Welcome to the next edition of Bookworm, my regular column where I extract useful insights from books and shareholder letters written by leading investors and businesspeople.

These insights are grouped under three core principles:

  1. Own high-quality assets
  2. Foster a long-term mentality
  3. Put process ahead of emotion

Today’s insight falls under the “own quality assets” pillar and comes from one of my favourite books on investing: Capital Returns.

Capital Returns is a collection of essays written over several years by employees of Marathon Asset Management and edited masterfully for the book by Edward Chancellor.

Today’s insight

Marathon is best-known for its “capital cycle” approach to equity investing.

While others focus on forecasting demand, this approach looks at how changes on how the ‘supply side’ of an industry are likely to be affected by flows of capital in and out of it. And, in turn, how this might affect future profitability and returns on capital for companies.

Capital cycle theory posits that high profitability and returns on capital in an industry will attract a wave of fresh investment from new and existing participants.

Eventually, this will result in excess capacity, weaker pricing and profits, and crumbling returns on capital.

By contrast, an industry that exhibits low returns on capital will repel new investments and eventually see capacity shrink through players cutting back and leaving the industry.

This sets the stage for a period of higher profits and returns on capital for players that remain, and so the cycle can start again.

The truest hallmark of business quality?

Marathon once focused most of their attention on finding industries poised to experience improved profits following a retreat of capital and supply capacity. Over time, however, they used their analysis of the capital cycle in a very different way: to find companies immune to it.

This is because a company that is sheltered somehow from the boom and bust cycles depicted above has more potential to grow massively in value over the long-term. Why?

Because earnings growth can persist for longer than the market expects, and the compounding of sustainably higher returns on capital can reach what Horizon Kinetics’ Murray Stahl calls “escape velocity”.

This isn’t too far removed from Morningstar’s moat philosophy. We think a high quality business is one that is protected by some form of structural advantage and can therefore compound in value without other companies competing away their profits and returns.

How, then, might we find such a business? The essays in Capital Returns mention several qualities that Marathon’s analysts look for in this regard. They are too numerous and, in some cases, too nuanced to cover in one go.

One that really stood out to me, though, was the idea of intrinsic pricing power combined with intangible barriers to entry.

Intrinsic pricing power

In the essay “Quality Control”, intrinsic pricing power is defined by the writer as follows:

“Intrinsic pricing power is created when price is not the most important factor in a customer’s purchase decision. Most often, this property is generated by the existence of an intangible asset.”

Situations like this could arise when the seller’s product or service performs a critical role in the buyer’s product offering and simply must work.

In this case, things like brand and a track record of safety or effectiveness are likely to matter more than whether the product costs a few cents or dollars more.

Or it could occur when the solution is so deeply embedded in the buyer’s business that switching to another provider would entail 1) a lot of effort and 2) serious disruption (and lost revenue) if the move doesn’t go smoothly.

Importantly, the writer makes the point that intrinsic pricing power is enhanced in situations where the buyer’s outlay on the product or service is small compared to their total costs of doing business.

Pricing power is usually lauded for its ability to drive higher profits and margins over time because prices can be increased without clients running for the exits.

In the context of the capital cycle, this power – and the intangible assets that create it - can also be seen as a barrier to entry. Or at least a barrier to effective entry.

This is important because Marathon were looking for businesses where others might be able to see high profit margins and returns on capital being achieved, but they can’t touch or affect them. Even if they invest lots of money into trying to take a slice of them.

An example from my portfolio

CME Group owns exchanges on which financial derivative contracts are traded. It facilitates around 95% of trading volume in US Treasury futures (which are used to hedge interest rate risk), as well as leading futures markets related to several other assets.

The beauty of CME’s US Treasury futures business is that traders are worried about the price and liquidity of the contract itself. Not CME’s transaction fees, which are tiny in comparison.

As our CME analyst Michael Miller notes in his report on the company, Treasury contract prices increase or decrease in increments or ‘ticks’ of $15.625, while CME charges between $0.30 and $0.75 per contract in trading fees.

CME’s near-monopoly on trading for this kind of contract essentially guarantees that traders will be able to execute best on CME’s exchange. This is your classic network effect situation, where every additional trader on CME’s exchange adds value to every other trader by adding more liquidity to the market.

As a result, getting even one ‘tick’ worse of a price elsewhere would make any saving on transaction fees redundant. This gives CME pricing power on these fees, while making it very hard for other exchanges to lure traders away with lower fees.

That’s before you even start thinking about how hard it would be to build a market that can compete on liquidity and trading volume.

“A potential competitor would need to attract a critical mass of trading volume before it could offer its customers comparable execution” says Michael in his report. “This is a difficult prospect as its initial user base would need to be willing to accept higher trading costs during the startup process.”

I think it’s clear that CME Group’s interest rate futures exchange has “intrinsic pricing power” stemming from intangible assets that also form powerful barriers to effective entry. Others might see the excellent profitability and returns on capital being achieved, but it’s unlikely they will be able to touch them.

Disclosure: I own shares in CME Group (NAS:CME).

Previously on Bookworm