Discretionary Investment Management | Mark Bousfield
09 Jan 18

2017 Q4 Newsletter

“Madness, madness, they call it madness
Madness, madness, they call it madness
It’s plain to see
That is what they mean to me
Madness, madness, they call it gladness, ha-ha”

 

Madness, Madness 1979

In many respects this has been an extraordinary year for investors, especially when you stop to think about some of the crazier stuff that has been happening. You don’t have to look very far:

Bitcoin
Perhaps one of the best publicised areas of craziness is cryptocurrencies. I can certainly understand the desire for a  non-government-backed currency; however, the parabolic rise of Bitcoin surely contains an element of irrational exuberance. Bitcoin, which for all I know could be worthless, has risen from about $950 to about $16,500 as I type. This isn’t to say that Bitcoin will fail, but we have reached and surpassed the moment of blind faith. Until literally the last week of 2017, people were just buying, buying, buying. Where next, crypto?

Debt
The amount of debt in the world continues to rise at a frightening rate (there is approximately $225 trillion of debt globally, which is about 325% of global GDP). As investors desperately reach for yield, the risk associated with that extra yield increases. There are numerous examples of investors relaxing their usual caution towards credit risk where the investment in question happens to pay a good yield. Here are a couple of examples:

  • Argentina - has a history of failing to pay and has defaulted on its international debt 7 times (and its domestic debt 5 times) since becoming independent in 1816. Most recently, in 2001, Argentina defaulted on its bonds and spent the next 15 years restructuring its debt. Given that track record, one is forced to raise a Roger Moore-style eyebrow (or perhaps tip one’s hat!) at Argentina’s recent ability to issue a bond maturing in 100 years’ time for an 8% coupon.
  • Tesla – a company, lest you need reminding, that doesn’t make money – issued an unsecured bond maturing in 2025 with a coupon of 5.3%. Tesla already has almost $5 billion of debt and a revolving credit line of $1.6 billion.

Collectables – wine, art, stamps
Collectables have also been through a period of madness. Of course, like everything, the value of something can only ever be what someone else is willing to give for it. But even this behaviour is exaggerated in the world of art and wine. For instance, in November, a collector paid $450 million for a rediscovered Leonardo da Vinci painting of Salvator Mundi (Jesus Christ), making this the most expensive painting ever sold by some considerable distance. However, this wasn’t a complete one off, since earlier in the year Qi Baishi, Twelve Landscape Screens (1925), sold for $140.8 million and Jean-Michel Basquiat, Untitled (1982), sold for $110.4 million. Similar scenarios have played out across the collectable universe from cars to wine to stamps and you can’t help but think that this is the inevitable consequence of an ocean of liquidity (cash) created by almost free and unlimited leverage having to find a home somewhere.

Equities
Equity markets haven’t been immune either. The broader market, the MSCI World Index, is trading at elevated levels. Over the last 15 years the average Price Earnings ratio (PE) has been 14.2x, but now stands at approximately 17x. And this doesn’t tell the full story. It’s only when you open the valuation lid that some of the excesses are revealed. For instance, Netflix has risen by more than 2,000% over the last five years and currently trades on a PE of 117x. Tesla has risen by 1,114% over the last five years and, whilst an incredibly innovative company, remains loss-making since its founding.

2017 Q4 MSCISource: Bloomberg

Looking at the world through the PE prism, we can see that markets are looking stretched; in many areas they are looking irrational. Whilst all of this does make for a great newspaper read, it does not, in our view, make for a sensible investment strategy. We find ourselves in a position where equities and bonds look expensive; accordingly, we have reduced our exposure to the most expensive sectors. For clients, this means that we have a lower-than-normal equity exposure and a shorter (more cautious) bond duration across our lower risk multi-asset strategies. This is likely to remain the case for some time, i.e. until value re-emerges. As night follows day, value will eventually reappear. Assets don’t remain overpriced forever, but in the meantime we should not obsess over the short term. Whether it is a telling tweet, such as Hilary Clinton’s attacking drug prices in the US causing a sell-off in healthcare stocks, or an unexpected rate-rise or sequence of rate rises by a central bank impacting bond prices, value will out.

Looking forward into the New Year, we continue to remain patient, waiting to top-up our holdings in preferred themes and assets.


