Tandem

Capital-Intensive Stocks Led This Quarter, Driven by Capital Cycle Reversal

Quarterly Performance Highlights: A group of capital-intensive companies in the portfolio (shipping, mining, oil, banking) delivered strong performance, including Pacific Basin, Diana Shipping, Teck, Freeport, First Quantum, Alcoa, ConocoPhillips, Apache, Canadian Natural Resources, Avis Budget (even before its "meme stock" surge), Ferroglobe, Bank of America, and Wells Fargo. The report argues that the common thread among these stocks is that low long-term returns on capital led to underinvestment, and returns have now unexpectedly rebounded—a trend foreseeable through capital cycle analysis, rather than simply attributed to inflation or supply chain news.

Capital Cycle Framework: Recovery in Low-Return Sectors as Core Opportunity

Capital Cycle Logic: High-return sectors attract new entrants → competition intensifies → returns decline (sometimes below the cost of capital) → investment decreases, capital stock ages, consolidation/exit occurs → supply improves → returns recover. Meanwhile, stock market sentiment fluctuates in tandem: optimism when returns are high, share price declines as competition intensifies, prices bottom when returns hit a trough, and then rise as expectations recover. The author notes that opportunities for capital cycle investors come from two main areas: first, the market overestimating the speed of decline in returns for certain high-return companies; second, the market underestimating the likelihood of recovery in depressed sectors (when supply-side improvements have already occurred).

The author states: "What makes the capital cycle so versatile as a tool is that as well as providing a framework for investing in companies with low but volatile returns which are likely to recover sooner than the market credits, it also highlights the opportunity in companies with high and stable returns which enjoy barriers to the supply of new capacity which will mean that those returns will resist the gravity of mean reversion for longer than their share price suggests." This means: the versatility of the capital cycle tool lies in that it not only provides a framework for investing in companies with low but volatile returns that may recover sooner than the market credits, but also highlights opportunities in companies with high and stable returns, where barriers to new capacity supply mean those returns will resist the gravity of mean reversion for longer than their share price suggests.

Portfolio Structure: Coexistence of Capital-Intensive and High-Stable-Return Companies

Portfolio Actions (specific buys/sells not disclosed, only composition described): The portfolio has a higher proportion of capital-intensive stocks than most peers, but its largest holdings include Amazon, Alphabet, Tinkoff Credit, Costco, and TSMC—companies with higher and more stable returns. The author self-assesses: "We are foxes, not hedgehogs" (implying flexibility and diversity rather than a single strategy). What the author explicitly avoids are companies with no positive returns in the past, relying solely on distant future expected returns ("we leave those to smarter investors").

Historical Overinvestment Led to Long-Term Overcapacity, Recent Supply-Side Improvement

Historical Context of Capital-Intensive Stocks: The low returns of many companies trace back to before the global financial crisis—cheap and abundant capital, a China-driven commodity "super cycle," and wasteful capital allocation by management, leading to massive overexpansion and overcapacity. Asset lifespans are long: mines require a decade of approvals and capital expenditure before production, and ship orders take at least two years from order to delivery with a 20-year service life. In the shipping industry, for example, the global ratio of new ship orders to the existing fleet has been declining for a decade from a 50% peak, but the absolute fleet size continued to grow until recent years, when new ship growth only matched or fell below demand growth.

China Factor and ESG Jointly Suppress Supply, Benefiting Existing Capacity

China's Aluminum Industry and Energy Crisis: China, driven by economic self-sufficiency strategy, has prioritized investment in aluminum, using stranded coal assets in the west to generate power for aluminum production, both for domestic consumption and export, destroying international competitors' capital returns over the past two decades. China's commitment to peak carbon emissions by 2030 and reduce carbon intensity by 65% over the same period may signal a turning point. The recent energy crisis in China has brought short-term benefits to Alcoa (reduced Chinese aluminum exports). The author believes that the root of China's power shortage lies in long-term underinvestment in traditional global energy, with the mistaken belief that renewable energy could quickly, cleanly, and cheaply replace it. Capital Cycle and ESG Synergy: Industries are punished for poor historical investment performance and simultaneously restricted due to excessive emissions—the result is the same: longer periods of high returns. Constrained reliable power supply, combined with post-pandemic demand recovery, has boosted returns for LNG, coal, and developed-market aluminum smelters that survived Chinese competition. Similar dynamics are also evident in the silicon market (via investment in Ferroglobe).

Capital Flows to Asset-Light Industries, Essentially a Penalty for Capital Waste

Market Narrative Analysis: Over the past decade, capital has been attracted to asset-light industries (where intangible assets are hard to replicate and demand growth offsets overcapacity concerns). Investment commentators might describe this as "growth" beating "value" or "quality" beating "cyclicals," but the author believes this is essentially the market penalizing certain industries and their management for wasting capital, while rewarding those that achieve higher valuations (or at least promise to do so) through prudent capital management.

