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Complexity Investing Process at NZS Capital

I don’t often walk through specific scenario analysis for companies or talk about what I think stocks might be worth in the future in this newsletter. There is a good reason for that – our process relies on not needing to narrowly predict the future. We don’t necessarily believe in popular investor concepts like mean reversion, intrinsic value, pattern recognition, growth investing, GARP (growth at a reasonable price), or what the market is currently infatuated with: QAAP (quality at any price). A more pejorative term for ‘mean reversion’ is ‘luck.’ Most market forces are governed by power laws with fat tails, not bell curves, so the idea that there is a mean to revert to is usually an illusion. Relying on an ability to use data and models to determine an actual intrinsic value for a stock is a good way for your brain to trick you into believing that you are exceptionally brilliant. 

Instead, we try to find investments where we are likely to make money over the long term with as few predictions as possible. And, when we do make predictions, we want them to be broad. For example, we think electronics are pushing deeper into the world, and, therefore, we will have more need for semiconductors, sensors, and connectivity over time. This seems like a fairly safe long-term prediction. The narrower the prediction, or the bigger the parlay bet of predictions (this has to happen, then this has to happen, then this has to happen...), the smaller the position size will be in the portfolio.

We also try to get a sense for the duration of growth combined with a stock’s current free cash flow (FCF) yield (defined as FCF per share divided by stock price). A business with a safe set of wide predictions, long duration growth and a good FCF yield starting point can be the basis for a larger position size. 

We seek Resilient cash flow streams with steady growth (a combination of positive feedback loops with negative feedback loop governors) and management teams with a long-term focus on innovation, adaptability, and creating Optionality around the business core. Lastly, we constantly absorb new information as objectively as possible and take a Bayesian logic approach to adjusting our credence up or down, while working as a team to identify when someone’s brain is tricking them so as to try like hell to avoid cognitive bias. This process built on elements of Quality, Growth, and Context of a business is the heart of our Complexity Investing framework.

As a case study of Complexity Investing and how to classify narrow and broad predictions, below is our framework applied in detail to the announced merger of Viacom and CBS. ViacomCBS would not necessarily be a stock we would invest in for a technology strategy, but we have been historically successful investing in Disney as it transitions to a digital platform, so it’s an interesting exercise to go through (but, there’s that dangerous “pattern recognition” creeping in!).  Before I go further, If anyone needs more background, this detailed post on REDEF does a great job describing what went wrong at Viacom and what might go right. 

ViacomCBS: Quality, Growth, and Context Analysis

In terms of Context, we look at valuation and the balance of tailwinds and headwinds. The starting point on ViacomCBS is likely a FCF yield to equity holders of over 10%; that’s a nice cushion, but remember we don’t believe in mean reversion, so we won’t take that to the bank. The tailwinds are somewhat complex, and everyone is aware of the headwinds for traditional cable/satellite TV in the US as people cut the cord. The good news is that the decline in this business is 1) fairly well known with a somewhat predictable curve (which can change, so I watch it closely – the above REDEF link has a great chart to visualize this); 2) partially offset by increased transmission fees and rising advertising rates (due to scarcity value of large audiences, live sports, and a need for cable and satellite to continue to support their remaining subscribers to the end). The positive tailwinds are the growing appetite for consumers to stream multiple apps and the expanding global audience of potentially billions of people. From a top-down perspective, I think it’s a broad prediction to say that consumers in the US will continue to have $100-200 to spend on video and broadband (more with wireless and 5G; I covered this analysis in more detail last week). I also think traditional cable and satellite will be enablers of the shift to multiple streaming apps, and we saw good evidence of that in Disney’s announcement with Charter this week, which contemplates future distribution of Disney+, Hulu, and ESPN+. So Context is mixed: valuation is an easy hurdle here, but there are mixed tailwinds and headwinds; I think the tailwinds – including global distribution, price increases for retransmission and advertising, and a growing content library – offset the headwinds for now, but I realize the vast majority of the market believes this is just Pollyanna having her cake and eating it too, if you’ll indulge a mixed metaphor. Another part of Context is debt and leverage. ViacomCBS is targeting 2.8x combined net debt/EBITDA with a goal of remaining a strong investment-grade borrower. Moody’s, a bond rating service used as a crutch for many investors, is concerned about the merger, and debt can be a wild card that evaporates equity value for stockholders (especially in a recession for a business with cyclical advertising exposure), so it’s something to keep an eye on. The ratings agencies do impact the rate at which the company can borrow in the future, and leverage concerns could keep ViacomCBS from being able to do content acquisitions such as Lions Gate or Sony Pictures (both of which have been rumored). 