Happy New Year

CAUTIOUS PORTFOLIO: LOWER RISK
BY BOB TANNAHILL

Objective: The Cautious Portfolio’s objective is to increase its value by predominantly allocating capital to fixed-income investments. The portfolio can also invest into global blue-chip equities with strong cash-flows and progressive dividend policies. A neutral position would be a 75% bond/25% equity split and the maximum equity-weighting is approximately 35%. The cash generated can be re-invested to provide capital or taken as an income stream.

This year has been another pleasing year for performance with the Cautious Strategy – returning 4.7%, including both capital gains and income received. Moreover, we have performed in line with our peer group while running the most defensive portfolio since launch in 2009.

Starting the year-end portfolio round-up with equities, our global equity income funds performed well, providing a total-return contribution to overall performance of approximately 2.9%. BlackRock Global Equity Income has been the best performer and there has been one key reason for this. After the Brexit vote in 2016, our global, unhedged, equity exposure gave all portfolios a boost as a result of the weakening pound. We then decided that we wanted to have a more balanced currency exposure, since we do not invest with any view on the direction of a currency. To do this, we switched into the sterling-hedged class of the BlackRock Global Equity Income Fund. Over the course of this year, the pound has regained some of the ground it lost in 2016 and the BlackRock Fund has thus reaped the benefits. The two other global equity income funds, Fidelity and Guinness, have both performed as expected, but we have not had the same currency benefit since these remain unhedged.

In what seems like a bout of 2016 déjà vu, non-cyclical sectors such as Consumer Staples (a favoured sector) had a stronger first half of the year; but, in the second half of the year, cyclical sectors such as energy, financials and materials had the stronger returns.

As we have touched on in the past, with this strong drive upwards in equity prices comes an increase in valuations – which gives us pause for thought. Valuations are a measure of the price you are asked to pay today for the future earnings of a company. The typical, and perhaps most simple, way of calculating this metric is to divide the price of a company’s shares by its earnings-per-share figure. Historically, one has been asked to pay around 14.2x for every £1 of expected earnings. Today, however, this has increased to around 17x – even for companies at the more defensive end of the equity scale. We are acutely conscious that if markets were to stumble at 17x there would be much further to fall than at 14.2x. This is one of the key reasons why we are  cautious.

The bonds in the portfolio have behaved as expected. Sterling-bond exposure, both corporate and gilt, finished the year with modest positive returns as uncertainty over Brexit continued to create volatility in UK markets. High-yield bonds, which we trimmed recently, also made good gains. This was an area we initially topped up in February 2016 when we felt they offered value from a fundamental standpoint. They have since rallied from that point and we now feel that there is limited upside left at current prices. We have also shortened the duration in the portfolio as fixed income, too, looks rather expensive: this will give us a bit more protection should we experience an increase in yields.

When we think about how we approach 2018 it is helpful to remember where we are today. This year has been undeniably one for the optimists. Improvements in economic growth indicators globally and expectations of business (and so earnings) friendly tax reforms in the US have driven markets higher in a near straight line (see chart below). Looking at world equities (in dollar terms) you would never guess that the Federal Reserve had spent the year hiking interest rates or that North Korea had spent the year firing missiles over Japan!

2017 Q4 Cautious Chart

Source: Bloomberg

On top of this you have exotic and unproven financial assets – cryptocurrencies this time around – handing out seemingly “free profits”. Bitcoin is up a staggering 1,500% on the year! This sort of environment is a heady one for investors and one where it is easy to lose one’s way. I note that every Bitcoin or Ethereum owner that I speak to, despite healthy profits and a ready willingness to accept the striking resemblance to many historic bubbles, is equally unwilling to take a single penny off the table. I keep hearing: “I will sell, but not quite yet”. It is this sort of behaviour that rings alarm bells. The way we aim to keep ourselves from getting carried away in such environments is to ask ourselves: what are the assumptions being priced into assets and are we being paid for the risk that they are wrong?

When we look at our asset classes today it is hard to say that the riskiest parts of the market are rationally (and appropriately) pricing in the risks. Equities assume that high valuations today will either be sustained tomorrow or will be justified by strong growth in earnings – both possible, but on the optimistic side for this late in the cycle. More interest-rate-sensitive bonds, such as 10-year UK government bonds, assume that the Bank of England will not manage to raise interest rates by more than 0.75% before we see the next recession. This, again, is possible, but does not provide much margin for error. Such a relaxed attitude to risk makes us nervous and has led, over recent months and years, to a slowly reducing exposure in all of our strategies.

