Personal finance and investing insight beyond the basics

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Market Brief (Jan. 18, 2019): Netflix growth accelerates

The reaction to Netflix’s latest quarter announcements has been odd. Headlines range from “Netflix beats” to “Netflix misses” and everywhere in between. But, I guess this is what you should expect in today’s world where nobody really does any research.

The bottom line is that Netflix is incredibly dominant, and this quarter just further cements this opinion. Netflix is transitioning to reporting only net paid subscriber additions (how many new paying subscribers there are) versus reporting on total subscriber additions (paid + free trial subscribers). I believe this transition is creating confusion which is why some are missing just how good this quarter was. The bottom line is that Netflix guided 7.6 million new paid subscribers for the quarter, and the company delivered 8.8 million.

The company is forecasting another 8.9 million new paid subscribers for the first quarter of 2019.

My favorite chart that Netflix has been publishing on their investor relations documents is this:

This chart shows you how Netflix is essentially growing faster each year. Not only that, but the rate of growth is accelerating. Notice how the gap is widening for each year interval. The gap between 2018 and 2017 was the widest amongst the year differentials. Subscriber growth is indeed accelerating.

Will 2019 continue to accelerate? We’ll see, but I have strong reason to believe that it can. Netflix hasn’t even begun to reap the benefits from the major talent acquisitions they’ve made in recent years such as Shonda Rhymes and Ryan Murphy. There is so much in the pipeline that’s difficult to fathom the volume of content still coming. And this is only going to continue. Netflix is not letting up.

As the chart shows, Netflix added over 28 million new paid subscribers in 2018. In 2017, they added approximately 22 million. In 2016, just over 18 million. In 2015, just over 16 million. We can reasonably estimate that Netflix will add somewhere between 30 and 40 million new subscribers in 2019. This would put Netflix at around 170 to 180 million paid subscribers by the end of the year.

Another way to look at this is that Netflix is going to have about 175 million paid subscribers when Disney+ launches. Disney+ is starting from zero, while Netflix has 175 million people essentially contributing $8-15 per month into Netflix’s coffers to fuel more growth. Disney obviously has resources and will have a great platform, but let me be clear… Netflix has already won.

Netflix has already won for three reasons: the massive head start, the dedicated pursuit of growth and dominance in this market and the unshackled, singular focus of the company. Let’s briefly address each one.

  1. The massive head start – As stated, when Disney+ launches, Netflix will have 175 million subscribers contributing cash each month to Netflix to fuel additional growth. Disney has resources, yes. Tons of them. And they’ll invest heavily. But at the time Disney+ launches, Netflix will essentially have $1.75 billion in monthly revenue from existing users that they can use to continue to plow into growth (and they will). Disney will likely get a batch of early adopters / Disney enthusiasts to sign up immediately. Let’s estimate 5 to 10 million. Then, their growth process will begin. How many paid subscribers will Disney+ have at the end of 2020? 10 million? 15 million? 20 million as a best case scenario? Disney+ will likely take at least ten years to get to the number of subscribers that Netflix will have when Disney+ launches.
  2. The dedicated pursuit of growth and dominance – Netflix just raised prices on US consumers, yet didn’t adjust its negative free cash flow projection. What’s this mean? They’re using the price increase to continue to fuel new content and growth. Netflix is going all out on long-term dominance in what I believe is a winner-take-most global market. The profitability opportunity ten years from now is so massive, that nothing else matters. Netflix understands this. All out pursuit of long-term dominance. Fueled by the largest paid subscriber base in the world.
  3. Unshackled, singular focus – Netflix has no legacy businesses that they care about. They have the DVD mailing business, yes. But it gets literally no attention from the executives. Disney (and other media companies) meanwhile are trying to maintain legacy cash flows while transitioning to the future. It’s not bad business, it’s just reality. Netflix, meanwhile, is singularly focused. Every decision is being made in light of long-term dominance in streaming. Disney is making decisions to maximize short term profits of their cable unit, their parks, and yes, transition to streaming. Disney is a fabulous company, but when it comes to streaming and streaming alone, Netflix has a major advantage.

Game over. Sit back and enjoy the ride. It’s going to be lucrative.

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Market Brief (Jan. 4, 2019): Selling into this rally

The Dow closed down over 600 points yesterday on news of Apple’s pre-announced revenue miss. Today, the market is up over 700 points. What’s the correct trend?

To me, the trend is lower, and today gives you an opportunity to unload some equities exposure. A few reasons why:

  1. The jobs report that was very good today is a lagging indicator. Jobs will often continue to power higher as we enter into a slowing growth scenario.
  2. There are going to be bounces as the market heads lower. Economic data has weakened and we’ve simply hit the end of a cycle. The market’s going lower. Selling the bounces is a way to reduce exposure.

There are no fool-proof indicators in investing, but I do monitor a few different ones. One indicator which I learned from Jim Otar in his excellent “Unveiling the Retirement Myth” book is the analysis based on the 5-month moving average and the 12-month moving average. It goes like this:

  • Compare the 5-month and 12-month moving averages of the S&P 500.
  • If the 5-month moving average is below the 12-month moving average AND the 12-month moving average is declining, then get defensive.
  • Otherwise, stay aggressive.

I like this indicator because 1) it’s simple, 2) it’s based on monthly checks which means it’s not going to have you trading in an out every day and 3) it only has two states of aggressive and defensive. You can define what that means for you. Aggressive might mean 100% equities or 70% equities. Defensive might mean 100% cash or 30% equities / 70% bonds.

