Portfolio manager Andrew West, CFA, explains how selecting companies with strong balance sheets and low debt safeguards against the potential erosion of the value when interest rates are elevated.
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Can a Raw Deal Be Good for Netflix?
By Uday Cheruvu, CFA, Analyst, Telecommunications Services, Media and Entertainment | January 30, 2024
It’s an expansive deal, beginning in January 2025 and running for ten years. Netflix will air Raw in the US and internationally, and will have the rights to all WWE shows outside the US. It also may be a harbinger of what’s to come in the world of streaming services and sports. Over the next several years, the contracts for broadcast rights to the NBA, NFL, NHL, and MLB in the US will come up for renewal, as well as the domestic and US rights to top soccer leagues such as the Premier League (UK), La Liga (Spain), Seria A (Italy) and Bundesliga (Germany). The streaming services will be serious contenders in the bidding for all of them.
Netflix has previously declined to jump into sports. “We’re not anti-sports, we’re pro-profits,” co-CEO Ted Sarandos said last year. Making a major foray into sports, even if it’s a scripted one, may be a signal that Netflix is seeing—or at least planning for—a ceiling in terms of how many new subscribers it can attract without sports.
The biggest problem with sports programming is that while it does the things a broadcaster wants it to—steadily bring in dedicated viewers—over time the rights can become addictive for companies. If a sport increases in popularity, that improves profitability and hopefully leads to good returns on the investment for the rights holder. However, those attractive returns also lead to a higher renewal contract, which resets profitability at a lower level even when competitive dynamics are benign.
The problem for Netflix is that the sports-rights competition is not benign. Netflix will be competing with Paramount, Peacock, and Disney, as well as big-tech companies that have completely different strategic goals. For tech companies like Amazon and Apple, for example, “success” in terms of sports programming is more about e-commerce or hardware sales than subscriber profitability.
Netflix has spent roughly US$17 billion a year on content since 2021, a level it plans to maintain for the foreseeable future. The company said that the WWE deal would not add to its content budget, meaning it expects to spend less elsewhere. On one level, then, this is not an expensive bet. WWE already has a fanatical global audience and NBC is paying nearly US$300 million annually just for the US rights. Maybe US$500 million a year for global rights is a bargain.
Given Netflix doesn’t have any legacy networks to protect like some of its competitors do, it sidesteps a lot of the messy problems in the industry. But Netflix has its own set of pressures with which to contend. In 2023, Netflix’s subscriber base rose to 260 million, which was a record. Its growth rate, however, is slowing. In the past two years, the subscriber base is up 17%. In the two years prior to that, it rose 33%. Netflix used to be valued and treated like a tech stock. These days it is valued and treated more like a media company.
Shaded area represents the pandemic and post-pandemic period.
Source: Statista
With this 10-year deal, the company has now locked in billions of costs, and it will have to prove over the next decade that Roman Reigns, Rhea Ripley, and Finn Bálor will be enough of a draw to make the deal profitable. If WWE programming can help Netflix both bring in new subscribers and keep churn at current levels or lower, then the deal is absolutely worth it.
Netflix is being ambitious by entering into the sports rights rat race, but it won’t be clear for some time whether it’s being ambitious and opportunistic or ambitious and foolhardy. Last year Netflix earned US$5.5 billion, up from US$4.5 billion the year before. In streaming, any profits are rare, so Netflix is looking better than its peers. But like its subscriber-base growth, its earnings growth rate has been decelerating, too. With earnings growth in mind, it will be important to keep an even closer eye on Netflix’s content spending from now on.
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Japan Digging Out of Chronic Deflation One IT Worker at a Time
By Takayuki Hayano, Analyst | January 05, 2024
But one Japanese company in the Information Technology (IT) sector has taken an unusual approach to reinvigorating the labor market. SHIFT, which provides software-testing services, is poaching and re-training workers from other industries, turning them into IT pros. As Prime Minister Fumio Kishida advocates for the reskilling of workers and for companies to increase wages, SHIFT’s system is an example of how companies could help put a dent in Japan’s entrenched model of lifetime employment, helping the country dig out of a decades-long deflationary environment.
Among its labor-market challenges, Japan faces a major shortage of IT engineers. Of the 75 million people in the country’s working population, only about one million are IT professionals. That’s a lower proportion than in other developed countries such as the US and Germany. But SHIFT estimates that 10% of Japan’s non-IT workers aspire to join the space.