This defensive positioning means that if markets do meet their high expectations and the good times keep coming, then our  portfolios, while profitable, will likely lag behind more aggressively positioned peers or benchmarks. On the other hand, if markets do disappoint, then we should be in a better position than others to weather the downside and benefit from the eventual recovery.

We hope you had a good Christmas and wish you all a happy and profitable 2018.

 

BALANCED PORTFOLIOS: LOWER-TO-MEDIUM
BY SOPHIE YABSLEY

Objective: The Balanced Portfolio’s objective is to provide capital appreciation through a balance of fixed income and global equities. A neutral position is a 50% bond/50% equity split and the maximum equity weighting is 60%. The cash generated can be re-invested to provide capital growth or taken as an income stream.

As we begin 2018, many investors will be feeling understandably wary about what political and economic changes may lie in store; however, we would like to reassure you that the Balanced Strategy is no stranger to a politically and economically uncertain backdrop! Whilst many would argue that today’s outlook is closer than ever to out-and-out disaster, we would remind investors of one of our favourite quotes from one of our favourite epigrammatists, Sir Winston Churchill:

“When I look back on all these worries, I remember the story of the old man who said on his deathbed that he had had a lot of trouble in his life, most of which had never happened.”

That is not to belittle the very real threat of nuclear warfare or to dull down the severity of civil unrest, human displacement and the plethora of other challenges that dominate today, it is merely to observe that the landscape now is likely no worse than at many points in the recent past.

We instead remain focused on our tried and tested investment ethos of investing in high-quality assets, in line with our global investment themes, and buying them at the right price. This discipline has led us to maintain our cautious positioning as we wait patiently for value to reappear. If we do see opportunity arise, we will move swiftly to take advantage; however, until that point we remain circumspect and will likely start to lag our less cautious peers in an upward market.

During the year, the best performing holding by far was Polar’s Global Technology Fund, which has beaten both the sector and the peer group (rising over 37% year-to-date at the time of writing). As well as delivering excellent returns, Polar remains one of the best managers for contact and relationship maintenance, and we continue to receive an excellent level of service. Whilst we are big fans of the managers, their process and the growth potential within this investment theme, we are also conscious that the growth-orientated stocks the Fund seeks to own provide the potential for increased volatility and, therefore, that the holding needs to be weighted appropriately for balanced investors (currently around 5%).

During the quarter, we took the decision to reduce our exposure to Fundsmith and lock-in further profit. As we wrote in our last newsletter, we know that we want to own Global Brands for the long term; nevertheless, we are very aware of their elevated valuations. The asset has continued to become more and more expensive, so trimming these holdings was deemed a prudent course of action. Staying with consumption as a theme, some of the sale proceeds were used to top-up the existing holding of Arisiag Global Emerging Market Fund – which provides us with a similarly diversified exposure in consumer discretionary and staples companies, but within Emerging Markets. Arisaig is currently trading on a slightly cheaper forward price/earnings ratio than its historic average, making it more attractive in an expensive environment. In addition, a small proportion has been allocated to short-dated gilts – a further contribution towards our most defensive stance to date.


GROWTH PORTFOLIOS: MEDIUM RISK
BY SAM CORBET

Objective: The Growth Portfolio’s objective is to provide long-term capital appreciation by investing predominantly into global equities. A neutral position is a 35% bond/65% equity split and the maximum equity weighting is approximately 85%.

In Mark’s opening commentary, he made reference to some of the stranger situations that occurred throughout 2017. Whilst I do not wish to retrace ground, I would like to spend a few moments expanding on some of the phenomena highlighted, since an awareness of such investor exuberance is useful when trying to gauge the levels of euphoria currently surrounding certain pockets of the financial markets. It has been hard to ignore the phenomenal return Bitcoin has provided holders throughout 2017. It is, perhaps, unsurprising that such a performance has prompted a growing number of questions from our investor base. Whilst we remain fascinated by the technology that underpins cryptocurrencies (and the growing number of ways in which they are being used), when analysing the merits of any investment we seek to own on your behalf, our process requires us always (and unemotionally) to return to valuation.

