Brief Introduction to Capital Cycles

There are many ways to search for deep value opportunities in the financial market. Some wait for financial events that affects several companies temporarily. Often, such cases may surface stocks with depressed prices far below their intrinsic value.

However, there is little certainty if you’d wait for such random sporadic events. Years may go by and opportunities may not even arise.

There is nothing wrong with looking out for such situations. However, to make the searching process more intelligent, we start by asking a few questions.

When do these opportunities usually arise? What should you be looking out for? How certain are you that it is only temporary, in other words, it does not affect its intrinsic value?

If you have a look at market history in the big picture, there are clear cyclical trends attached to most industries. Is this purely by chance or is there any fundamental reason behind?

The main driving force behind this is extreme psychology of players in the market – investors, managers and bankers.

The above chart succinctly summarises why capital cycles and mean reversion occurs. It illustrates how changes in the industry as a result of psychology and economics influence investors’ sentiments.

As long as investors behave like humans and businesses are managed by humans, capital cycles will persist. There will always be over- and under-reaction in the market. When bullish sentiments are flooding the market, investors confuse luck with skill, dumping more into their prized holdings. On the reverse, investors fear that the market will go to 0 when stocks tank.

Being aware of the dynamics of our Mr. Market is the first step towards insulating ourselves from the influence and work towards exploiting the trend instead.

Mean reversion in capital cycles

What does holding a share mean to you? It shouldn’t just be a number that ticks up and down. It must track the fundamentals of a business. It represents a fractional interest of the company. Whatever value the business generates, it will translate to compounding your wealth in the long run.

Understanding this will reveal that shares should never be fluctuating so much in a short span of time all the time. While there are exceptional cases where the government shuts down a company completely, these aren’t the norm.

The best way of illustrating these trends is through an understanding of capital cycle:

For instance, in the property industry.

1. Expansion

Cause: Developers are bullish because property prices are steadily rising.

Effect: Greater optimism leads to more en-blocs and acquisition of land to expand operations.

2. Contagion

Cause: Other firms observe and recognise the increased profit margin as a result of increasing rate of rising prices

Effect: Further expansion.

3. The tipping point

Cause: Too much housing supply in the market and demand cannot catch up

Effect: Prices stagnates and start to reverse in order to reduce the excess capacity.

4. Contraction

Cause: Falling property prices

Effect: Decreasing margins for developers as costs incurred are fixed. Decreasing margins and prices lead to a self-fulfilling prophecy. Investors start to get out of the market and developers reduce price further to avoid occupancy taxes and lack of sales.

5. Trough

Cause: Depressed property prices and margins

Effect: Inefficient property developers go bankrupt and consolidating of the industry starts to occur. Supply falls sharply and demand slowly creeps up

And the cycle repeats itself again.

Understanding the capital cycle will enable you to make smarter decisions without the influence of the market. You will understand the counter-intuitive concept about how expansion leads to destruction of value and how contraction leads to creation of value.

We are pretty sure that this cycle sounds very familiar to you. The Singapore market has recently been through an expansion phase where housing prices were shooting up furiously. Recently, the Singaporean government responded to this exuberance by raising taxes and hammering the prices down.

Could this be a turning point of the capital cycle?