Interestingly, this indicator just flashed a sell signal. Also interesting is that it flashed sell signals prior to the major drops in 2000 and 2008. See below:

Is it perfect? No, but it’s one tools of many. I’m in the process of refining my overall model which will utilize 3-4 indicators. This will likely be one of them.

I think the market will hit newer lows in the first quarter of 2019.

As of now, I don’t think we hit a recession, and there are three catalysts that will make the market bottom and move higher later in the year:

  1. The end of the Fed’s rate hikes – If I had to guess, the Fed is done hiking. They will eventually make this clear to the market.
  2. A trade deal with China – This will remove the uncertainty involving trade.
  3. An infrastructure deal from Congress – The one area of cooperation between the Democrats, Republicans and President Trump, in my opinion, will be a bill on infrastructure spending.

Growth is indeed slowing and we’re at the end of a cycle. But, watch the above three items as I believe these items will help the market bottom at some point in 2019 and also help the economy avoid a recession.

For the near term, be cautious.

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Stock market for kids: Tips and resources for teaching your children about stocks

Is the stock market for kids? Yes! Sure, it’s unlikely that your kids are going to be managing money and trading actual stocks (at least at a young age), the stock market can be an incredible tool for teaching your kids about math, finance, personal finance and investing. If your kids are older, you can even touch on subjects such as psychology and economics.

For quick reference, you can jump to specific sections regarding various ages groups and what might be an appropriate depth of study regarding the stock market for kids:

Quick Links

  1. Ages 7-10
  2. Ages 11-14
  3. Ages 15-18+
  4. Bonus Advanced Topics

As a parent, I’m extremely interested in finding ways to teach my kids about a wide variety of subjects. I really like the stock market because it ties together a number of math concepts with a very real and important mechanism in our economy. Moreover, kids will be naturally intrigued (and incentivized) by the idea that they can make money! Of course, it will be fake money as they won’t actually be in stocks, but some parents might consider a $10 reward if their stock market portfolio hits a certain level of performance. Our goal isn’t to get our kids to find some winning stock portfolio. Our goal is to get them to be engaged so that they learn. Sometimes a simple $10 reward after a period of time is useful for encouraging engagement.

I’ve found that kids are often drawn to learning about the stock market for a variety of reasons. First, the transactional nature of the stock market is exciting. After learning how you can sell a financial instrument for profit, many kids will often remark, “You mean I can make money without doing chores?”

Second, you can focus on stocks of companies that your kids are already quite familiar. Nearly every kid gets exposure to ipads and iphones at an early age, and kids in today’s world are typically quite familiar with those Amazon packages that come each week. Or, consider the Ford car in the driveway. Or, buying groceries at Walmart or lunch at McDonald’s. Your kids are more familiar with some of the world’s most traded stocks than you likely realize, and your kids will enjoy learning about how the stock that trades in the stock market intersects with the companies they interact with in everyday life.

Third, the stock market is a living and dynamic world, and provides a rich method for exploring math topics that kids might otherwise find mundane. Practice problems on worksheets are useful of course, but watch your kids actually enjoy some math when they are calculating how much money they may have gained in their model portfolio!

So, depending on the age, I think there are some key learning goals. Let’s look at them briefly. Note that these age ranges are just a guideline. Some kids are ready for more advanced topics and are mature enough to focus on hard subjects at an earlier age. Other kids need more time before they’re ready for harder topics. You know your kid best, so adjust accordingly.

Stock market for kids between ages 7-10

For kids in this age range, the goals are to introduce the overall concept of the stock market and the transactional nature of it. For instance, children in this age group need to learn that you can take money and exchange it for a particular stock (a BUY transaction). At this point, you now own the stock. You can also sell a stock and exchange it for money (a SELL transaction).

Learning to record transactions and tracking value

To learn this, your child can keep his own ledger that records transactions. Perhaps start with an imaginary $1,000 (this is your first entry on the ledger). Then, allow your child to use some of that money to purchase stock. Stick to a company your child is familiar with (Apple is everybody’s favorite it seems). The goal here is for your child to learn how to log transactions and to simply understand that when you buy a stock that you are exchanging money for the stock that you own.

The next piece of this is to understand that the value fluctuates even when you aren’t making transactions. So, take your ledger that your child has been building, and consider creating a new document that tracks the overall value of the portfolio perhaps once per week or once per month. Each week or month, your child will need to look up the stock price of his or her holdings, calculate the value of each holding, add it up with the cash and tally the current value of the overall portfolio. This part is very key to your child understanding the basics of investing and the basics of the stock market. Can your child understand how the value of his or per portfolio is moving up and down as the stocks trade on the market?

Understanding this takes consistently doing the following two things: First, your kid logging the values each week. Practice makes perfect. Doing this repeatedly over time really will solidify the concept. Secondly, ask your child questions such as, “Why did your portfolio change values even though you had no transactions?” and “Can you explain what a transaction means?”

The following image shows what your child’s ledger might look like. This ledger both logs transactions and values the portfolio once per month given no transactions. As you can see, we track the cash value, the stock value, and the two of these add up to overall portfolio value.

stock market for kids

Percentage change & Cumulative return

What about math concepts? Remember a big part of why teaching the stock market for kids is a great idea is because of the math concepts it teaches. For kids in this age group, two math concepts that are perfect to teach and practice are percentage allocation and percent increase and decrease.

