing increased competition in what is already an industry with razor thin margins.

The new entrants are using the capital they have raised to effectively subsidize their offering in an attempt to gain market share. This is the equivalent of selling a $3 ice cream for $1 at the beach on a hot summer's day. You can sell as many ice creams as you want, as long as you are prepared to forgo $2 on each. Given the war chest some of these businesses have now raised, they can continue to do this for quite some time.

We think this influx of capital will drive down returns for all players for a period of time. Eventually, there will be a shakeout, but in the meantime, consumers will enjoy the benefit of low prices and choice. However, we don't think this makes for an attractive investment opportunity, no matter how good the story is at the moment. And of course, all of this assumes the economics of food and grocery delivery are attractive at maturity, a topic we do not at this stage have a high degree of confidence in.

Other sectors where we see similar dynamics playing out are telemedicine, autos and streaming. In a sense, the pandemic may have been the worst thing that could have happened to a business like Netflix, as it forced all their competitors to finally embrace streaming and take it seriously, leading to a surge in high quality content – alongside a step-change in content costs.

It is 2 o'clock on the capital cycle clock, and competition is coming.

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