As firm believers of the K.I.S.S. acronym, trying to decipher a meaningful value for Bitcoin almost certainly falls into the “too complex” category. However, at the risk of dramatically oversimplifying the enormity of this task (and in order to provide some context) we can turn to the markets that Bitcoin is mooted to replace. The two most common schools of thought are that Bitcoin will either act as a disruptor to the conventional payment system or that Bitcoin will become a store of value – the digital equivalent of gold bullion.

Let’s start with the former. The largest incumbent payments provider is Visa (who were responsible for processing over 50% of global card transactions in 2016). As a transactional-based business, Visa’s ability to generate revenue (and thus its valuation) goes hand-in-hand with its capacity to cope with volume. This is something Visa has excelled at and (on average) it now processes over 2,000 transactions per second (substantially below its reported peak capacity of 56,000 transactions per second). By contrast, the technical constraints associated with committing each Bitcoin transaction to the blockchain ledger means that the network has a capacity restraint and can only process a measly 7 transactions per second.

At the time of writing, the market capitalisation of Bitcoin has surpassed $300bn and exceeds that of Visa (at circa $260bn). Looking at Bitcoin purely as a payments competitor, it is hard to fathom an argument which justifies paying a premium for a system whose maximum capacity constraint is only sufficient to be able to process 0.35% of the incumbent’s average transaction rate and whose peak capacity rate is currently 8000x lower!

As for Bitcoin being used as a store of value, the suggestion is almost laughable. When looking for an asset to maintain wealth you generally want an investment where preservation of capital is prioritised with a return profile that is sufficient to counteract the effects of inflation. Something as volatile as Bitcoin, where huge loss of capital is possible, certainly does not fit these criteria.

All this leads us to the conclusion that the rise of Bitcoin (and other cryptocurrencies) has, so far, been fuelled by speculation, blue-sky thinking and misguided promises about what may come. You know investors have become punch-drunk when digitally rendered images of cats are trading hands for thousands of dollars (or the token equivalent) via the CryptoKitties website, which uses Ethereum’s blockchain (a Bitcoin rival) to verify ownership. Perhaps equally scary was the revelation that Long Island Iced Tea saw its share price increase by 500% purely on the news that it was changing its name to “Long Blockchain”. I don’t know about you, but I wouldn’t have thought the skills acquired through years of soft-drinks manufacturing would be particularly transferrable to the cryptocurrency market…

Whilst cryptocurrencies remain an interesting topic, as investors in our Growth Strategy you should be comforted to learn you have no exposure to these assets. I hope that we have been able to demonstrate that they are being valued as if they have already conquered the markets to which they pose the biggest threat, when, in reality, their feasibility (at least in current form) and thus ability to stand the test of time should be under serious question.

During times when money is flowing into highly speculative asset classes almost haphazardly, knowing exactly what you own (and why) becomes paramount. Such focus acts as an antidote to irrationality and underpins the confidence to forego chasing short-term performance. Instead, we remain invested in high-quality assets aligned with our long-term themes.

The Growth Strategy had a strong 2017, returning over 13% to investors – which, to provide some context, is in line with the return on world equities (as defined by the MSCI World Index) – despite having 25% of the Strategy allocated to more defensive assets, i.e. cash and bonds.

Continuing with the trend set in the first three quarters, our exposure to the tech sector continued to be a strong driver of performance during the fourth quarter. Throughout the course of 2017, Polar Capital Global Technology Fund (our preferred specialist technology fund) returned over 37% (net of fees); an outperformance of 9% versus the sector. Aside from tech, the Strategy’s core global equity positions continued to perform well as did exposure to the emerging markets.

We enter 2018 neutrally positioned – roughly 75% to equities and 25% to bonds and cash. A neutral stance is appropriate and allows us the flexibility to adapt quickly regardless of the direction markets choose to take from here.

Crypro Cats
Source: Bloomberg

 

GLOBAL BLUE CHIP PORTFOLIOS: MEDIUM-TO-HIGHER RISK
BY HOLLY WARBURTON

Objective: The Global Blue Chip portfolio invests into approximately 25 -30 global blue chips that are in line with our long-term investment themes. The aim is to invest into such companies at an attractive valuation and hold them for the long-term. The cash generated can be reinvested to provide capital growth of taken as an income stream.