As you child does his or her fake transactions, have them calculate the percentage of the portfolio that each position holds (including cash). As the overall portfolio value moves up and down, they can re-calculate the percentages for additional practice. As they’ll see, each position can become more or less of the overall portfolio as individual positions move up and down in value. Ask them questions regarding this to ensure they understand how a position can now make up more of a portfolio even though they did not buy any more stock of that company.

Additionally, as your child tallies the portfolio value for each period of time, it’s time to add in the percentage increase or decrease. You can do this a few different ways. If this is a relatively new project, just stick to calculating the percentage increase or decrease since inception of the portfolio (from the initial value of $1,000). For example, if the portfolio has a value of $1,150, you would calculate the percentage increase by calculating 1,150 / 1,000 – 1 = .15. Then, help your child understand that .15 equates to 15%. Similarly, if the portfolio value is down, say $900, you can calculate the percentage decrease by calculating 900 / 1,000 – 1 = -.1. This equates to -10%. 

Note that in financial terms, this equation is commonly referred to as the cumulative return. When considering the percentage increase, or percentage gain, from the beginning of the portfolio to the current date, you’re determining the cumulative return of the portfolio. Cumulative return is a key term for your kids to learn. With this in mind, let’s generalize our previous calculation, and make note of this important formula for calculating cumulative return:

cumulative return = (ending value / beginning value – 1) x 100%

One quick example to demonstrate the use of this formula. If our portfolio has a starting value of $50,000 and now has a value of $83,000, we can determine the cumulative return by first determine 83,000 / 50,000, which equals 1.66. Then, we subtract 1, which gives us .66. Next we do .66 x 100% to get 66%. Our cumulative return is 66%.

Note that cumulative return doesn’t tell us anything about the span of time in which this return was gained (or lost). Cumulative return is just the return from beginning to end, regardless of the time span. We’ll get into return rates for specific periods of time in the next section.

Stock market for kids between ages 11-14

To consider this stage, your child should already be familiar and extremely comfortable with the concepts discussed in the ages 7-10 range. Again, the specific ages aren’t overly important. For this age group, we will expand upon the previously discussed areas and introduce a few more complex concepts to teach and introduce.

Learning About “The Market”

At this time, we’d like to introduce young stock market students to the idea of stock market indices and benchmarks, namely the S&P 500 and the Dow Jones. Kids need to learn that often times when people say “How’s the market doing?” they are referring to the performance of either the S&P 500 or the Dow Jones. So what are they? 

The S&P 500 makes up, generally, the 500 largest companies in the U.S. stock market. The Dow Jones makes up a broad selection of 30 largest U.S. companies. Both the S&P 500 and the Dow Jones index are intended to give investors an easy way to see how the major U.S. companies are doing at any given time. Do they perfectly represent the U.S. economy and stock market? No, but they’re decently representative, and more importantly, traders and investors cite them daily as indicators for stock market performance.

The next step for kids who are already comfortable tracking their portfolio performance across time is to begin comparing this performance against the Dow and S&P index values. This will serve to accomplish a couple things. First, your children will get continued practice in regular tracking of the stock market. Second, they will get practice comparing performance across assets or indices.

Conceptually, the most important thing to teach here is that how your portfolio performs compared to the market (we’ll assume this means the S&P 500) is extremely important. Rarely do we cite raw performance of a stock market portfolio (“My portfolio is up 8%.”). Raw performance without comparison against the market doesn’t tell us as much. Instead, it’s important to be able to say “My portfolio is beating the S&P 500 by 3%.”  

Rate of return for specific periods of time

Previously we discussed cumulative return. Next, we need to look at the rate of return for more defined periods of time. For instance, year-to-date return (YTD) is a very common number cited in investing. Investors will often want to know, “What is the S&P up year-to-date?” Well, calculating this is easy if you already know how to do cumulative return. We essentially just adjust our start date for the equation.

YTD return = (today’s value / Jan. 1 value – 1) x 100%

Let’s look at a quick example. If the S&P 500 is currently trading at 2,650, and the S&P 500 opened the year at 2,323, what is the YTD return of the S&P?

YTD return = (today’s value / Jan 1 value – 1) x 100%
today’s value / Jan 1 value = 2,650 / 2,323 = 1.141
1.141 – 1 = .141
.141 x 100% = 14.1%
We can say that the S&P 500 is up 14.1% year-to-date

Ok, now that we’ve addressed market indices and year-to-date return, it’s time for your child to build upon his or her tracking document or spreadsheet that we discussed in the previous section. Along with tracking portfolio performance at regular intervals, we should now add a column for tracking the S&P 500 performance. Each time we log the value of our portfolio, now we can log the current value of the S&P 500. Next, add a column for cumulative return for your portfolio and a column for cumulative return for “the market.” If your child desires, add a third column that compares the performance for his or her portfolio vs. the market performance.

The below image shows an example updated ledger with columns for cumulative return, S&P 500 performance, and S&P 500 return. Note: We used SPY instead of the raw S&P 500 values. SPY is an ETC that tracks the performance of the S&P 500, so for this type of situation, SPY is sufficient.

stock market for kids 2

Introducing diversification

One of the most important concepts in investing, and certainly one of the most discussed, is the concept of diversification. Our interest here isn’t to have our kids master all of these concepts, but to introduce them enough to where they can understand the basic concept and begin the process of thinking how these concepts might be applied.

To introduce diversification, first ask your child a series of questions about the stock or handful of stocks they have been tracking. In our examples above, we’ve been tracking Apple (AAPL). So, we might ask our child, “What happens if Apple has problems, and AAPL goes down significantly?” Additionally, “Would having all your money in a single company make your nervous?” Then, finally, “Can you think of a better approach that might make you less nervous?”

