Month: April 2016

Book Review: Capital Account – A Money Manager’s Reports on a Turbulent Decade

After reading the book review of Capital Return on the excellent “valueandopportunity” blog (here), I got curious about Marathon asset management and their capital cycle approach. Thus, I decided to buy “Capital Account – A Money Manager’s Reports on a Turbulent Decade” a book that covers Marathon’s most important writings from the decade 1993-2002.


Whereas Capital Return is a collection of Marathon’s management letters from the 2012-2015 period, I decided to start with this book as I was not an active market participant back then and I am always looking to add to my limited personal experience by reading historical accounts.

And the book is a gem, indeed.

One of the things I especially enjoyed is the fact that Marathon seems to ask “the right questions”, i.e. they have an uncanny ability to focus on the relevant things when assessing the attractiveness of certain stocks or sectors. This allows them to write down their idea concisely, usually backed-up with some interesting number, but without leaving the reader with a feeling that something has been left out. We are all familiar with analyst reports where important questions are not discussed rendering them virtually worthless. Not so with Marathon’s letters, after reading them one feels satisfaction to have gained a new and fundamental perspective on a certain subject.

Here is a short summary of my main takeaways.

Management quality is paramount

Over time, the bulk of a firm’s equity consists of retained earnings that have been reinvested in the business which highlights the importance of capital allocation skills. Marathon prefers companies where management has been place for a long time, such that capital allocation qualities can be properly judged. This goes hand in hand with the need for evaluating management integrity, i.e. does management really walk the talk, or does it announce one thing, just to do something else. The letters are full of high-profile examples where this is not the case. Oh, before I forget it: they try to avoid companies where the board consists of investment bankers and management consultants – Valeant anyone?

All turnarounds are not equal

When assessing turnaround situations, it is essential to understand how the firm got into the mess in the first place. Interestingly, Marathon thinks it makes a great difference whether the problems have arisen because management was overly aggressive in targeting sales growth, or because of a focus on earnings growth. It is the latter which is relatively more problematic, as it is highly likely that management was saving on essentials (R&D, capex etc.) to reach its goals thereby potentially permanently impairing the product/brand and making high investments (at unfavourable capital costs) necessary for the turnaround to succeed – hence the higher risk.

Earnings quality, EVA and ROIC

When assessing earnings quality most investors (myself included) focus on the interplay between the P&L statement and the balance sheet. Irregularities in the working capital position or serial acquisitions are an indicator that earnings should be taken with a grain of salt, or companies avoided altogether.

Marathon goes a step further: it also looks at the earnings quality from a qualitative viewpoint by analysing capex and R&D dynamics within their capital cycle framework.

In a letter from the end of the 90ies they write how Johnson & Johnson, the consumer goods giant, had delivered earnings growth on the back of cuts in R&D. Marathon judged this to be a sign of weak earnings quality (and proof of a short-term focused management) given that Johnson & Johnson at the time did not have cost problems (high margins), but was lacking sales growth. Thus, by cutting essential costs they were not addressing their main problem, but rather were making it worse.

In their letters they repeatedly caution against the superficial use of metrics such as EVA and ROIC which do not make sense unless properly understood. They often find that the adoption of EVA leads to a short-term management focus to cutting of essential costs to boost margins as this is the easiest way to improve EVA, even if it impairs the long run prospects of the firm in question.

Most interesting, however, I found their discussion of ROIC – a value investor favourite. ROIC can be highly misleading, if not properly corrected for the “product life cycle” of a company’s products. They mention that this is especially important for consumer goods companies which can have high ROICs in combination with short product life cycles forcing them to constantly “reinvent” themselves – a notoriously difficult thing to do. A company with a spectacular ROIC of 40 percent and a three-year product life cycle might still destroy shareholder value, if its capital costs are 10 percent!

Of course, judging the product life cycle is more art than science, but there is no way around it. Keep that in mind next time someone tells you Apple is a no-brainer “buy” at a PE of 10…

Excessive valuations now and then

Given that most of the letters were written around the dotcom bubble, it was especially interesting to see how the situation back then compares to the present.

It is my impression that most observers generally agree that the current market is slightly overvalued, but not worryingly high since we are not observing excesses seen during the dotcom bubble, as evidenced by the following chart,


Yes, the current average 10 year PE for the S&P 500 is substantially above average (thick red line), but it is a far cry from the excesses seen around 2000. Add to this the fact that alternatives such as bonds, Emerging markets etc. seem relatively less attractive than back in the days and one can see why bulls (and the Fed) do not seem overly worried.

This line of reasoning has never appealed to me, however. For one, the market feels “qualitatively” much like a bubble: M&A activity, stock buybacks, proliferation of non-GAAP earnings, rising wealth inequality as well as record levels of conspicuous consumption do no neither look normal nor sustainable. It simple doesn’t feel right.

And then, of course, there is this chart,

MedianPELooking at the median PE and PS ratios one gets a completely different picture than by merely looking at PEs. According to these metrics the market is the most overvalued ever. I personally have liked this metric more, as it confirms my personal “on the ground” experience: it is hideously difficult to find anything meaningfully valued – at least for me.

The question I have been asking myself for some: how can these metrics give such conflicting signals?

I think I have found the answer while reading Marathon’s book.

One topic that comes up repeatedly in their writings at the time is the distorting effect of benchmark hugging mutual funds buying stocks regardless of price. Marathon documents how the effect of this mindless buying is amplified due to the fact that benchmark indices (MSCI et al.) did not adjust the index weights for the available float back then. Thus, a megacap like Deutsche Telekom where a substantial part of the shares was held by the German government was nevertheless fully included in the index, albeit the truly available shares were a fraction of what the weights would suggest, resulting in some sort of artificial shortage. There are plenty of similar examples in the book. Once the shortage was lifted, those stocks collapsed.

It was this artificial “squeeze” of benchmark funds that was responsible for the ludicrous valuations of basically mature businesses. I believe this was the main reason behind the ludicrously high index PE ratios seen at the turn of the millennium

Nowadays the situation, albeit similar, differs in one major respect: most indices that currently serve as benchmarks for ETFs (the index hugging mutual fund of our day) do adjust for available float and hence the type of artificial shortage of shares seen at the time of the millennium is less likely to occur. The overvaluation nowadays is broader as the mindless ETF flows are evenly distributed and it therefore shows up much clearer when looking at median ratios.

In short: a repeat of the mad valuations of large cap stocks, as we saw during the dotcom mania, is highly unlikely. The PE ratios of the indices will not reach new all-time highs and the market is excessively valued already.


The book is fantastic and it should be read and re-read many times over. I am already looking forward to get my hands on Capital Returns, their most recent book.