Moving on to Growth, this is where we contemplate duration of growth, the shape of the S-curve, the ability to stack new S-curves, network effects, and most importantly, the NZS of the business: to what extent is the company creating more value for its constituents than itself? The revenue outlook is ok, but heavily dependent on the debatable assumptions above regarding tailwinds and headwinds. The core business today appears to have enough Resilient qualities that it can feed the ability to grow a new business in direct-to-consumer (DTC) streaming. That’s the “have your cake and eat it too” assumption that I am most vulnerable on. But again, the starting point on valuation provides me a little bit of cover (that’s perhaps the most dangerous statement in this writeup, valuation never covers fundamentals!). We know the traditional business is at the top of its S-curve and rolling over. The new DTC effort needs to stack a new S-curve, and combining the libraries and studios of CBS and Viacom gives this a better chance, but it’s not guaranteed. In terms of NZS, the analysis is mixed. Consumers are getting more value, convenience, and selection by going to direct streaming apps from expensive cable packages, but it also complicates the user interface to have multiple apps without any good universal search available. In general, I think media companies create good value for their customers, suppliers (talent), and themselves, but it could be better. The network effects of streaming apps are relatively strong, but not necessarily defensible. There is a solid flywheel of subscribers and content, but others can do this as well. I think ViacomCBS will have a large enough budget to hold their own and sustain a subscriber flywheel, but that too is worth monitoring (I estimate the following non-sports content spend in 2019 at the majors: Disney $18B, Netflix $15B, NBC Universal $15B, WarnerMedia $14B, ViacomCBS $8.5B, and Amazon $6B; combining Amazon with ViacomCBS almost seems too obvious). It’s worth noting that ViacomCBS has 750 episodic series on order or in production including shows for Netflix and Disney+. There will be 5 studios with global scale (Amazon is a 6th contender), and Hollywood is capacity constrained. Further, the artists in Hollywood have a say in outcomes, and it’s likely that the talented writers, actors, directors, etc., and perhaps most importantly their agents and managers, don’t all want to work exclusively for Bob Iger and Ted Sarandos! This obviously cuts both ways as this group has leverage over the studios, but it appears a winner takes most network effect is unlikely to manifest. In this case supplier power acts like a negative feedback loop keeping other streaming platforms from reaching escape velocity.

Lastly, I come to Quality: to what degree is the company management thinking long-term, innovating, and adapting? I don’t know the current management team well enough to answer this yet. However, I believe what Jim Lanzone has done with CBS Interactive has been very forward thinking and set the company up to succeed in DTC a few years ahead of Disney, Warner, and NBCU. The headlong push into DTC and the motivations behind the ViacomCBS merger are consistent with my analysis of the Context and Growth variables. Overall, Culture is my biggest unknown – I would seek more insight into whether the management will lead with innovation and adaptability and allow a decentralized organization to continue to support artists and produce great content. 

Putting this all together, there is a lot to like and a lot to monitor closely. There are some comfortably broad predictions, but a couple of more narrow ones that require further analysis. Normally, we start bottom-up with Quality, then move to Growth and finally Context; however, in the case of ViacomCBS, I feel the top-down consumer behavior trends are more relevant. From here, I would take into account each incremental bit of information, analyze as objectively as possible and attempt to root out any cognitive bias. For this process, I will lean on my investing partners because we can much more easily see bias in others than in ourselves. I don’t see any of the classic bias traps so far in my analysis, but it’s likely I am blind to them at this point. The process I used here is the one we discuss in much more detail in Complexity Investing. It’s designed to help inoculate us from as many mistakes as possible. It also informs the position sizing relative to the fundamental risk of the business. Please reach out with any thoughts/debate you have on our process or ViacomCBS.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.