The Strategy ended the year with a positive performance driven by the Technology sector, where earnings kept exceeding expectations driving share prices to new highs. Conversely, our other preferred sector, Healthcare, was sluggish in light of  continued pricing pressures due to shifting dynamics within the US market, the largest market for most pharmaceutical and device sales.

From a stock perspective, Intel and Microsoft benefitted from good earnings results earlier in the quarter maintaining their positive run of momentum. Intel, in particular, surprised the market with a better than expected performance within its data-centric businesses whilst its Client Computing Group fared better than the broader industry. In contrast to its healthcare peers, Johnson & Johnson also produced some very good earnings, driven by sales growth across all its business divisions. Year-on-year sales grew over 10% due to a mix of organic growth and acquisitions. Net of acquisitions, growth was very reasonable at just under 4%.

As equities ticked higher we took profits out of those stocks whose valuations looked most expensive and added to those that had relatively underperformed and looked better value. Unsurprisingly, given their performance, those profits were taken from Intel, Microsoft and Apple and reinvested into some of our preferred pharmaceutical holdings.

2017 Q4 Pills

The threat of generic drug competition and cheaper alternatives is nothing new for drug companies and is often seen as part of the business cycle. Most of our pharmaceutical holdings reduce the impact of generic competition by having a broad portfolio of drugs and innovative pipelines that bring a steady stream of new products to market regularly.

Amgen, our favoured biotech position, has, in contrast to our ‘usual’ pharmaceutical holding, a relatively concentrated portfolio of very successful and valuable drugs. It is therefore the most exposed to patent-cliff expiries on its products. In December, it was reported that Biocon, India’s largest biopharmaceutical company and its US partner Mylan, had received FDA approval for one of its copycat drugs of Herceptin, Roche’s breast cancer blockbuster. The news may mean the partnership is close to receiving FDA approval for its biosimilar of Neulasta, Amgen’s blockbuster chemotherapy drug. Neulasta makes up roughly 20% of Amgen’s revenues and any competitive threat will have an impact on the market’s short-term expectations for the Company’s earnings and will likely bring with it some unwanted volatility. Although at odds with other trades, this imminent threat was enough for us to reduce the Strategy’s exposure by half.

Despite short-term concerns within particular drug cycles, the secular trend within Healthcare remains intact with global ageing and the need for more healthcare products and services on the rise. Further demand for healthcare services is coming from increasing global wealth and subsequent rising standards of living that is resulting in better access to healthcare products and services. These trends should continue to grow the opportunity set for all of our healthcare companies.

Our investment approach, regardless of the broader market environment, always focuses on our long-term themes: irrefutable trends in global demographics, advancements in technology & science and increasing global wealth. These trends will most likely continue to provide a positive operating environment for all of our global businesses, offering them the opportunity to thrive.

As we start 2018 the entire Blue Chip team would like to take this opportunity to thank you for your continued support and to wish you all the best for the New Year.

 

FUND IN FOCUS: THE FUTURE CONSUMER
BY SAMANTHA DOVEY 

For those that are investors in our strategies or avid readers of our articles, you will know that the consumer is at the heart of our investment ethos. Whether via our “shopping trolley” stocks, the rise of the emerging consumer or technology-led consumption in the form of products from behemoths such as Apple and Microsoft, our society and ultimately our investment thesis revolves around the consumption story.

This got us thinking about the “future” consumer and what the next consumption story will be – in ten years or more – and how we might access this in today’s investment universe. After some searching, we ultimately handed this mantle over to a gentleman called Pieter Bussher, who is the manager of the RobecoSAM Smart Materials Fund.

At the thematic level, the Fund invests in long term megatrends such as demographic change, scarcity of natural resources,  pollution and climate change. These megatrends create long-term sustainability challenges and opportunities.

This strategy offers investors an approach that goes beyond simply investing in natural resources. It focuses on innovative materials and process technologies, the very mechanisms that have driven efficiency gains over time and that have enabled humans to cope with limited natural resources despite population and economic growth (these might be termed the Malthusian factors, things that are arguably only going to become more challenging).

