Netflix, Precision, and Stories

We think in terms of stories and analogies. We were born to do it. In SapiensYuval Noah Harari argues that our penchant for telling and believing in stories is the “mysterious glue” that allowed humans to cooperate and dominate the world.

While stories may encourage cooperation, they can sometimes blind us to reason. Daniel Kahneman illustrates how stories can breed fallacies in Thinking: Fast and Slow.

He describes an experiment involving a fictional woman named Linda. In the experiment, Kahneman and his partner Amos Tversky described Linda as a young, single, outspoken, brilliant philosophy major “concerned with issues of discrimination and social justice, [who] also participated in antinuclear demonstrations.”

They then asked people which was more probable:

(1) “Linda is a bank teller.”

(2) “Linda is a bank teller and active in the feminist movement.”

They found that “85% to 90% of undergraduates at several major universities chose the second option, contrary to logic.”

We can be so willing to take a narrative, form a mental picture, and categorize things that we set aside reason.

The same thing can happen when discussing businesses, and few companies are as well discussed as Netflix. In a recent appearance, CNBC guest David Trainer argues that Netflix’s valuation is “disconnected from fundamentals.” He claims that that investors “seem to be unbelievably gullible these days,” and that Netflix is a “story stock.” Trainer mentions profit margins and multiples to suggest that Netflix is hugely overvalued, and explains that investors are falling victim to a false narrative.

But which is the false narrative? Although Trainer derides Netflix as a “story stock,” isn’t he constructing his own story here? He seems to apply a standard valuation framework, compares Netflix to other content creators like Disney, and posits that it’s “a tough business to be in”. He asks, “can you name any businesses in the history of the world that have consistently [sic] created profitable new content?” The framing of that question sounds suspiciously close to a story.

The problem with this way of thinking is that some businesses have predictable economics and some have highly uncertain economics.

In an electric utility, for example, we can be somewhat confident in forecasting future cash flows. We might look at population trends, trends in energy consumption, and the utility’s cost per watt. The industry is highly regulated, so utilities have limited ability to increase margins. Given those constraints, if we try to place a value on XYZ Utility, maybe we’ll say it’s worth $1 billion, or maybe it’s worth $1.2 billion, but it’s definitely not worth $10 billion. With this type of business, we could use multiples or industry comparables and feel pretty good about our estimate of value. It’s a fairly predictable story.

With a business like Netflix, the future is incredibly uncertain. We do not know what its programming content will cost in ten years or how much pricing power it will have. We don’t know what its innovations will be. Trying to use a quantitative approach like discounted cash flow or even comparables to value this type of business is fraught with danger.

So why might Trainer be wrong? Why might the market think Netflix is worth $60 billion?

Consider what the business is, who runs it, and what it could be in ten years. The company is building a massive stream of recurring revenue with sticky subscribers. It has an innovative team. We can see the trends in cable vs. streaming, and we can imagine a future in which Netflix could raise prices without losing many subscribers. A business with almost no need for physical capital has the potential to send additional revenue directly to the bottom line. Netflix might not live up to lofty expectations, but there is something real here. Maybe investors aren’t just being “gullible.”

Sometimes, using a valuation formula or comparables can be dangerous. To quote Seth Klarman, “Any attempt to value businesses with precision will yield values that are precisely inaccurate.” We should be skeptical of any stock that has a sky-high valuation, but we should also be skeptical of valuing a business by formula or by analogy. Valuing a business like Netflix is like looking through fog. If you’re looking through fog for land on the horizon, don’t use a magnifying glass.

Disclosure: I do not currently own shares in Netflix.

Stock Picking and the Zero-Sum Game

Most stock fund managers fail to outperform their benchmarks. This is a widely discussed and repeatedly corroborated phenomenon. There are studies showing abysmal rates of outperformance among active U.S. equity managers in recent years. Warren Buffett made a famous bet against hedge funds that looks better every day. The flow of funds from active to passive (index) investing is one of the most popular discussion topics in modern investing.

All this raises the question: is it even possible for actively managed funds, as a group, to outperform passive funds?