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Appendix: Position Moves

Position	Action	Key Logic & Data
Pacific Basin	Hold & Observe	Dry bulk shipping, benefiting from capital cycle reversal, return recovery after prolonged low returns
Diana Shipping	Hold & Observe	Same as above
Teck	Hold & Observe	Mining, benefiting from return recovery after historical underinvestment
Freeport	Hold & Observe	Same as above
First Quantum	Hold & Observe	Same as above
Alcoa	Hold & Observe	Aluminum, benefiting from reduced Chinese exports due to energy crisis and global underinvestment in traditional energy
ConocoPhillips	Hold & Observe	Oil, benefiting from supply constraints and post-pandemic demand recovery
Apache	Hold & Observe	Same as above
Canadian Natural Resources	Hold & Observe	Same as above
Avis Budget	Hold & Observe	Car rental, strong performance (even before the meme stock surge)
Ferroglobe	Hold & Observe	Silicon, benefiting from similar supply-constrained dynamics
Bank of America	Hold & Observe	Banking, benefiting from return recovery in capital-intensive industries
Wells Fargo	Hold & Observe	Same as above
Amazon	Hold & Observe	High-stability return company, one of the largest holdings
Alphabet	Hold & Observe	Same as above
Tinkoff Credit	Hold & Observe	Same as above
Costco	Hold & Observe	Same as above
TSMC	Hold & Observe	Same as above

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Capital Cycles Determine Return Duration, Asset Life Is the Key Variable

The length of low-return periods in capital-intensive industries depends on asset life, supply constraints, and external shocks. The author argues that the "antidote" to low returns is low returns themselves—prolonged underinvestment eventually pushes up returns on remaining capital. However, the wavelength of capital cycles varies by industry, primarily influenced by asset life (time needed to depreciate old capacity), with three additional prolonging factors: 1) Premature bottom-fishing by private equity (e.g., the mid-2010s influx of new capacity in the shipping industry extended the downturn by several years); 2) Supply constraints can actually accelerate the recovery of returns (e.g., only two manufacturers of U.S. logging equipment remain, leading to long lead times for new capacity delivery; European papermaker UPM-Kymmene proactively closed plants ahead of schedule); 3) Dried-up financing channels (Nordic specialized banks in shipping went bankrupt or closed shipping divisions), government regulation (cancellation of North American oil and gas pipelines, restrictions on new drilling), and geopolitics (regionalization of supply chains reducing global capacity) all constitute supply barriers.

The Capital Cycle Framework Provides a Basis for Contrarian Investing, Not Blind Bottom-Fishing

The core value of capital cycle analysis lies in providing confidence to accumulate positions when industry returns hit bottom, distinguishing contrarian investing from value traps. The author emphasizes that contrarian thinking alone risks falling into value traps, but combined with bottom-up capital cycle analysis, it enables betting at the moment when "odds are most favorable and the situation is about to reverse." The author's original words: "To be right too early is to be wrong, we say that you will never own a stock at the bottom unless you are prepared to be early" (meaning: "Those commentators who say 'being right but too early is being wrong'—we believe that unless you are prepared to enter early, you will never buy a stock at the bottom"). Diversified portfolios and long-term performance fee structures provide room for such patience.

Current High Returns Are Not Fleeting; Supply Constraints Extend the Profit Cycle

The market views current earnings of cyclical stocks as a one-off pulse, but supply constraints mean high returns may last longer than valuations reflect. The author notes that short-term performance-oriented participants tend to attribute current earnings to "headline factors" like inflation, energy prices, and port congestion, while Hosking focuses on a more fundamental question: What are the constraints on new capital entry? What is the outlook for capacity expansion? Analysts try to forecast future demand to the decimal point, but the author prefers to make rough estimates of supply based on observable phenomena such as capital market activity, capital expenditure projects, and hiring announcements—these signals can indicate the arrival or absence of new supply in advance.

Performance comparison: The author uses Chart 4 to show that the capital expenditure/depreciation ratio for developed market mining stocks is at historical lows, confirming sustained underinvestment on the supply side.

Supply Constraints Create Valuation Anomalies: Buy at Low P/E, Wait for Mean Reversion

If supply constraints (i.e., barriers to entry) mean high returns will persist longer, then current low valuations present an opportunity. The author explains the cyclical stock valuation paradox: P/E is extremely low at peak profits (the market believes earnings are unsustainable), and extremely high or even negative at trough profits. However, if supply constraints cause returns to persist longer before reverting to the mean (with an inevitable overshoot to the downside thereafter), a valuation anomaly exists to exploit.

Key stock: Pacific Basin (dry bulk shipping)

• Thesis: Bullish; the author explicitly cites it as a "vivid portfolio case."
• Evidence: Forward P/E of only 3.2x; the chairman just spent $500,000 to increase his stake by 9%. The author's original words: "This kind of insider behaviour should be catnip to the patient outside investor" (meaning: "Such insider behavior should be as enticing as catnip to patient outside investors").
• Risk: Not explicitly stated, but the shipping industry's capital cycle history shows that return recovery can be prematurely ended by new capacity.

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Position Moves

Ticker	Direction	Author's One-Sentence View	Key Data
Pacific Basin	Hold & Watch	Dry bulk shipping, core case of capital cycle reversal, strong insider buying signal	Forward P/E 3.2x; Chairman increased stake by 9%
Alcoa	Hold & Watch	Aluminum benefits from China's energy crisis reducing exports, global underinvestment in traditional energy	China's carbon neutrality pledge may limit aluminum exports
ConocoPhillips	Hold & Watch	Oil, supply constrained (pipeline cancellations, drilling restrictions) coupled with post-pandemic demand recovery	Developed market mining capex/depreciation ratio at historical lows
Ferroglobe	Hold & Watch	Silicon market, similar supply-constrained dynamics	Specific data not disclosed
Amazon	Hold & Watch	High-stability return company, one of the largest holdings, benefits from supply barriers	Specific data not disclosed
Alphabet	Hold & Watch	Same as above	Specific data not disclosed
Costco	Hold & Watch	Same as above	Specific data not disclosed
TSMC	Hold & Watch	Same as above	Specific data not disclosed
Tinkoff Credit	Hold & Watch	Same as above	Specific data not disclosed
Bank of America	Hold & Watch	Banks, benefiting from recovery in returns from capital-intensive industries	Specific data not disclosed
Wells Fargo	Hold & Watch	Same as above	Specific data not disclosed
Avis Budget	Hold & Watch	Car rental, strong performance (even before the meme stock surge)	Specific data not disclosed