"The Ideal Investment: Companies That Don’t Invest"

From James Mackintosh at the Wall Street Journal:

From my desk I can count 44 construction cranes, as London’s boom in office and apartment towers transforms the city.

Building surges tend to end badly, and London’s grimy air already contains more than a whiff of concern about the number of new luxury flats coming to the market.

This is not only about London. Investors should study the city’s premium property market to learn once again a lesson all too often ignored: High prices eventually lead to supply, which leads to lower prices. London has among the highest prices for residential real estate in the world, but the lesson applies to any company, in any sector, when it gets its moment in the market spotlight.

The pattern is evident in markets time after time, yet investors repeatedly make the same mistake, arguing that this time is different, because this time demand is running ahead of the surge in supply. Mining and oil companies are suffering the effects of the biggest of these capital cycles, with holes in the ground still being dug years after commodity prices plunged. But even in these most cyclical of sectors, investors still got carried away with their projections of demand in the good times, ignoring the solid evidence of increasing supply.

In London, house prices have been rising for so long that it is treated as normal. In the 18 years since I bought a home in the city, the rise in the value of it and its successors have made me more money than my total after-tax pay. Many other London homeowners have done even better from soaring prices, thanks to bigger mortgages. This is, of course, an illusion: unless I sell up and leave London, I’ll never see that “value.”

Londoners occasionally need reminding that higher prices are not inevitable. It’s true that London has changed for the better, justifying higher prices as more people want to live here. But in recent years something else has changed too: restrictions on tower blocks were loosened, so construction could finally respond to those high prices. More than 35,000 new luxury homes are planned over the next decade, according to consultancy Arcadis, a 40% rise in less than two years.

Investors looking for the next bust should pay close attention to the capital cycle of corporate-investment surges followed by retrenchment. Edward Chancellor, an author and former fund manager, sets it out nicely in Capital Returns, a collection of essays by Marathon Asset Management LLP. “All too often,” he writes, “high returns attract capital, breeding excessive competition and overinvestment.”

The ideal management—from a shareholder perspective—would invest the absolute minimum, operate in an uncompetitive industry and return its fat profits to the owners....MORE

...Eugene Fama, winner of the economics Nobel, and his colleague Ken French, have expanded their famous “three-factor” model to include corporate investment as a driver of returns, alongside value, momentum and size (they also added profitability). Broadly speaking, companies which invest more tend to underperform those which spend little. But, as with the other factors, it may take years to profit from such an approach....