Of course this line of questioning is aimed to get our children to think about the risk of having all your eggs in one basket. Helping them come to the conclusion that spreading their money around a bit might be less risky is our goal. Some kids will immediately get it, others might need some help getting to this point.

You can further drive this point home by discussing the idea that while one company can fail, it’s much less likely that a group of 10 or 20 or even 100 companies will all fail at the same time. Therefore, if we’re invested in a larger group of companies, if one fails, we’ll still be ok. If we’re invested in one company, and that one fails, we’d potentially lose all our money.

If you want to take the discussion even further, you can introduce the idea of different sectors. For instance, if you own Apple stock, ask your child if you’d be more diversified if your second stock was another technology stock like Microsoft, or if your second stock was a company like Walmart (WMT)? You can discuss with your child how sometimes there could be problems with specific sectors and it can be useful to diversify across multiple sectors to truly reduce your risk.

In the previous sector, we introduced the idea of having our kids calculate allocation percentages of a portfolio. You can re-visit the allocation percentage discussion with regards to diversification. If you have, say, 5 positions spanning allocation percentages anywhere from 10-25%, ask your child to group these allocations by sector. Is any one sector too “over-weight” (too much allocation to one sector, preventing proper diversification)?

Introducing dollar cost averaging

Moving along to further instruction, we want to get into the topic of dollar cost averaging, But before we do that, we need to take a step back and talk about the idea of investing over time. Until now, we’ve invested with the idea of having a chunk of money, then investing it over time. We never put more money into the equation.

The biggest thing we can do with our kids is teach them the value of saving money and investing that money regularly. If you’re reading about the stock market for kids, then undoubtedly, you’ve talked to your kids about saving money as well. Extend that conversation further. If you’re saving regularly, what are you doing with that money? Part of it should be invested regularly as well.

The beautiful thing about investing over time is that you benefit when stocks go up or down. When they go up, your portfolio gains in value. When they go down, your regular contributions get to buy more shares at lower prices. This is the idea of dollar cost averaging. To solidify the concept, I encourage you to work through a few examples. For instance, if you want to buy five shares of Apple over four months, the purchase price might be something like the following: 1 share at $150, 2 shares at $175, 1 share at $180, 1 share at $200. What is the average purchase price of the shares?

( (1 x $150) + (2 x $175) + (1 x $180) + (1 x $200) ) / 5 = $176
The average purchase price of the five shares was $176, or the 5 shares cost $880 total.

If you want to do a more complicated, real world example, find a stock that is under $100. For instance, as of writing, Target (TGT) is trading at about $62 per share. Make up some price fluctuations such as $68, $72, $58, etc. Have your child work out the following. If you invest $100 each month and use it to buy Target stock each month, how many shares do you end up with after one year? What is the average cost per share? This kind of exercise will help solidify the concept of dollar cost averaging for your kids.

Stock market for kids between ages 15-18+

For this age group when discussing the stock market for kids, it is time to introduce some of the fundamentals around stocks as well as other important considerations for investing such as dividends, splits, and more.

Most of what we’ve covered in this stock market for kids guide has centered around the actual transactions of buying and selling stocks, how you can gain or lose money and what investing over time means. Now we’re going to discuss more advanced topics and introduce some factors for how to select stocks.

The first fundamental to learn: The P/E Ratio

Before we get into specifics about fundamentals, let’s talk about them at a higher level. It’s important that your child understands that each stock represents a company. That company is a real company or business with employees, products and services, brands and more. Companies have revenue and costs. When you consider the revenue brought it by selling something, and subtract the costs associated with producing and selling it and running the business, the business has profits. When it comes to investing (and accounting), we typically refer to the business profits as earnings. Earnings are very important in investing.

In investing, we also consider important metrics such as a business’s earnings on a per share basis. So, rather than saying that Company ABC earned $2 billion, we often say that Company ABC earned $4 per share. If you know the number of outstanding shares of the company, you can easily go back and forth between total earnings and earnings per share as follows:

earnings per share (EPS) = total earnings / outstanding shares

total earnings = EPS * outstanding shares

A quick example: If Company ABC earning $2 billion, and they have 400 million outstanding shares, what was the earnings per share (EPS)? We know that EPS = $2,000,000,000 / 400,000,000. EPS = $5.

The P/E ratio stands for the price to earnings ratio. What this does is give us, at a glance, a quick way of determining how expensive a stock might currently be. It does this by telling you what kind of multiple you are paying for the company’s earnings. If Company ABC is earning $5 per share, and its stock is currently trading at or priced at $40, it means that to buy the stock, you have to pay 8 times its earnings to own the stock. Its P/E ratio is 8. You can calculate the P/E ratio as follows:

P/E ratio = Stock price / Earnings per share (EPS)

A quick example to solidify the concept: Company DEF is earning $4 per share and currently trades at $85. What is its P/E ratio? We divide $85 by $4 to get the P/E ratio. 85 / 4 = 21.25.

Now, if Company ABC has a P/E of 8 and Company DEF has a P/E of 21.25, ask your child which company is more expensive? The correct answer of course is Company DEF. Ask probing questions to ensure they understand the concept of a multiple. The multiple of earnings that a company is valued at is an extremely important overall concept to understand in business and in investing.