The Fund invests in companies that enable sustainable economic growth and look at this world via four investible clusters:

  • Advanced Materials – Strategic and speciality metals, as well as functional and coatings businesses
  • Transformational Materials – Lightweight materials, E Paper, bio-based materials and energy storage; includes exposure to lithium, glass, carbon-fibre companies
  • Process Technologies – Recycling and reuse, industrial gases and analytical instruments and recycling companies
  • Automation and Robotics – Robotics and lasers, automation and process control and software

The best way to gain a sense of the types of companies the Fund seeks to provide exposure to (as well as the companies it aims to avoid) is via an example. Let’s focus on the rise of the electric vehicle. The hard statistics underpinning this investment opportunity are that in 2016 only 2% of global car sales were electric; but they are no longer a futuristic dream, soon they will be a way of life. Bucking the historic trend, the French were the first to announce that they would ban sales of petrol and diesel cars by 2040, with Germany and the UK soon following suit. The leaders of sustainability champion, Norway, plan to ban the sale of petrol or diesel-powered cars by 2025.

The auto industry faces tough emission standards and expectations are that CO2 emissions over the next 8 years will have to fall dramatically – for example, China has to reduce its emissions by 40%. One of the cheapest ways to achieve this is by utilising lightweight materials such as high-strength steel, aluminium, magnesium, plastic, glass and carbonfibre. Lightweight material usage in vehicles is expected to rise from approximately 29% in 2010 to 67% by 2030, so companies such as Kaiser Aluminium should experience growth, as should Hexcel Corp. Kaiser is the leading producer of high-strength steel, as well as high-end aluminium. Hexcel specialises in lighter, stronger and more efficient materials.

2017 Q4 Chimneys

Moreover, whilst EV innovators such as Tesla are in the news, the Company itself is not in the portfolio. Rather RobecoSAM is playing the lithium story. Since it is expected that the lithium-ion battery market will grow by over 150% by the year 2025, one of the Fund’s holdings in this sector is FMC Corp, a conglomerate that has a business sector dedicated to the metal. Lithium has a number of uses within this organisation: batteries, constructing polymers, pharmaceuticals and lubricants.

Whilst we have highlighted the uses of transformational materials, there are many other opportunities, such as: robotics, computer-aided design, automated manufacturing and motors that power robots, as well as recycling companies and energy efficiency in areas like lighting – these sectors are growing and there is heightened demand.

The Fund forms part of our future consumer allocation. We continue to believe that despite entering an era of unparalleled resource pressure, human ingenuity and innovation will enable the global economy to adapt to resource scarcity. Companies that pioneer innovative ways to use resources more efficiently – and facilitate the substitution of supplyconstrained resources with intelligent alternatives – will gain a long-term competitive advantage.

As a specialist provider of thematic and sustainable investment products, it is RobecoSAM’s business to find and invest in game-changing companies that, through resource-efficient solutions, deliver the best technological and financial return – both for  investors and (we trust) society as a whole.

 

STOCK IN FOCUS: DISNEY
BY BEN BYROM

Disney

Nothing it seems is safe from the scourge of disruption – not even the largest entertainment company in the world, The Walt Disney Company (DIS). The media conglomerate, known for its cartoon characters, such as Mickey Mouse, and action films, including the Star Wars franchise, would seem to have its work cut out as it confronts new, deep-pocketed rivals, whilst having to address fast-changing consumer habits. A tall order, some would argue, yet Walt Disney has – at least historically – thrived in an industry that has always been in a constant a state of flux as it seeks new and innovative ways with which to draw and entertain the masses. Is it any different this time?

On a TV set, computer, mobile or tablet device not too far away…

…a war is being waged for your custom. Traditional ways of producing and distributing content is undergoing a huge shift as technology, once again, drives change. With the proliferation of mobile devices and increasing preference for online streaming, consumers have never had so much choice over what they wish to watch, how they wish to watch it – or, indeed, when. The  landscape of TV programming, cable-bundling and pricing are changing faster than ever.

The biggest difference in our minds is that the threat is no longer confined to the media industry. As technology is helping drive much of the disruption, it should come as no surprise to hear that Silicon Valley behemoths such as Amazon, Apple and Netflix are at the forefront. Why? Why not? After creating a vast network of loyal followers, these companies are looking at different ways of integrating their products and services into our daily lives, making them increasingly indispensable. Content is one of those ‘ways’ and, as access to content becomes more expensive, it becomes more cost-effective to add value through the production of their own exclusive content; these shifts are having a profound impact.

