I’m sure most of you are as shocked as I am by the footage from America. To say I was – and continue to be – stunned is an understatement though The Bulwark crowd of Never Trumpers have been warning about the possibility of insurrection for months and weeks. It’s easy as investors to treat this terrible episode as confirmation of a narrative I have explored in this blog – the slow, irreversible decline of American political and economic supremacy. That could in turn move us closer to the concept that the USA might disintegrate, causing a seismic shockwave for investors globally.

But there is a positive narrative that deserves consideration. First off, markets have already reacted positively to the two Georgia wins by the Dems, positing a much more aggressive reflationary package. I think that is spot on and I would be spending quite some time focusing on US green energy stocks and ideas currently.

The other possible positive is that this terrible episode might provide a shock to the system which might, in turn, make America realize what a hole it is in politically. It might embolden sensible Democrats and sensible Republicans to start addressing some big structural problems. This narrative suggests renewal from a very low level over the next decade or so.

My hope is that the latter narrative is closer to the truth. I also think that Democratic control of both houses is really good news (no prizes for guessing which party I would support stateside). In truth, I thought (or should I say hoped) this might be the case back in the autumn when I quietly prayed for a Dem clean sweep. That in turn encouraged me to think about diversifying my stateside portfolio, away from tech stocks towards a more cyclical bunch of brand names.

Cue Walt Disney.

In October I bought into this as a classic either way bet. It has a huge traditional business franchise based around theme parks and travel plus traditional media which I thought would do well in a rebound. But Disney also has the single largest collection of valuable entertainment (and sports) content globally. And in a digital world, content is king. My sense was that Disney would make an aggressive play on building its digital content. Which it has indeed gone and done, prioritizing using its Disney + channels as its new pipeline to consumers. That places Disney smack bang in the middle of a fight with Netflix and Amazon. Everyone else, and especially Apple, is an afterthought and will fold. That focus on extra content also helped justify its price increases.

The fantastic Ben Thompson of the Stratchery blog nicely summed up the bold new digital strategy as follows:

“I think it is reasonable to expect more price raises in the future, as Disney+ is clearly transforming from an ecosystem driver first, and moneymaker second, to an ecosystem harvester/moneymaker. What other way is there to interpret 10 new Star Wars properties, 10 new Marvel properties, plus 15 Disney and 15 Pixar properties (the latter are more in number but, I suspect, less significant in terms of driving subscriber growth)? Disney created these universes through its movies, and it is looking to collect a monthly fee from the fans those movies generated……

What is important to note, though, is just how important Disney’s IP is to its optionality. Over the last week creator after creator has decried Warner Media’s unilateral decision to shift movies to HBO Max; this is a big problem for a studio (Warner Bros.) and network (HBO) that have traditionally differentiated themselves by their creator friendliness. Disney, on the other hand, starts with attractive IP, and only then seeks out creators: Star Wars is bigger than any director or actor, as are Marvel properties. This is an exceptionally useful asset not only in terms of negotiating traditional issues like residuals but also distribution channels and lengths.

This also is a reminder that Disney+ remains a very different service than Netflix: whereas the latter draws viewers to unknown shows simply because it is a service they already have, the former draws viewers to a service for shows that they already want. The challenge for other would-be alternatives, particularly HBO Max, is figuring out on which side of the divide they fall: HBO used to be a reason to watch, but AT&T seems determined to make it a default choice. It’s not entirely irrational, but it would be easier if its long-term differentiation rested more on controlled IP, and less on creators who can go anywhere.”

The key here is that Disney is the uber brand of content and it is now deploying its firepower to building global market share.

I’m not the only investor who has started buying into the Disney story.

Its shares recently shot up after a big investor day confirming this new strategy. Some interesting maverick UK fund managers have also been adding to their Disney positions as well.

Take the Arbrook US fund which has been quietly building an excellent track record for investing in large cap names trying to move into the digital world. According to numbers upto December 31st of 2020, the fund was up 23% against 17% for the S&P 500. The fund has also been delivering above benchmark returns for the last 2 and 3 years.

Looking at its portfolio, one of its top 10 holdings is…Disney at 3.7% of the fund.

