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High returns in an industry attract new capital and new capacity, and the added supply then drives returns down, often below the cost of capital. Poor returns in turn cause capital to leave through closures, consolidation and halted investment, and the shrunken supply restores profitability. Industries swing through this cycle, so current returns are a poor guide to future ones.
Demand is hard to forecast and investors are already crowded around it, while supply changes are slower and more visible: capex plans, capacity announcements, new entrants, and consolidation can be tracked years ahead. Analyzing how much new capacity is coming gives a more reliable and less competed-over signal of future industry profitability than predicting demand growth.
Companies and sectors that are expanding their asset base rapidly through heavy capex, acquisitions, and equity or debt issuance tend to deliver poor subsequent shareholder returns. Firms that are shrinking investment, buying back shares, and consolidating tend to outperform. Rising capital spending is therefore a warning sign rather than a sign of confidence to reward.
In the late 1990s, investors' belief in explosive internet and telecom demand fueled huge capital raising and fiber-optic network building. Demand did grow, but capacity grew far faster, so bandwidth prices collapsed and many carriers went bankrupt. The episode shows that a correct demand thesis can still produce ruinous returns when the supply response overwhelms it.