The Secret That Drives Company Returns
+ Ideas from Hosking Partners, GQG, and the Cheapest 4x PE Large Cap You Never Bought (but still can)
I have started to write up the 40+ ideas I heard in New York at the Value Investing and Quality Growth conferences. I wasn’t sure whether I should look at them in any particular order, do value one week and quality the next or whether I should mix them up. Please let me know if you have a preference.
This week, I feature several ideas from the value conference and the cheapest stock from the quality growth conference. For a reminder of all the stocks pitched, you can see the value stocks and the quality-growth stocks in my previous articles:
Introduction
Before getting to the value ideas, we need to explore one of the more vital concepts in equity analysis. What’s most surprising is that this is still one of those hidden secrets of investing.
Total addressable market, market growth and revenue growth are the dominant issues for most equity analysts. But imagine how difficult it is to forecast demand accurately for many industries – think of the variables:
- Economic growth
- Disposable income growth
- Consumer confidence
- Business confidence
- Corporate tax rates
- Interest rates
I could go on. Tariffs….I wrote enough last week.
But what is the most important variable in profitability for almost every company? I wish Substack would let me leave some blank space here to allow you to have a think about this:
The Most Important Variable
Price is the most important variable for almost every company on the planet. Please email me if you have an example otherwise. But for almost every company I have looked at, increase price and the impact flows directly to the bottom line. If you were only able to only look at one thing to determine a company’s prospects, this surely would be the factor to look at. And how is price determined? It can be the power of a brand, and it can be driven by many other factors which constitute moats.
But for many companies, price is a function of the balance between supply and demand. If demand is growing faster than capacity, price will generally increase. Marathon Asset Management made this a central tenet of their investing philosophy. But because they had limited resources and because demand was difficult to predict, they chose to focus on capacity. And they found that this was a very lucrative practice.
Those of you who have read Edward Chancellor’s books, Capital Account or Capital Returns, will be familiar with the concept – it’s usually very profitable to buy stocks in industries where capital is exiting.
When an industry starts to ration capital and to be more disciplined in adding supply, and particularly where it is closing capacity, returns usually improve significantly. This is true today of a number of commodity sectors which have been starved of capital. It’s also something to watch for in industries which have been consolidating – as companies merge, they often seek to take out duplicate capacity and this can be a powerful driver of margins and even more so of returns – higher margins on a lower asset base.
Marathon as the name implies had (and still have) a long term investing philosophy, which is important, as the pricing benefits are not always immediate – they can take time to work through.
At the hedge funds, I used this philosophy as a risk gauge – for example, when I became interested in the Indian cement sector. I used to compile a list of plants under construction and proposed – it was a pretty long list. It was quite easy to translate that into a rough growth in capacity. Actual opening dates move around, but you can easily (and sufficiently accurately) estimate the growth rate each year and know that over the next three years, 25% or 30% of new capacity is going to come onstream. I would then map that against economic growth projections and assess the risk in the sector. It was quite crude as it was national, but I could refine that by geography when I started to drill down to the individual stock level.
I used to do a similar exercise for the airlines – how much capacity are the majors adding, how much are the low cost carriers adding – is growth going to be high or low? Often the answer was too high, but occasionally I saw the perfect storm. The industry was losing money and had started to defer deliveries. Meanwhile valuations had collapsed, as had earnings estimates. The reduced growth in capacity would lag demand growth, with a positive impact on price. You can make a lot of money quickly in airline stocks when that down cycle starts to reverse. But the key is understanding the capacity – demand balance.
Premium subscribers can read on for a half dozen interesting stocks, including Hosking Partners’ Django Davidson’s take on the capital cycle impact on an important sub-sector. His partner Jeremy Hosking, one of the authors of Capital Account, left Marathon to set up his eponymous firm. I interviewed him for my podcast, 3 years ago this month.
And if you would like to learn more about the capital cycle, I have a suggestion:
Join Me for a Live MasterClass on April 24
Join me for this session where I’ll be exploring the Capital Cycle framework—a timeless approach to equity investing—with a modern twist. It’s on Thursday, April 24 at 1pm BST / 8am EST.
We’ll walk through how this framework applies to sectors like aviation, data centers, and commodities today, and how new AI tools are transforming how we uncover supply-side shifts and evaluate profit pools.
I’ll also demo how I use AlphaSense’s Generative AI—including Gen Search, Gen Grid, and the brand-new Deep Research—to surface high-quality insights faster and more effectively. It’s like having an analyst in your corner, running the numbers while you focus on what matters.
If you're serious about generating alpha through smarter research, this session is worth your time.
Register to attend or access the replay here.