Lastly, if you child grasps the P/E ratio quickly, you can explore more thoughtful questions with him or her. Ask your child why might some stocks trade at higher P/E ratios than others? Why would someone be willing to pay a high multiple for some companies than other companies? Most kids, if investing is new to them, will struggle to find correct answers to this question. Some possible answers to discuss are growth rates, sector or industry and public relations. For instance, if a company is growing revenues at 50% versus a company that is growing revenues at 5%, the higher growth company will command a higher multiple. Additionally, some sectors or industries are considered to be declining sectors versus some industries are considered up and coming sectors. For example, a company that manufactures railroad parts will likely have a lower multiple than a company manufacturing electric car parts. Lastly, multiples can be depressed if a company goes through a series of bad publicity. When Chipotle (CMG) got hit with a series of headlines about how people got sick eating at their restaurants, the stock and the multiple went down dramatically.

Dividends, Market Cap & Stock Splits

So far, we’ve only discussed making money by buying a stock, seeing its price rise, then selling it for a gain. There are other ways, however, you can earn a return on your investment. The main way most investors focus on is the dividend.

At its basic level, a dividend is a payment from the company to its shareholders. When a company accumulates earnings, it can take a part of those earnings and distribute them to shareholders as a reward for owning the stock.

Let’s go back to our Company ABC example that was earning $5 per share. EPS can often be a quarterly figure, but for simplicity, we’ll assume that it earns $5 per share per year. As a reward for owning the company, ABC also pays a $2 dividend per year. Dividends are typically paid on a quarterly basis, so that $2 dividend will be four $.50 payments per share that you own every 3 months. If you own 100 shares of ABC, you’ll get $50 every quarter which will total to $200 per year.

Considering dividends is a very important part of calculating the total return of the stock. So, let’s look at a complete transaction to understand total return. Let’s say that on Jan. 1, 2018, you purchased 100 shares of ABC at $35 each. You sell the 100 shares on Jan. 1, 2019 at a price of $42. You also collected 4 quarterly dividend payments at $.50 per share. What is the total return of the stock?

Total return = Price appreciation + dividends collected
Price appreciation = (number of shares x sell price) – (number of shares x buy price)
Price appreciation = (100 x $42) – (100 x $35)
Price appreciation = $4200 – $3700
Price appreciation = $500
Dividends collected = Number of payments x number of shares x quarterly dividend
Dividends collect = 4 x 100 x $.50
Dividends collected = $200
Total return = $500 + $200 = $700

Conceptually, it’s important for new investors to learn that dividend payments help earn a return on your investment even without selling the shares themselves. In fact, some investors might hold a particular company for decades without ever considering selling and just collect the dividends year after year.

Stock splits are the other important element that kids should become familiar with. Over time, a company may decide to issue a stock split and reduce the trading price of each unit of stock. For instance, a company that is trading at $500 per share might decide to do a stock split where they double the number of outstanding shares, but now all shares are trading at $250 instead of $500. The key element to understand here is that fundamentally, nothing changes with the value of the company. The market cap doesn’t change. Market capitalization, or market cap, refers to the total value of the company (as evidenced by the value the stock market assigns to it). We can calculate it as follows:

Market Cap = Share price * Number of outstanding shares

If a company has 500 million outstanding shares and trades at $100 per share, we know that the company has a market cap of $50 billion. If the company issues a 2-for-1 stock split, the result would be 1 billion outstanding shares that now trade at $50 per share. The market cap is still $50 billion.

Beginner investors sometimes are confused into thinking that they’re winning by the company issuing a stock split. In truth, nothing has really changed. The company still has the same value even if the share price changed.

Bonus Advanced Topics

If you’ve surpassed the wide range of topics in this stock market for kids guide, then here are some additional advanced topics you might consider.

Risk adjusted returns

Introducing the topic of risk and risk adjusted returns is a key element to understand for savvy investors. This is a major topic, but teaching your child how to calculate daily returns, how these daily returns can be used to calculate volatility and how volatility can impact the notion of risk adjusted returns is a powerful concept to understand. To perfect this, you might want to research and understand how to calculate daily returns, standard deviation and the Sharpe ratio.

Technical indicators

Technical indicators are used to describe the action and movement of a particular stock. They are often utilized in conjunction with charts that show how a stock has moved up and down over a period of time.

The best indicators to start with are moving averages. Understanding how a moving average essentially “smoothes” out the price action of a stock (and increasingly smoothes out the price action as longer time periods are used) is an important consideration. Additionally, when two moving averages of varying durations intersect or cross, it can be interpreted as important signals (e.g. when a 50 day moving averages crosses below a 200 day moving average, many consider this to be a bearish signal).

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Market Brief (Dec. 19, 2018): Tech is on sale, should you buy?

The big tech names such as Facebook, Amazon and Netflix have been down big from its highs a few months ago. Few people disagree that these aren’t great companies. High growth with massive revenues and varying levels of profitability depending on the company. 

These stocks were at wild valuations not long ago, and there was near unanimous support for buying and owning these stocks in the financial community. Now that they’re down 25-35%, the tone has changed. Note: This is basically how it always works and perhaps is an indicator that you should ignore most of the financial media.  

So, with these stocks on sale, should you buy? I think there are two main things to consider.

First, if you own a decent chunk of index funds like many investors do, there’s a good chance that you already own a lot of these tech names. Let’s look at an example. If you pull up the Schwab S&P 500 Index fund (SWPPX), you can check out the top holdings in the fund. As of writing, here are the top holdings in the fund and the percentage of what they represent in the fund:

  • Apple – 4.51%
  • Microsoft – 3.48%
  • Amazon – 3.27%
  • Facebook – 1.7%
  • Berkshire Hathaway – 1.62%

As you can see, the four largest holdings are big tech names. Interestingly, Berkshire is no. 5 and Berkshire owns a ton of Apple stock!