The changing landscape is most evident in the way content is now being delivered. The consumer increasingly favours online- streaming platforms (also known as over-the-top OTT or direct-to-consumer DTC platforms). The first-movers have been the tech savvy, such as Netflix, Hulu, Amazon and the like. Those that enjoyed dominance and pricing power in cable TV (paid for TV) where consumers subscribe to cable ‘bundles’ that best meet their viewing/entertainment requirements are starting to feel the heat.

The clear advantage of the OTT business model is that consumers pay for the content they want to consume without having to pay for the stuff they don’t. As online offerings get better and are more broadly adopted, the practice of ‘cord cutting’ (cable subscribers – led by tech-savvy Millennials – cancelling their subscriptions) is accelerating. Whilst most people will recognise Disney for its theme parks, resorts and long, illustrious history of producing box-office blockbusters, much of its revenue and profitability is in fact generated by its Networks Division. During its 2017 fiscal year, roughly 43% of revenue and 47% of operating income was generated through the licensing of content, advertising sales and affiliate fees from subscribers to its cable channels ABC and ESPN. The acceleration in cord-cutting is having an impact – especially on its flagship ESPN Sports Channel, where the number of subscribers has fallen from 100m in 2011 to just over 87m today; and the trend is expected to continue.

The Force Awakens
Cord-cutting is not a new phenomenon. Yet every time Disney’s film-slate enters a lull, the market’s attention seems to drift back towards these woes – which in our view has offered the opportunity to top-up our position. Our rationale for topping-up is simple, content is king. And the king of content is arguably Disney. A shrewd acquisition spree of high-quality franchises, which included Pixar Animation, Marvel Studios and LucasFilm, has bulked-up Disney’s already impressive cache of content. At the same time, Disney has been working on its own DTC offering through its acquisition of a controlling stake in BAMTech, a company that was founded through the spin-out of Major League Baseball Advanced Media’s streaming technology business. Access to this infrastructure is allowing Disney to launch a DTC offering of ESPN content in early 2018 and a DTC subscription service dedicated to its own content in 2019. CEO and Chairman of Disney, Bob Iger, in a recent call to investors, called out Netflix as a direct target when he made a passing comment on pricing, stating that the new offering would be cheaper than their Silicon Valley rival’s.

The Empire Strikes Back
That was then, and this is now. As the landscape shifts once again, Disney is back on the acquisition trail with its biggest and most ambitious move to-date as it seeks to buy 21st Century Fox’s entertainment assets in a deal that values the target at $52 Billion. The all-stock offering would see Fox shareholders own roughly 25% of the new Disney, and create a mammoth entertainment business with the content and technology to hit back at its deep-pocketed rivals. The deal from a content and delivery perspective is simply mouth‑watering.

Disney Overview

Highlights:
21st Century Fox’s premier film and television studios, and their respective libraries, significantly enhance Disney’s content output and world-class portfolio of intellectual property…

Premier TV Table
…not to mention 21st Century Fox’s sports platform augmenting a market-leading line-up at ESPN.

Global Sports TableExpands global reach especially into rapidly growing regions, providing new avenues for growth especially across Europe, India and Latin America.

Broadens Disney’s direct-to-consumer capabilities, allowing delivery of more compelling entertainment experiences to consumers: 75% ownership of BAMTech, 60% ownership of Hulu and 39% ownership of Sky1.

DTC Table

The Company believes the tie-up would accelerate revenue and operating income growth whilst saving up to $2 Billion in operating efficiencies, having a meaningful impact on earnings per share.

It is likely that over the medium-term Disney will be able to generate significant value from these assets as it integrates them into the Disney Empire, utilising its different business platforms to cross-sell and monetise its augmented portfolio of high-quality content.

So, in answer to our question, is it any different this time? We agree new entrants and the way content is being consumed is creating a challenging environment; however, if you own the best content and are the biggest draw, the rest will simply fall into line, over time.

The Global Blue Chip Strategy has a 4% weighting in Disney and actively buys the shares on weakness.

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