by Brendan Duane

While the final shots remain to be fired, it seems clear now that NFLX has won the streaming wars. Its (re)ascent to the top of the streaming pile may be owed less to its own successful business activities and more to the market realizing that many of its competitors were easy money enabled malinvestments, and their chances of challenging NFLX’s control of mindshare are quite low.

At the height, there were arguably over a dozen streaming services vying for a piece of NFLX’s market. Nearly every one of them badly misjudged both the winning digital content model and their ability to compete against deep-pocketed tech companies and NFLX’s incumbency. It would be difficult to overstate how fundamentally ill conceived many of these multi-billion dollar projects were, despite the fanfare surrounding them. 

My birds eye view: the market getting flooded with doomed NFLX clones is, to me, the product of an advancing digital economy where America (read: Hollywood) has lost monopoly power over media and popular culture and must meet a globalized audience where they are: the internet.

Here, NFLX is uniquely positioned to benefit. 

–For years it has been spreading its tentacles into foreign markets to pluck the best shows and movies from Brazil, South Korea, Spain, etc. to add to its library, and now has stronger relationships and infrastructure globally than any of the new tech entrants or the legacy studios. Try to think of the last time Hollywood gave a sizable marketing budget to anything foreign outside of Oscar bait. Add failure to aggressively pursue content markets abroad to the fathomless pool of unforced errors welling from an incompetent Hollywood managerial class.

–Outside of their higher caliber and more far-sighted acquisitions department, NFLX’s size and longevity have given it insight into the streaming business that Hollywood is too calcified to see, and that Apple/Amazon are too inexperienced to realize. The classic criticism of NFLX’s slate of content is that it is an overgrown swamp of mediocre fare, peppered with a few cult classics and one or two blockbuster originals. Compare this to Apple TV or Disney+’s relatively finite libraries of maybe 100 “high quality” shows and movies

But owning a small number of valuable properties is not the winning model for online content distribution. That’s because an enterprising subscriber can binge everything they are interested in within a single billing period. Possibly even a free trial. After that, why pay? In contrast, an endless digital junk drawer is arguably infinite meh. But Netflix subscribers don’t seem to mind. In fact, they’re perhaps paying less to watch the content itself, and more for the security of knowing there’s something decent to watch in there somewhere, if they could be bothered to sift through a bunch of old rubber bands and pens first.

–The streaming wars also seem to have spurred NFLX to invest more heavily in the future. Their recent WWE deal looks to be the latest in a series of experiments with live content, and also a way to muscle in on the mid-40s, balding, action figure buying crowd. Beyond that, the NFLX choose-your-own adventure style content is laying the groundwork for interactive storytelling–an emerging genre of gaming–and those products may ultimately drive users to the little talked about cloud gaming service NFLX launched at the end of 2021.

And so NFLX marches on as the rest struggle, and merge, and cannibalize each other in the hopes of surviving to possibly catch up later.

…and why it’s so hard to get our arms around the extent of the current Chinese property crash.

people don’t trust the banks in China 

This is a typical phenomenon in emerging markets. 

Something like half the world’s demand for gold comes from developing countries in Asia, and specifically China and India. Some of it may be buried in the back yard. But a lot of it is worn as nam chuk jewelry, so you can break off a chunk to buy something in a stall or a store. No, you don’t collect interest. But, on the plus side, you

—defend yourself against possible devaluation of the currency

—don’t have to worry (so much) about counterfeits

—have immediate access

—don’t have to worry that your bank will fail 

—retain anonymity. There may be a substantial barter or underground economy in a country, especially where official economic affairs don’t always run smoothly. Or a successful business may fear government punishment if the extent of its success were evident in bank balances

–may be able to earn much higher income on investments elsewhere.

Chinese commercial banks have been like government piggy banks

For any government official, getting ahead in the Communist Party depends on achieving economic growth. The easiest way for, say, a mayor to do this is to build something–housing or a commercial complex. Just the act of construction creates GDP growth–and maybe you’ll be promoted (and gone) before the success or failure of your projects are evident. And the easiest way to do this is to arm-twist your fellow Party official who runs the local bank into making a loan to fund construction.