When index funds gained popularity in the ‘80s and ‘90s, many professional investors dismissed them, believing that any decent business school graduate could outperform the market. Now, some commentators dismiss outperformance as an impossible challenge, arguing that market “efficiency” has wiped out the possibility of achieving excess returns.

Amid this discussion, a well-worn maxim is the idea that stock picking—and therefore active management—is a zero-sum game. The idea holds that market participants, as a whole, cannot outperform the market, and therefore active participants, as a whole, cannot outperform passive participants. The zero-sum game concept is often touted as an argument for passive management or for the futility of active management.

By rephrasing an assertion from William Sharpe, we can define the zero-sum game concept of markets in the following way:

The Zero-Sum Game Rule of Markets: Before costs, for any distinct set of securities, the collective return of all active participants must equal the collective return of all passive participants.

This is simple enough logic. For a distinct set of securities, any excess return achieved by one active participant comes at the expense of another.

This logic can be misused in common discourse by suggesting that actively managed funds as a group cannot, by some immutable law of finance, outperform the market. Although there is ample evidence that most actively managed stock funds have performed poorly in recent years, the zero-sum game concept does not suffice as an explanation. It is theoretically possible for active funds, as a group, to outperform passive funds, as we will see below.

Actively-Held Stocks vs. Passively-Held Stocks: a True Zero-Sum Game 

Let’s imagine the universe of equity shares split into two buckets: passive and active. The passive bucket represents all shares held by those who can only hold stocks at the market weight. The active bucket represents all shares owned by those who can hold and trade shares at any other weight. The active participants determine the market weights of all equity shares, while the passive participants must accept the market weights. Combined, the two buckets represent all publically traded equity shares. For simplicity, we will exclude fees and assume that the passive investors can invest perfectly with zero tracking error. The two buckets look like this:

Given these assumptions, the passive bucket and active bucket will always have the same return. The returns of individual active participants may differ widely, but as a group, their stocks cannot outperform the stocks held by passive participants. This is a true zero-sum game.

But, as William Sharpe also points out, there are a number of ways that active equity funds could outperform the market.

Active Funds vs. Passively-Held Stocks 

Remember that the zero-sum game rule holds true for a distinct set of securities (i.e., the set of all stocks). But active equity funds are not bound by this set; they can choose to substitute some amount of cash, bonds, or other securities outside of the set held by the passive funds, as illustrated below:

In theory, one advantage held by active equity managers is that they have a broader investable universe than index funds. And because they can reach beyond the set of securities held by the market, they could collectively outperform it. In theory, they could hold more cash in falling markets and less cash during rising markets. They could short equity futures in falling markets or sell covered calls in flat markets. This is the crucial distinction: while the returns of active stocks must equal the returns of passive stocks, the returns of active funds do not necessarily equal the returns of passive funds.

Consider the following example in a hypothetical stock market. Imagine there is one passive fund, one active fund, and other active participants who trade stocks at a variety of weights. For the first half of the year, the stock market returns -5.00%. For the second half, the market returns +10.53%. To exclude the effect of stock-picking, imagine the active fund invests all of its stocks at market weights and only adjusts the size of its cash position.

For the full year, the return of the passive fund equals the market return. But imagine that the active fund held 15% in cash for the first half of the year and 1% in cash for the second half. Assuming cash returns 0%, the results are summarized below:

The active fund outperformed the passive fund simply by modifying its cash position. Because active funds can reach outside of stocks into a broader investable universe, the zero-sum game rule does not prevent them from outperforming the market.

Active Funds vs. Other Active Participants 

Of course, there is a second (and perhaps more obvious) source of potential outperformance. Excess returns for active funds could simply come at the expense of other active investors. Anyone else who trades stocks at non-market weights including individual investors, corporations, and employee stock-plan participants (the supposed “dumb” money) could underperform, effectively transferring excess returns to professional fund managers (“smart” money).

Conclusion

This exploration is simply a reminder that actively managed equity funds could, in theory, outperform the market, and that the zero-sum game rule does not prevent them from doing so. None of this is intended as an argument for, or against, active management.

The interesting thing is that most active funds don’t outperform the market. The reasons for this deserve further exploration. Structural causes of underperformance, along with thoughts on how to tackle them, will be the subject of future pieces.