Where it comes from

many times by accident…

Overcapacity may arise—but more often is perpetuated—by a wealthy individual who decides to enter a business for non-economic reasons (read: ego). He may be unaware of the economics of the industry he is becoming a part of, or indifferent to them.

Sometimes, an entity—usually a government—will create or support a business for economic, but not profit-related reasons. Typically, this will be to provide employment for citizens. The recent bailouts of General Motors and Chrysler in the US are an example. In emerging economies, government-owned enterprises—mining in South America, for instance—have sometimes used less profitable, more labor-intensive, extraction techniques for the same reason.

Outsiders can goof.  They see the apparent profitability of  a business, but overestimate the size of the market or miss (or not care about) the negative effect their entry will have on overall industry profitability.  Also, newcomers may not grasp the difficulty of actually running an enterprise that seems relatively simple to someone on the outside. The sequential opening of gambling casinos in the northeast US market, starting with Atlantic City in New Jersey, then native American casinos in Connecticut, followed by racetrack-related gaming in New York and Pennsylvania, has resulted in shifts in which state receives gaming taxes, but trouble for all participants as gamblers gravitate to the newest or nearest venues.

In these instances, because the key business decision is the investment of initial capital, the economic damage is done long before business owners are aware of it. Trouble begins as soon as new capacity is created.

Bankruptcy doesn’t help, unless the plants are demolished and the equipment destroyed. Otherwise, a new owner will acquire the assets at a bargain price in a bankruptcy auction, and reopen shop. Ironically, because bankruptcy will eliminate burdensome debt, such an enterprise may have a significant cost advantage over previously better-run rivals.

…but most times not

In my experience, most overcapacity comes, not from outsiders or from non-economically motivated entities, but from a deliberate decision to reinvest cash flow by existing market participants.

Especially in basic industries, like paper and cement, I’ve watched with almost morbid fascination as firms that are flush with cash from outsized profits when prices are at cyclical peaks build new capacity. The company managements clearly realize that prices are at unsustainable highs. They also know that the new capacity they are creating may be enough to tip the industry into oversupply and send prices plunging. They realize that their decision will likely motivate other firms in the industry to add capacity themselves—surely creating a slump.

Yet they reinvest anyway.

Why is that?

Let’s start with the obvious, but I think, less important reasons, at least for shrewdly led companies:

–CEOs have spent their lives building. They’re not going to return money to shareholders in dividends. (Over the past thirty years, I don’t think shareholders have wanted dividends, either. That attitude is probably changing today.)

–Many corporate diversifications into new areas turn out to be financial disasters. I think this is because managements that may be great chess players have trouble when the new game turns out to be bridge or checkers.

From watching managements over thirty years, I’ve come to think there are two other strategic reasons that managements expand at cyclical peaks:

1. One extra plant may not be enough to destroy pricing in a market. Everyone knows that the first plant is like the dam breaking and it will be followed by others. The last new plant will surely be opening in hard times. But the first—even the first few—may have a period where one can still achieve well above-average returns. This reason, by itself, might not be enough to get a management to commit to expansion, knowing that a lean period will doubtless follow the boom. But there is a second, namely,
2. A company that does not expand risks being marginalized in the next upcycle.An example: Let’s suppose that industry demand rises by 3% per year and that all capacity is currently being used. Let’s also say that when companies expand capacity the smallest addition that makes sense is 30% of the existing plant and equipment.

   If it takes a year for the industry to determine it will expand and the new plant comes into service two years later, then supply will be 30% higher than it previously was and demand only about 10% up. This implies a couple of years of price competition as firms vie to use otherwise idle plants.

   What happens after demand catches up with supply? Prices rebound, and maybe reach new highs. Also, the average order from a customer is probably a third larger than it was at the prior peak.

   Consider the competitor who has not expanded. He has made the downturn shallower and shorter than it would have been had he expanded, too. That’s good for his financial health, but for everyone else’s, too. But now—since order size is 30%+ larger and he hasn’t expanded, he can’t satisfy all the demand from his traditional customers. They’re forced to approach his rivals to obtain the raw materials they need. They risk thereby being relegated from primary supplier to second source.

The key to this favorable argument for expansion of capital-intensive businesses is the assumption that demand in the customer’s industry will continue to expand at a reasonable clip. It wouldn’t sound so good as a rationale for expansion for paper companies faced with technological change—with the replacement of physical newspapers and magazines by e-readers, to say nothing of physical paper-borne correspondence to email.  Nor would it be a great reason for a US-based cement company to add capacity soon, given the vast amount of commercial real estate still waiting to be absorbed.