Generally speaking, it’s very hard for an investor to see into the loan book of any bank, but Chinese banks are particularly opaque, I think, because of the power relationships between them and local governments.

speculation in property development

The basic structure: a developer acquires property to build a big apartment complex by leasing land from the government. Buyers put down a large initial deposit, maybe two years before anticipated completion, which gives them the right to buy a specified apartment at a given price on completion of the project. The developer then borrows from a bank (or issues overseas bonds) to get construction funds. The project is completed, final payments are made by buyers, loans are repaid and the developer moves on to another project.

Property is a bigger thing in China than in the US. Here, a bit less than half of individuals’ aggregate net worth consists of property ownership. Estimates for China are more like three-quarters.

Property speculation has been rampant in China for a long time, with–as always happens, everywhere–increasing amounts of financial leverage. Part of this is investor preference, part the lack of alternative investments, part a steady rise in housing prices over the years, part the “piggybank” relationship between governments and banks that has made loans flow like water–without much thought about the chances of repayment.

My Hong Kong experience suggests to me that speculation by potential retail buyers has been very big: I want to buy one unit for myself; I put an advance payment down on three (locking in a fixed price of all of them), with the intention of selling the other two in a year or so, when prices have risen and they may be worth 50%? 100%? more than today. Great when prices are going up, not so good today.

the three red lines

In the summer of 2020, Xi Jinping made explicit in his Three Red Lines rules governing financial leverage among banks and property developers, in an attempt to cap increasingly dangerous speculative lending. This, of course, started a slide in property prices.

ANT Financial

Shortly after that, Jack Ma announced that his Ant Financial consumer lending operation was going to, in effect, destroy the commercial banks’ consumer offerings. That got him disappeared so he could be “reeducated.” An almost incredible miscalculation by a presumably very savvy entrepreneur–indicating to me that the banking system’s solvency problems are much bigger than even the most well-informed outsiders are aware of.

my conclusions

We’re still in early days of this crisis. This is most likely worse for Chinese banks than the crooked mortgage derivatives scandal in the US in 2007-08 was for US-based banks. The only parallel I can come up with is the parlous condition of state-owned Chinese industry when Deng declared a new era of Socialism with Chinese Characteristics. Hard to imagine Xi doing something similar with the banks, though. So all we may see is slower than expected economic growth for the overall domestic Chinese economy.

the short version:

–the end of Hong Kong as a meeting ground between China and the rest of the world, and

–the end of “Socialism with Chinese Characteristics,” and the consequent return to central economic planning

Hong Kong

I started managing a Hong Kong equity portfolio in 1985 and remained an active investor there for about twenty years.

The nineteenth-century history of the UK in China in general, and in Hong Kong in particular, is horrifyingly ugly. In 1898, the UK used its military strength to extract a 99-year lease over the Hong Kong and the vicinity. In the early 1980s, China announced it would not renew the lease and would retake possession of Hong Kong in 1997. The two sides agreed to a 50-year transition period after that, during which Hong Kong would be a democratic, self-governing Special Administrative Region. 

After the initial shock of the handover announcement wore off, my Hong Kong business friends began to realize the incredible money-making opportunities that reunification would offer. They reestablished contact with family members still on the mainland and cross-border business began to boom. Hong Kong became, in effect, the commerce capital of China–and a gold mine of information about mainland political and economic trends, as well as about individual companies and their prospects. 

That era is over, however. A bit less than halfway through the transition period, China reneged on the agreement, neutered the local legislature and essentially imposed Chinese law on the former British colony. So we’re now past the era of free enterprise and in a new one of state control and thought crimes, where the runes are hard to read and the penalty for missteps draconian. The shades have been drawn over the West’s best window into China. Investment in either Hong Kong or the mainland exchanges (which one can access through Hong Kong), therefore, has become much, much riskier.

