MI Rewind: Valuing Netflix Stock w/ Tony Coniaris

0:00You're listening to TIP. On today's show, we've started to reshare some older episodes that are my favorites for a few reasons. One, we get a bunch of new listeners each week, so the new listeners may not have heard this episode before. Two, even if you've been listening for a while, you may have missed this episode when it originally came out. Or three, even if you've heard it before, it can be a great episode to learn from again. If you've already heard this episode or you're not interested in hearing it, feel free to just skip it. There's no harm in that. And you can pick up with our new episodes next week.

0:34All right, guys, that's all I had for you for this new intro. Everything going forward is going to be from the original show. Hope you guys enjoy it.

0:45And the way we're thinking about Netflix is I think we all can agree that the media business is moving video, especially moving towards streaming, right? From linear television. Netflix has a huge lead and it's transitioning from a more local media business globally to much more of a global scale business. On today's episode, I'm joined by Tony Konieris. Tony is a portfolio manager at Oakmark Funds, which manages over$64 billion. During the episode, Tony and I chat about Oakmark's criteria for quality value investment, what it means to have a bottoms-up investment approach, why Netflix qualifies as a value investment, Tony's thoughts on the recent volatility of Netflix's stock, how Tony thinks about the value of Netflix, a recent addition to Oakmark's holdings, Willis Towers Watson, and much more.

1:41As always, the portfolio managers from Oakmark and Harris Associates bring their A-game, and Tony is definitely no exception to that. They break down the complex world of investing into a very simple framework, which helps keep me grounded as an investor. With that, I hope you enjoy today's episode with Tony Conieres. You're listening to Millennial Investing by the Investors Podcast Network, where your hosts, Robert Leonard and Clay Fink, interview successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation.

2:19Welcome to the Millennial Investing Podcast. I'm your host, Clay Fink. And today I'm joined by Tony Conieres. Tony, welcome to the show. Hi, Clay. Thanks for having me. It's a pleasure having you on. We had your colleagues, Bill Nygren and Mike Nicholas on the podcast recently. That was episode 138 for those that are interested in checking that out. For those who missed that episode, could you talk to our audience about the investment process and philosophies at Oakmark? Happy to do that. So really, there's not philosophies. There's one philosophy at Harris that we use across the Oakmark funds and all of our other products here.

2:56And it's a three prong process. So in every investment, all three criteria need to be met. The first one is we only buy businesses at significant discounts to intrinsic value. The second criteria is more of a quality filter. We only buy businesses where we see a clear path to that value growing over time. And the third one is we only invest in companies that have management teams that think and act like a real owner of the business would. And that means maximizing the long-term per share value of the business. You hear all the time that value investors, they want to find an asset, determine what it's worth, and simply buy it for less than it's worth.

3:35Or put another way, to buy an asset for a price that's less than its intrinsic value. Within your value investing strategy, what do you think makes Oakmark's strategy different from other value investors? I'm glad you asked that. There's a couple of things. Let's go back to the first criteria, significant discount to intrinsic value. That sounds pretty humdrum value-y, but it's really not. There's two really important words that are differentiators in there. The first word is significant. There's a lot of value managers. And again, I don't mean this as a criticism. I'm just trying to make a distinction here.

4:08There's a lot of value investors that require ad discount, right? Any discount. And that's fine. They can do what they want to do. We require a significant discount, significant margin of safety in the Seth Klarman vernacular. And that's a differentiator. And by significant, I mean a 30 % or more discount to value. Okay. That's a big one. The second important word is intrinsic. So there's lots of ways to do the value thing. There's statistical value. There's relative value. We don't do either. So what we do is take like a private equity approach to valuation. What are the future cash flows of the business?

4:40What kind of a discount rate's appropriate for the business? Value the company as if you were going to buy it outright. And is there a significant discount to that? And what does that do for us? It frees us up a little bit because we can look at businesses a little differently. For instance, growth is a component of value. It's not exclusionary like it might be for a value manager that just looks at a certain index and says, I can only own what's in this index. We look at the world as a little more broadly and think, well, if a company is growing and of high quality, that's not off limits because it's at an average or above average price.

5:11It might be worth a well above average price, in which case it is a real value. Secondly, we do have a quality filter and there are a lot of cigar butt type value investing out there and you can do well doing that. We choose not to. We look for things that have underlying growth in the business and that have a clear path to earning above their cost of capital. You think about every business requires capital. If you put a dollar in and get 80 or 50 cents out, that's not going to work real well. And so we want to make sure that our businesses have a real moat that allows them to earn a good, fair return.

5:45And then thirdly, this management criteria is really important. When you buy businesses at low prices and hold them for long periods of time, what management does with their capital, like how they reinvest, how they allocate capital really matters. You could imagine buying a company at 10, 12 times cash flow and holding it for five years, you could get back 50, 40 % of the enterprise value back in free cash. How that's invested or distributed really matters. How they take care of customers and employees really matters. And so what management does is really important to us. And we interview our management teams.

6:19We want to make sure that they have skin in the game and are on our side. And I think why do a lot of value managers ignore management teams? I think some do it because it goes back to one of Warren Buffett's old comments of, you know, you want to own a business a monkey can run because a monkey will eventually run it. And there's some truth to that. On the other hand, we don't want to invest our client's capital in a company run by a monkey. So we're just not going to do it. And that's just us. And there's different strokes for different folks, right? Now, looking into your background, you've been in the investment business since 1999.