Tech is moving the market in more ways than one. First, most investors are watching these big names to take direction on which way the market is heading. Second, these stocks literally make up the largest chunk of these index funds. If Apple, Microsoft, Amazon and Facebook are heading lower, it’s really hard for the S&P 500 to head higher.

So, before you rush to buy these stocks, consider how much you indirectly already own via your index funds before doing so. Are you comfortable with the level of diversification you’d have if you purchased more directly?

Now, with that out of the way, it’s definitely a great time to buy these stocks. Recently I filtered through stock data and discovered that there are only four US non-energy companies that have a market cap of at least $100 billion and are growing revenues at 25% or more each year. They are Facebook (FB), Netflix (NFLX), Amazon (AMZN) and Salesforce.com (CRM).

This is a select group of companies achieving incredible levels of growth even at the large size of these companies. Note that of the names listed above, Facebook’s P/E ratio is the only one not at or near triple digits. To me, this shows just how beaten down Facebook has been due to bad press. 

I personally like to buy stocks that have incredibly healthy businesses but have been beaten down by bad press. Facebook certainly falls into this camp. The recent company that I bought for similar reasons was Chipotle (CMG) after it was beaten down due to a series of food illness headlines. The stock has rebounded nicely from these lows. 

One of my favorite positions is already documented here on this site: Netflix. But, Facebook is really attractive at current levels. Is there risk? Of course. The bad headlines seem to be coming every day for Facebook, but Facebook is also a popular punching bag for the press these days. It’s not clear how much of this is affecting the actual business (less than you’d think in my opinion).

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Market Brief (Dec. 7, 2018): What’s causing the volatility?

I’ve had a number of people ask, what’s causing the market volatility? The economy is good! Why would the market be going lower if the economy is good?

Unemployment is low, consumer sentiment is still good, corporate earnings are still great, so what gives?

For new investors, it’s important to always remember that the stock market is a forward looking vehicle. A company might have just reported record profits, but if the market believes that the future is murky, the stock is going to tank. What you did yesterday really doesn’t matter.

As such, many analysts expecting a slowing economy looking ahead. This doesn’t necessarily mean recession, but it’s about rate of change. If the economy is slowing as a result of a variety of factors (more on those in a minute), then stocks are going to go lower.

Moreover, it’s worth noting that we’ve had a historic bull market in terms of both duration and lack of volatility. A 7% move off the highs only feels dramatic because we’ve been lulled to sleep by the lack of volatility going back almost a decade.

Fed rate hikes have a knack for ending the party and we’ve had a bunch in the last couple years. The September 2018 rate hike was the 8th time the Fed hiked interest rates going back to the first hike in December 2015. As the Fed attempts to normalize interest rates from historic lows since the 2008 crisis, it’s not ideal for stocks. 

One thing I’m watching in the months ahead: Technology stocks have led this market for a while. Gains in 2017 and 2018 from the large cap tech stocks such as Apple, Amazon, Google, Facebook, Microsoft and Netflix drove the overall market higher. In fact, most people don’t realize that much of their index gains came from these stocks as well (See: Just three stocks responsible for most of the market’s gains this year). 

Tech stocks also peaked earlier than the S&P. Tech stocks rolled further over before the S&P did. For instance, many of the large cap stocks had their 50 day moving averages cross below the 200 day moving averages in the last month. The S&P is close to doing this as well. So, the large cap tech names have been leading the market lower. 

This dynamic is interesting for a couple reasons. First, some great companies are on major sale right – Netflix continues to be my favorite. Second, should tech rebound, you can probably expect the S&P to follow at least until this current dynamic changes.

So, what about 2019? Most would bet that it won’t be a great year for the broad stock market. But most are also typically a prisoner of the moment, and the sentiment right now is bad. If the economy doesn’t go into a recession, then it could represent a great time to move some cash into valuable names that have been beaten down. If a recession risk increases, then your first goal needs to be to make sure you have enough cash to get through any unemployment risk. If unemployment or income disruption isn’t an issue, then we might have a fantastic buying opportunity coming soon. 

Stocks really aren’t down that much yet, though (S&P 500 -10.1% off its all-time highs, Dow -9.0% and the Nasdaq -14.1%). So, I say be patient. Stick to your strategy, and if you’re like me and have been hoarding some cash waiting for good opportunities, don’t fire until you see the whites of their eyes. 

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Why the shift to streaming is my favorite trend, and why I’m long Netflix (NFLX)

As with any article which discusses stock-picking, I want to give my overall investing disclaimer. So, here it is…

Investing Disclaimer: I think marketing timing and picking stocks is very difficult. Not impossible, but difficult. I do very little (almost none) trading in short time horizons. Roughly 80% of my portfolio is in a few, simple index funds. I withhold about 20% of my portfolio in either cash or a small group of stocks that I spend a lot of time reading about or researching. The stocks I invest in directly are typically in one of the following scenarios: 1) I believe strongly in the long-term value of the company. Typically this company is a leader in a sector or industry with a tremendous amount of growth ahead. 2) I think a high quality company has been beaten down too much by the market and it represents an attractive buying opportunity. Ideally, the number of transactions I make in direct stocks is only a handful per year at the most.

Streaming is one of my favorite long-term trends to follow for a number of reasons. It’s a significant trend that is impacting not just the obvious areas such as television and movies, but it’s even bigger than this. It’s impacting behavior. It’s impacting how we spend our time. It’s impacting how we interact with others.

Like Apple’s iPhone altered the landscape not just for mobile phones, but for how we consume content, how we take photos, how we surf the internet, how we communicate with others, and more, I believe streaming is having a similar widespread affect on our world.

Similar to how the rise of mobile has been one of the most important trends of the 21st century, I believe streaming is one of the most important trends and its effects will be widespread.

Why I’m extremely bullish on Netflix (NFLX)

Netflix is one of my favorite companies to both follow as a business and as an investment. I’ve been long NFLX since mid 2016 and plan to own the stock for years.

Streaming is a massive trend upending a number of industries, and Netflix is the tip of the spear of this trend.

The streaming landscape

The percentage of the U.S. population spending time on streaming platforms has been growing for years. A combination of an increase in our “on demand” expectations, a secular decline in traditional cable, and overall better product have fueled this growth.

For years, Netflix has been the clear leader when it comes to streaming entertainment into the home. While it started with licensed content from other studios and content owners, Netflix was years ahead of competition in an aggressive shift towards original content.

To understand the landscape, we need to first better understand how we arrived at this current moment.

Netflix grew its brand and its subscriber base off the backs of other studios. This happened by Netflix offering studios cash in exchange for letting Netflix license its content and allow Netflix users to stream shows like Walking Dead, Breaking Bad, and more. The studios viewed this as just another way to monetize content that they already paid for, so why not? Of course, they drastically underestimated that they’re essentially helping build a monster that would directly compete with them in the future.

Fast forward to today and the studios are now aware of their current predicament. They of course would love to further monetize their content, but do they dare continue to help fuel Netflix’s growth? For most companies, they’re in a no-win situation, and they need the cash. Only companies like Disney are strong enough to truly break away of the Netflix ecosystem (more on Disney later).

That doesn’t mean the other studios and networks aren’t trying to build up their own streaming platform. HBO is another example of a strong company with strong enough owned brands like Game of Thrones to be able to go direct to consumer. But for networks like CBS, AMC and others, the future is quite uncertain.

Consumers are probably willing to pay for a handful of streaming services (many already do), and perhaps up to 4 or 5. But it’s not likely that consumers will be steadily paying monthly fees to ten different streaming platforms.

Other networks are also at a disadvantage in the sense that they have to consider the cannibalization of other revenue streams (namely carriage fees from traditional cable) while they attempt to pivot to the on-demand streaming world. While companies such as Disney have made impressive moves toward this next era of their businesses, even Disney has made half-commitments to the future world of streaming as they attempt to maintain valuable cash flows from the previous era. This is prudent, but also a concern that doesn’t exist over at Netflix.

Many analysts look at the future of streaming as a fight to get into the elite tier of streaming platforms. The head of HBO put it this way in mid-2018:

A broad theme that I believe is occurring in the industry is there aren’t going to be an unlimited number of platforms that have direct-to-consumer relationships. There will be a select number of platforms that have direct-to-consumer relationships. It’s not going to be 10, it probably won’t be two. Now, is it going to be eight, six or four? I don’t know, but if it’s four we need to be one of the four. If it’s six, we need to be one of the six.

He’s not the only media executive to comment on what they view as a basket of streaming platforms that nearly all consumers will eventually subscribe to. And there’s typically a very common assumption that underlines all of these comments. Netflix is already in.

And that’s why I believe Disney’s commitment to streaming and the idea that this is a major risk for Netflix is severely overblown. Netflix executives, for years, has mentioned that with the rise of additional entrants like Disney, it can actually help Netflix. Why? Because as additional streaming platforms get better, it will accelerate the trend of consumers moving out of traditional cable and into streaming. And Netflix will always be in the elite tier of streaming providers.

Lastly, I enjoy Netflix’s summation of the landscape and the opportunity from its “Long-Term View” page on its Investor Relations website:

Changes of this magnitude are rare. Radio was the dominant home entertainment media for nearly 50 years until linear TV took over in the 1950’s and 1960’s. Linear video in the home was a huge advance over radio, and very large firms emerged to meet consumer desires over the last 60 years. The new era of internet entertainment, which began about a decade ago, is likely to be very big and enduring also, given the flexibility and ubiquity of the internet around the world. We hope to continue being one of the leading firms of the internet entertainment era.

It continues:

Eventually, as linear TV viewing falls in viewing and value, the spectrum it now uses on cable, fiber, and over-the-air will be reallocated to expand internet data transmission. Satellite TV subscribers will be fewer and more rural. In a few decades, linear TV will be the fixed-line telephone: a relic.

These statements from Netflix give us clear insight into the long-term view of this company. Like companies like Amazon, Netflix is investing in the long game. Keep this in mind as we delve further into the Netflix strategy.

Netflix’s strategy

Netflix foresaw and has managed the shifting media landscape extremely well. The company was already well underway in its investment into original content before the other studios caught on and began to signal that they will consider pulling their content from Netflix.

By the time all Disney content has been pulled from Netflix, Netflix will already have launched countless family and children focused shows. I won’t go into all the details of the various programming being launched, but it’s substantial. A few notable deals recently are: Netflix recently acquired the rights for C.S. Lewis’s Narnia franchise and also the rights for Roald Dahl’s works.

Netflix has doubled and tripled down on its first mover advantage in this space. Management understands the immense value that can be gained by being the leader in global streaming amidst the multi-decade, secular shift that is occurring.

As of writing, Netflix is approaching 140 million paying subscribers which provides a growing pipeline of capital that is being reinvested into more content and more growth. Netflix clearly understands the objective of the current phase it finds itself in. The objective is global customer acquisition.