And here’s Arbrook’s cogently articulated bull case, which I agree with wholeheartedly. The fund opened its position last March.

“…..we believed the market had “forgotten” about the transitioning business model towards streaming. We see three major sources of latency for Disney – cyclical recovery of their parks and resorts business, switch to subscription driven streaming from cable networks and finally the ability to convert linear TV advertising into a higher revenue direct model

In the last few months Disney has announced and made significant progress on transitioning its business model to focus on streaming and this month Disney had its analyst day that showcased these changes and the upcoming slate of new titles. We believe Disney has by far the strongest content brands of any film or TV producer and to quote media analyst Michael Nathanson, Disney’s recently announced “content tsunami” is “frightening to any sub-scale company thinking about competing in the scripted entertainment space”. This is critical to driving consumers to adopt a monthly subscription to Disney streaming products such as Disney+ or Hulu in preference for other options such as traditional cable bundles. Although, this subscriber latency will take some time to unlock, we believe there is a secondary effect on advertising that is less well understood.

We believe Disney will grow its advertising revenues because it is at the confluence of three structural changes in TV viewing. Firstly, post its 21st Century Fox acquisition Disney is now the largest provider of premium content3, making it one of the most attractive places for advertisers. Secondly Disney’s relationship with (i.e. knowledge of) the viewer is dramatically improving through direct subscription. Thirdly, connected TVs (“CTVs”) are providing a software platform to enable targeted advertising. The key point here is we believe targeted advertising is still very early in its adoption and critically much higher revenue for the seller. There is little clear published independent data on the comparable cost of advertising across platforms and everything we believe about the industry has been gleaned from discussion with industry participants and our own research. Generally, we estimate that average advertising rates (measured as “per impression”) for cable networks are half of that for broadcasting networks which are half again that of connected TV. Disney’s advertising revenues still derive mainly from cable and broadcasting and therefore we see substantial opportunity to grow advertising revenues as the business transitions to streaming. In a normal year Disney generates around $9bn of operating profits from revenues that include over $11bn of advertising. We believe growth of high margin advertising dollars will directly impact Disney’s profits going forward.”

Leveraged products for the medium term?

Anyway, back to more parochial investment matters. A reader contacted me this weekend to canvass my views on leveraged exchange-traded products (hat tip to Rory). These gear up the daily returns from a major benchmark, with the most widely used offering 3 times either the upside (long) or the downside (short). The conventional view is that these are very short term speculative instruments, aimed at the day trader crowd. It’s certainly the view I have always had – I have never used any of these products largely because I have never had any confidence that I am able to predict what might happen to broad markets on a day to day basis. The other challenge is that once you hold on to these instruments over weeks and months the compounding effect of daily price volatility tends to undermine their potency. In simple language, these products are absolutely fine for expressing a view over days or maybe a few weeks, but over longer periods the daily compounding starts to impose a roll cost that destroys returns.

But is that always true? In the table below I have summarised price returns over various periods for the S&P 500 and FTSE 100 indices against two long 3 x leveraged ETPs from Wisdom Tree, the largest player in the S&L (short and leveraged ) space here in the UK. What’s interesting is that right up to the nine-month mark these have provided roughly what they said they would do on the biscuit tin. They have provided three times the cumulative returns from the benchmark index. And if one dips down into day by day returns the pattern holds steady. That 3 x return profile fades away at the 1-year level but its persistence is much stronger than I thought possible. One could argue that perhaps volatility was hugely subdued over these time scales, as markets pushed forward. Thus in a normal, more volatile market – less obviously positive momentum based – the returns would fit a pattern of fading away over months. But in truth daily vol in these two benchmark indices has actually been fairly elevated, both on an intraday and inter day basis. If this proves a more durable phenomenon then perhaps we could use these as a more medium-term hedging product, rolling over every six to nine months?

Returns % for 3 x ETP vs Benchmark 1 mth 3 mth 6 mth 9 mth 12 mth
3USL 6.56 34 61.2 175 10.2
S&P 500 1.99 12.2 18.6 41.6 16.2
3UKL 14 50.2 28.2 71.9 -39.9
FTSE 100 4.61 15.2 9.03 22.8 -9.53