Tailwinds ,Capital cycle , decision making and the suffering multiplier

Capital repeats patterns to those who can see

The Lack of sectoral tailwinds and Profit pool expansion in the sector takes down the probability of incremental returns in your investment , even the most efficient business models may not be able to return the shareholders

So it is very very important to gauge where any business and sector is in the capital cycle of what I’d say is a broad capital returns cycle

Things to think about and analyze if we are in an :
1) Expansion phase with favorable pricing environment
2) Contraction phase with margin erosion and competition choking pricing
3) Demand supply gap over last 5 years is expanding or reducing
4) spreads for the sector have been increasing/decreasing ( tracking global)
5) Sectoral ROCE of listed players median of 10 years and where are we today , and same for margins

6 ) Viability of incremental capex , and point of no IRR is a great sign for where the level of pain can be seen

7) Gauging the depth of the profit pool to incremental capacity delta of the sector , its very important to take a sector wide capacity presence to understand the sustenance of profit pools when an industry is seeing peak pain or gain , it helps you to map out a peak earnings trajectory that is fact based and not on stories

8) In cyclical companies , good managements come out in tough times , bad managements come out in easy times , that’s why you buy the inefficient player in an aggressive bull market and buy a good player in a bear market , doing otherwise will make you question the efficiency of markets and not let you capture the cycle

Big players kill ROCE for volumes in tough market conditions ( look at what supreme did in Pipes ) , don't fight capital infusion by big groups but actually watch it to see how difficult is it for a newer /older player to survive or do the same , if sector ROCE's collapse because of Excess capital , Maybe IPO'S , PE funds pumping money, Big cash rich groups eating the pie , typically you will see phased out consolidation in incremental capex and asset turns as there is a complete pivot in capital cycle at least for a few years

Cement , PVC , Paints are recent examples , lot many more to come

In a cyclical business it is very important to see and analyze every move of the management in the the tough times , what are the decisions they make , are they strengthening for the next cycle or just reacting to it

Is the company better placed to ride the next upcycle , debottlenecking , lower cost acquisitions , spreading value chain , capacity geographically expansion

Strong cyclical business have to be Antifragile , business that can gain from disorder or irrational pricing in the sector and re emerge stronger out of the cycle Just a framework to think

The nature of the capital cycle has to be understood , there are no permanent bad and good companies, it is just where they are in the cycle and if the industry profit pool is real and growing, tailwinds is the cherry on top . I have spoken about this many times to gauge the strength of a tailwind think in terms of profit to market cap ratios coming together , to say it in few words , try to gauge if the sector profit pool could be what the market cap is today in 5 years , that's the megatrend

1) Large Tailwind theme + start early + mediocre investment = Phenomenal gains

2) Exceptional investment + tailwind missing = Frustration

to quote Madhu Kela " I have come out very frustrated in investing in best companies where the tailwind was missing"

The idea is use tailwind as the indication to justify the nature of incremental capital returns being higher with much more than estimated positive expectancy to keep having the ability to surprise on the upside aided by tailwinds enable a trajectory shift in the way earnings keep expanding , but always do remember, however strong the theme or tailwind is , the entry point will determine the return profile , do not overpay for small tailwinds , allocate only when the valuations make sense

Tailwinds mostly help the portfolio picture achieve those 1-2 outlier returns stories that you never thought could turn out to be so big , and that’s why they surprise everyone, so when tailwinds come after peak pessimism rate of change cycle with a good management the odds of those investments having a multiplier effect on portfolio level returns are immense

My framework I use on incremental rate of decision making to see what is beyond the numbers and is usually not understood enough

Incremental rate of decision making -

1)Analyze top 3 decisions ( tangible + intangible ) that every company has made in last 8 quarters , and current quarter , and see how they talk about it every quarter and how that commentary evolves

2) If a acquisition , use history of older acquisitions and post commentary to map out patterns on how acquisitions hit rate for this company

3) Decisions made in a tough business cycle is very important as that would let you judge if the company is best positioned to come out of that cycle

4) Use the history of decision making to judge consequences of current decision , this will make ability to gauge the intensity of any major decision better, and will be able to make you think with differentiated insights

A lot of stuff is in between the lines of qualitative management commentary , this is more of an art than science , we just need to know where to look and how to look, my framework has helped me not only to spot good qualitative changes in businesses but also avoid the ones that are good only on few quarters numbers but lack the depth of quality , and in the longer term we are all playing the losers game , that is to loose less is to win more .

Something I have been thinking about lately is what I want to call the suffering multiplier concept , does a company that has suffered earnings depression due to a bad cycle or bad decisions or capabilities based aggressive capex ( that stock market doesn’t like because the gains are either too back ended or are lumpy) deserve to re-enable a much larger asymmetric gains profile.

Does suffering multiplier always have positive expectancy ? I’d say no , but would I be able to increase my odds to identify business that can enable trajectory change for excess returns ? yes

In my opinion , suffering multiplier comes in when we look at trajectory change consequential decision making , is the business making moves that can enable a version of the business model that is far more resilient , adds to terminal value and enables re pivoting whenever necessary , these are the places where companies chose to suffer in the short term and gain in the longer term , suffering by choice to move to a league of consequence is where the suffering multiplier acts as a big source of returns of things work out with a capable management.

Thanks for reading till here to what is more of a philosophical and qualitative note on frameworks that matter