Capital-Intensive and Cyclical Businesses

Learn to Invest – Quantified Investment Course Capital-Intensive and Cyclical Businesses

Some industries require more capital than others. Some businesses require large investments in fixed assets before they even earn a penny, while others require zero investment to generate money.

What does capital-intensive mean?

In the business world, capital intensive is used to describe business ventures that require large amounts of capital to produce goods or services.

Such businesses have a high percentage of fixed assets, like property, plants, and machinery, and as such, are often marked by high levels of depreciation.

Most capital-intensive businesses are cyclical, which means that they are sensitive to the phase of the economic cycle — their revenues improve during periods of economic boom and decline during periods of economic downturn.

To explain capital-intensive businesses, let’s compare two companies: X and Y. Assuming Company X wants to start flights between Norway and Germany, it would need to get airplanes.

Whether it buys or leases them, airplanes cost a lot. So, Company X would require a lot of capital to start this business.

Let’s say Company Y wants to start consulting for the construction industry. Consulting business only requires human capital and office rent. Thus, the capital necessary to start the business is low.

So, Company X’s business requires huge capital, which comes with huge financial risk as well. Common sense indicates that businesses that are less capital intensive are more likely to offer better returns in the long term. But is this based on empirical research?

Research findings

A study by Hassan Elmasry from Morgan Stanley published in Journal of Investment Strategy No. 1 2007 states the following about capital-intensive industries:

“Companies that depend primarily on physical assets like real estate, factories, and machinery for their competitive advantage are unlikely to earn reliably superior returns on their invested capital over the long term.

Physical assets can easily be replicated by competitors which often leads to excess capacity, price competition, and erosion of returns on capital.

In contrast, companies whose key assets are intangible, such as brands, patents, licenses, copyrights, and distribution networks, can earn consistently superior returns on relatively smaller amounts of invested capital.”

In that study, Elmasry’s looked at 2,200 listed companies from both Europe and the USA from 1984 to 2002. He measured returns against capital intensity and found that the less capital intensive a company is, the better the return. See the graph below: