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Don't Hedge, Diversify

Here are a few examples of current situations where a thing could go one of two ways, and I genuinely don't know which way it will go, yet I'm placing a bet on just one of the two possible outcomes. Why would I do this? Simply because I see a good stock play on one side of the coin, but not on the other. In each scenario, I might be wrong, and if I'm wrong I will lose money (or maybe just suffer opportunity cost). But I'm not attempting to hedge against each individual outcome; rather, I'm spreading money out over all these bets, as well as over other long-term holdings, and letting diversification do that job instead.

Cable Providers vs 5G

  • If cable networks remain the most cost-effective way to get broadband internet into households, cable providers such as Charter Communications and Comcast will retain local monopoly status in many areas, and are currently undervalued because of the uncertainty over competition from 5G.
  • If 5G turns out to be the better option, wireless providers building out these networks aren’t likely to have significant local monopolies. The overlap between various 5G networks will be much greater than the overlap in different cable providers’ networks, so none of the providers will have great pricing power.
  • The coin flip isn’t "heads cable wins, tails 5G wins". It's "heads cable wins, tails nobody wins". So I’m betting on cable providers, but I'm not hedging that bet with purchases of Verizon or T-Mobile. Instead, I’m hedging that bet with other completely different bets that are independent of how this one scenario plays out.

Essex Property Trust vs Sunbelt REITs

  • For as long as I've known about such things, California has been a ridiculously expensive to live, and yet only gotten more so. But it's had good reasons: the talent/capital network effects of important industries which make tons of money located in its major cities. For the last two years, though, work-from-home options have put a sizable dent in the golden state's property values (at least on a relative basis). What's not clear is whether that dent was a temporary aberration, or the start of a trend.
  • I don't know whether Silicon Valley will ever surpass its former glory, or whether Southern California home values will climb from their already stratospheric heights to whatever sphere comes after strato-. But I am confident that if they do, Essex Property Trust has a ticket on that rocketship. If Austin or Phoenix or Raleigh are indeed the boomtowns of the next decade, I don’t see a great stock play in it.
  • The difference is that it’s super hard to build in California’s big cities (and Seattle), so if the total dollars sloshing around in those cities continues to go up, the share of those dollars finding their way into Essex’s pockets will stay high. Essex has ridden California (and Seattle) real estate to a 14% annual return since 1994 (handily outpacing the S&P at about 11%) and done so because of the supply-constrained nature of its markets. On the other side, it’s not as hard to build in the destinations chosen by those fleeing the west coast; if tech talent continues flowing into Phoenix, it will be matched pace for pace by new construction, meaning a big increase in competition for local landlords. In fact, I wouldn't be surprised if many of these locales get overbuilt with apartments in the next few years, and some of the more sunbelt-focused REITs run into trouble.
  • If California real estate resumes its outpacing of the US market, Essex will capture its share of that outperformance. If it doesn't, it's probably a bit overvalued currently. But I'm willing to bet on Essex because it has a moat, even if there are currently some real questions as to the value of what that moat is protecting.

Netflix vs Everyone Else

  • Yeah, this one's a little scary. Things have, ah, not been going well for Netflix recently. However:
  • I believe that despite high penetration rates in the rich world, SVOD (subscription video on-demand) is not yet a mature industry, and that when the dust settles, it may yet turn out to be yet another winner-take-most category, with one leader taking a plurality of the revenue and a majority of the profits, and several other players accounting for chunks of the market which are respectable in terms of volume but small in terms of value. Streaming doesn't have the network effects of search or social media, but it still has near-zero marginal costs and clear economies of scale. In question is just how much those factors will tilt the economics towards the biggest player.
  • Because of that possibility, I’m buying Netflix. But I’m not buying Disney, Paramount, Warner Media, or any of the other players as a hedge. If I’m right and this market turns out to be winner-take-most, I want the leader (as much as their leadership looks tenuous at the moment). If I’m wrong and it remains fragmented and competitive, I'm just not really interested in it.
  • Put another way: If I had to make a simple binary bet on whether NFLX or DIS will perform better over the next 5 years, I wouldn’t be too confident either way. However, ask me which stock has a better chance of quadrupling over that period, and I’ll take Netflix every time. If a winner in the streaming wars does indeed take most, the company most likely to be that winner is Netflix. If it doesn’t, then Netflix is currently overvalued, but the bet is worth taking because the upside is much greater than the downside.
    • Caveats: I do own some shares of Disney, but I bought them before Disney+ was a thing, and I am not adding. I also own Comcast, but not for their colorful bird platform, and Amazon, but mainly for AWS. I am adding to Roku, but not as a hedge; their business model is mostly orthogonal to that of Netflix and I think the most likely scenario is for both companies to do well over the next several years, not one at the expense of the other.
    • (I will also admit to being tempted by Warner Bros Discovery as a short-term holding, since merely escaping AT&T's management has got to give HBO a nice boost, but I plan to stay disciplined and just buy Netflix instead)