Socialism with Chinese Characteristics

When Deng Xiaoping took over as the political leader of China in 1978, the economy was in a shambles. One of the core problems was that in a complex economy of about a billion people, central planning bureaucrats in Beijing set production goals, industry by industry and plant by plant, without much regard for supply/demand or whether the factories were even capable of achieving them. Advancing in the Communist Party, however, depended on achieving these goals. The response of corporate leaders, all Party members, was to create a world of fake paperwork sent to the planners, all reporting that the goals had ben achieved. And local towns and companies would coerce area banks to lend them money to keep the lights on.

Deng declared a new era, one of Socialism with Chinese Characteristics, that replaced central planning with market competition–and ignited a decades-long explosion of growth.

That era is now over, too.

As Xi Jinping took over as head of the government, he began to perceive that the era of free enterprise Deng had launched had created powerful entrepreneurs who had become a threat to the dominance of the Communist Party. The attack on Hong Kong is one result of this. Limits on the activities of large non-Party-controlled companies, the confiscation of their assets and the jailing of their founders are others. Dealing with the problematic property market is another.

more tomorrow

“Discounting” is the term the stock market has traditionally used to describe the process through which the possibility of future company/stock developments, both good and bad, are factored to some degree into today’s stock prices before the actual news becomes public.

How does this happen?

Prior to the financial crisis in 2008, brokerage houses maintained cadres of highly-paid analysts, organized by stock market sector, many of them with extensive professional training and long working experience in the areas they covered.  They would use the products and services of the firms whose stocks they covered. They’d also be in constant contact with the companies in question, as well as suppliers, customers, government agencies …and any other sources of information they might think of. And they wrote detailed reports on their observations and their experience of how their firms would fare in different economic circumstances, for institutional customers who in many cases had analysts of their own. And they would also have access to gossip and rumors from within their own firms, which are companies with their hands in many different pies.

Sometimes, though less so since the passage of Regulation FD in 2000, publicly-traded companies will regard brokerage analysts as a public relations vehicle, releasing information to them for dissemination to favored clients (ahead of everyone else), as a way of softening the blow of bad news and at the same time in the hope of coopting analysts into becoming PR vehicles for them.

During the financial crisis, in what I see as the ultimate Wall Street triumph of jocks over nerds, virtually all these multi-million dollar analysts were laid off. 

At the same time, financial firms began to realize that they could use algorithms that read newsfeeds and react instantly to relevant information as it’s released, as a substitute for the immense expense of recreating a human research department. And, so long as no one else had a loose, say, $75 million to rebuild a pre-crisis research effort, it really wouldn’t make that much competitive difference if trading bots replaced people.

Yes, there is still a lot of sophisticated information inside brokers’ investment banking units. And, yes, I’m willing to bet that at least some of that leaks out to the rest of the firm. Still, I think the brokerage game has shifted significantly from discounting in advance to rapid reaction.

I think that’s a good thing for individual investors like you and me, who can play the discounting game, at the very least in areas we have or can develop expertise in, and by paying close attention to the malls we visit and our own consumption habits. For us, the only change from the pre-financial crisis days is that information probably travels more slowly, so if we’re acting (as we should be) on information we have that’s not yet in the market we may have to be more patient waiting for others to catch on.

US stocks are down this morning, apparently on news that the just-completed Christmas selling season was better than expected. The logic, if that’s the right name for this, behind the decline is that bond market pundits are concluding that the recession they’ve been (incorrectly) predicting for the past year+ is still not showing up. Their argument has been the straightforward one that lower rates will increase the price of already-issued bonds. To the extent that equities are also financial instruments with some percentage of bond in their DNA, lower rates would drive equity prices higher as well.

So today’s selloff represents a resetting of those expectations.

Personally, I think the notion that the Fed is wrong and that the economy is about to swoon–and the stock market to plunge–is crazy. 

Nevertheless, today’s market softness contains important information, I think. As I see it, the weakest stocks today are ones where the rationale for holding them is the most highly centered on the possibility for a substantial decline in interest rates. 

This is important information. How so?

If you think rates are headed substantially lower, soon, and your stocks are underperforming, today’s price action is confirming that you’ve set up your portfolio correctly. If you think, as I do, that macro conditions aren’t going to change that much, and you’re underperforming, there’s a good chance your portfolio has too little exposure to earnings growth and too much to the idea of quickly-declining rates.