Software testing is also one of the most labor-intensive processes in software development, as it entails the time-consuming work of manually looking for bugs within code and making sure an application works as intended. For firms that struggle to find experienced programmers to begin with, having those expensive programmers do testing doesn’t make sense. Some of SHIFT’s biggest customers are consulting firms that would rather have their own high-paid employees focus on their main business of consulting while outsourcing something like software testing to save money. For example, the average salary at Nomura Research Institute (NRI), an IT-consulting firm, is double the average at SHIFT:
Source: Company filings
Even though it’s lower than at other IT-related firms, compensation is a big part of the draw of making a career change to work at SHIFT. Candidates seeking to become software testers start by taking a recruitment exam, known as CAT, that filters applicants for certain skills and traits—comprehension, attention to detail, and judgment, for example—rather than computer-programming knowledge or IT experience. As of December, nearly 103,000 people have taken the CAT exam and about 16% have passed, according to SHIFT.
For the people SHIFT hires, it provides training and certification programs as well as performance-based compensation as incentives for continued learning and advancement. That sort of pay structure means that many of SHIFT’s personnel costs are variable, but the compensation scheme—and the fact that these workers were likely earning lower wages in their previous jobs—helps SHIFT attract and retain talent, which is important for the company to sustain growth. According to SHIFT’s filings, the average monthly unit price for its engineers is 818,000 yen (US$5,600). Engineer compensation accounts for about 60% of those sales, which implies an annual salary of about 6 million yen (US$41,000), higher than the average pay in Japan of 4.6 million yen (US$31,000).
By encouraging worker mobility and development of new skills, SHIFT is driving up Japan’s stagnant worker pay.
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4 Sources of Edge for Active Managers
By Simon Hallett, Vice Chairman | May 21, 2021
The sources of edge are often described as Informational, Analytic, Decision-making, and Organizational:
Informational
In an era of Artificial Intelligence and Big Data analysis, it’s very hard to generate an informational edge through data acquisition alone. Those who do find anomalies see them quickly arbitraged away. There is, though, the possibility of generating an edge by extending your time frame. A large segment of the market today is concerned with generating products based on dataset analysis, which generates excess returns for short periods of time, in the full knowledge that that advantage is temporary. However, no one has been able to turn the identification of companies that can generate returns over long periods of time into an algorithm. Focusing on long-term industry competitive dynamics and individual companies’ own competitive advantages within their industries can lead to insights that short-term data analysis often misses.
Analytic
Separating signal from noise can provide a potent analytical edge. As Benjamin Graham wrote in The Intelligent Investor:
“People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” Having a series of rules that help determine the passage of a company from the wider universe to research coverage is extremely helpful. Being structured in how to conduct research and pre-committing to the characteristics sought in a company are essential. Be objective in embracing what works from quantitative processes and systematic fundamental analysis. Structure and discipline help overcome human biases. Admit and learn from mistakes to be more objective and establish a framework to help analysts communicate with colleagues. The structure and discipline will help them focus on what’s important, and filter out what is not.
“Focusing on long-term industry competitive dynamics and individual companies’ own competitive advantages within their industries can lead to insights that short-term data analysis often misses.”
Decision-Making
Understand that all human beings have biases that inhibit both thorough analysis and sound decision-making. A good manager needs to set up structures to overcome these biases, and make sure that all team members stick to those structures. Overcoming our emotions and learning how to avoid cognitive errors should be at the core of any process that results in making decisions, especially decisions made under conditions of great uncertainty, which clearly includes investment decision-making. Conviction and confidence help sell ideas but may not be accurate guides to the success of those ideas.
Organizational
Incentivize analysts to get their decisions right, not to persuade portfolio managers. How an organization is structured, and how its people are incentivized and compensated, can provide the background that facilitates good decision-making and is thus a source of “organizational alpha.” For example, incentives should in part focus on long-term performance so that they’re aligned with the long-term nature of the informational and analytical edge. Moreover, individuals need to be accountable for their decisions to avoid the blame game that arises from consensus or group decisions. Finally, a good investment manager needs to communicate with clients, and, above all, set their expectations accurately.
At Harding Loevner, we think we have an edge because of what we know about decision-making and the structure and discipline of the process. Our analysts provide the necessary ingredients for successful, systematic portfolio construction. Our decision-making structure imposes individual accountability, mitigates biases, and ensures continuity, leading to better decisions and aligning each of us with our clients’ objectives.
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