Not only is Netflix reinvesting all revenue into growth, it’s also tapping the debt markets to pursue growth. While this is cause for consternation among some investors (Netflix remains cash flow negative), my position is that they are executing their strategy masterfully.

The resulting position of Netflix is one of dominance. They can easily pay more for top talent and top content globally because they are able to amortize it across 135 million subscribers. Compare that to HBO, Disney, Apple, and other platforms that seek to grow their streaming platform. No other streaming provider is as singularly focused and in such a dominant position to continue to execute growth.

And that includes Amazon. While Amazon obviously has resources to do just about anything, they have a different objective compared to Netflix. Amazon’s goal is to push individuals into Amazon Prime, and a handful of flagship streaming properties is useful for getting new people into the service.

Netflix is seeking to become the default entertainment choice for as many people globally as possible. When it comes down to the choice of whether to find something on Netflix or watching traditional cable or browsing Instagram or going to the movies or playing outside or going to sleep, Netflix wants to win that decision moment. And more and more, Netflix is winning that moment.

The risks

With any investment, it’s important to objectively analyze the risks. Let’s look at the possible risks with investing in Netflix (NFLX):

Debt / Cash flow risk

Netflix bears will be quick to note the $8+ billion in debt on the balance sheet. While worth watching, my position is that debt levels are acceptable and management is on top of the debt servicing. Payments toward interest are quite low with respect to revenue and operating profit. Even with a potential rise in interest rates for issuing new debt in the future (current debt has rates locked in through 2021-2028), the changes in debt servicing are pretty nominal. The risk here is a larger, macro-level disruption to the corporate debt markets. Some analysts have sounded the alarms with regards to levels of debt overall in the market. For years, corporations have tapped the debt markets to pretty high levels due to low interest rates. General Electric (GE) recently made news as it pursues asset sales to lower leverage levels. If this were to become a larger trend across the large cap companies in America, the debt markets would be rattled.

So, what to watch? As a Netflix investor, the negative free cash flow (FCF) number is a key one. Management has indicated that for 2018, FCF will be close to -$3 billion. They’ve also indicated that for 2019, it should be about the same. Investors, including me, would like to see that number narrow in 2020 as it starts to move towards a break-even cash flow scenario. Should that occur, and subscriber growth is still quite substantial, you’ll see this stock skyrocket.

Competition risk

To me, this is the risk mentioned most with regards to Netflix that is the most irrelevant. For reasons cited above, I don’t view competition as a major risk to Netflix.

Subscriber growth

The Netflix story still boils down to growth.

One of my favorite charts provided in the October 2018 quarterly release from Netflix is as follows:

Bullish investors are looking for Netflix to achieve paid subscriber growth into the 200-250 million subscriber range in the next few years. Should subscriber growth rate slow dramatically and Netflix struggle to hit these targets, the stock would definitely be impacted.

The future value

For the investment to make sense, we should anticipate tremendous value being delivered in the future. The opportunity as an investor in Netflix is as follows:

  • Achieving paid subscriptions in the 200-250 million range in the next 3-4 years.
  • The market’s response as Netflix achieves positive free cash flow in 3-4 years. Note: The market will respond well before actually achieving positive FCF. As FCF stops widening and begins to narrow toward the break event point, the stock will rally.
  • An upgrade out of junk status for its debt issuances.
  • The further build out of its moat with regards to content. As Netflix’s dominance cements in the streaming landscape, others will exit the arena.
  • The secular trend of household entertainment continually moving into streaming as outlined above.
  • Tremendous pricing power. We haven’t touched on this enough, but Netflix has kept prices low in the name of subscriber growth. In the future, especially domestically, there is tremendous pricing power.
  • In 7-10 years, Netflix could have utility-like cash flows. Think of the 1990s through 2000s where traditional cable was essentially a utility for households.

Here are a few scenarios to consider:

For simplicity sake, we won’t consider interest expense which is obviously an important consideration in the next couple years.

200 million subscribers, $10/mo average revenue per user (ARPU)

This clean example would result in $24 billion in annual revenue. Take out $8 billion in content costs and $4 billion in other administrative and marketing costs, and you’ve got $12 billion in profit. That’s $27.5 earnings per share. Slap on a 25 multiple, and that’s a stock price of $687.

225 million subscribers, $10/mo average revenue per user (ARPU)

This example would result in $27 billion in annual revenue. Take out $8 billion in content costs and $4 billion in other administrative and marketing costs, and you’ve got $15 billion in profit. That’s $34.40 earnings per share. Slap on a 25 multiple, and that’s a stock price of $860.

250 million subscribers, $10/mo average revenue per user (ARPU)

This example would result in $30 billion in annual revenue. Take out $8 billion in content costs and $4 billion in other administrative and marketing costs, and you’ve got $15 billion in profit. That’s $41.28 earnings per share. Slap on a 25 multiple, and that’s a stock price of $1,032.

These are rough examples, obviously, but they point to the potential massive cash flows in the future for Netflix. It is the size of the opportunity in the future that justifies management’s current (and correct, in my opinion) aggressive move to dominant this category.

Disney

This article is already lengthy enough, but I’m also very bullish on Disney (DIS), but for different reasons. First, I really like how they have pivoted in the last year into the new era of streaming. Second, company-wide, it’s a very strong company. The upside is lower compared to Netflix, just because Disney is a more mature company, but it’s a stock I seek to add to my portfolio when buying opportunities arise. I’ll plan to write a more lengthy piece on why I am bullish on Disney soon.