6:52I'm curious, has valuing companies become more difficult in the low interest rate environment that we're in that's really just elevated stock prices, at least to some degree? I wouldn't say it's more difficult to value businesses, but I'd say it's harder to understand the valuation that businesses are receiving in an interest rate environment like this. If valuing businesses hasn't become more difficult, has it become more difficult to find those companies that are trading at attractive valuations? That's a good question. And when you look at the market in aggregate, it looks pretty expensive, right?

7:28On the surface. If you look underneath the covers, there's a lot of dispersion in the valuations out there. There's a real story of haves and have-nots. And there's a variety of ways to look at this. We choose to look at value dispersions, like where are the highest price stocks valued versus the lowest price stocks. And that is significantly out of whack with where the market normally is. And you can argue about what's driving that, what's not driving it. I don't really know, but I know it's there. And it may be interest rates, it may not, but it's there today. And that means that even in a market that on the surface looks a little bit more expensive, and therefore investors should probably have lower expectations, under the covers, if you're picking the right companies, you can buy great growing companies with great returns, above average returns, above average growth at pretty terrific prices today.

8:16So it's this dispersion bifurcation in the market today that's providing opportunity for value managers like Oakmark. Yeah, I think that's a really interesting perspective. And I hear you guys say a lot that you have this bottoms up investment approach. And I think some people that are maybe newer to investing might question, okay, what does that really mean? So could you talk a little bit about what a bottoms up approach is versus the opposite, a top down approach? Okay. So this is all I've done my whole career. So I'm going to do my best to answer this. Two things. Okay. The first one is we're benchmark agnostic.

8:52There is a way to be a, you can be a quote active manager. And one way it's done is you start with the index and you say, here are the sector weightings and I don't want to be that different, but I have like a view within the sectors of these are the five best stocks and I'm not going to own the sixth. Or I'm going to overweight these relative to these in a minor way to try to be a little bit better than the index and justify my fee. So that's not being benchmark agnostic. We are. So we look at every investment individually, iteratively for the portfolio. It doesn't mean we don't consider diversification.

9:23We do, but everything we do is like, what is the discount to intrinsic value? How much confidence do we have in the people and the quality of the business and the investment case, and then weight them accordingly. So again, that's what bottoms up means. It means you're kind of doing things with no regard to where the index is and you look very different. You can't be better if you're not different, right? So that is an important thing. The second thing is, and this is just my view again, I could be wrong. There's no macro overlay at Harris Associates that says you can't own this, you can't own that because we think GDP is doing XYZ and consumer health is going this direction or that direction.

9:58So we don't start with trying to forecast a very dynamic global economy. We start by looking at each individual company. And the way the economy gets factored in is what are the facts and circumstances today? And what has this business done over time through business cycles? And then dollar average, the profitability of the business and the cash flows of the business for those ups and downs. So like a private equity investor would do. If you're buying a business, you'd say, yeah, they have one bad year for every six good ones. Let's smooth the earnings out for that. That's the approach we take rather than trying to predict when that downturn is going to happen and try to time the stock that way.

10:35The market does that for us by taking stocks down when they're concerned about things like that. In your funds, you're pretty heavily weighted towards financials. And my guess would be that the financial sector is just trading at a really attractive price and they're producing those consistent free cash flows and obviously have good management and meet your other criteria as well. So it's not that you guys necessarily like the financial sector. You just see that there's better value there relative to other sectors is the way I would interpret that. Is that right? The best way to think about when we have an outsized exposure, it's because our bottoms up process has led us there.

11:12And there's a variety of reasons it's led us into the financials. But I think the more important takeaway is that from time to time, we're going to look very different because of where the opportunity is. And sometimes it's bunched up. And that's not totally abnormal for a bottoms up value investor. It doesn't have to be a top down view. It can be a bottoms up view where the value is just simply very bunched up. Why do you believe that the financial sector is beaten down relative to some of the other industries? A couple of things. Number one, if you look at the income statements today, they're earning below their potential.

11:46And that's not fully appreciated. And part of that has to do with interest rates. And we're in a very unique period of time here. If you look historically, it's not a leap to think that the real return on the risk-free rate would be about zero or slightly positive, and we're nowhere near that. And that would be a significant positive for financials, which is just not reflected in their values. And then the combination of capital return, which again, we don't believe is fully reflected in their values, as well as the improved balance sheets, they look pretty attractive to us So we have a pretty large basket of value stocks in most all of our portfolios.

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14:56To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code STOCKS15 for a 15 % discount at checkout. All right, back to the show. Let's transition to talk about a pick that some people might question whether it's a value pick or not, and that's Netflix. And it's similar to some of these other companies you've invested in that are higher growth, call it Facebook, Meta, or Google. Netflix is another one of those names. That's higher growth that's in your funds.

15:36Could you talk to us about what the investment thesis is on Netflix and how it qualified as a value investment for you guys? Yeah, I think this is where we're showing our true intrinsic value stripes. You may not see the value on the income statement. It may not be readily apparent. And Netflix is one of those companies. And it's not necessarily because of the amount of spending they're doing. It was really at the beginning for us, it was about the revenue line. And the way we're thinking about Netflix is, I think we all can agree that the media business is moving video, especially moving towards streaming, right?

16:07From linear television. Netflix has a huge lead, and it's transitioning from a more local media business globally to much more of a global scale business. And again, there they have a significant lead. So there's going to be more of a winner's take most type of situation in the media business in the future than there has been in the past. And like I said, they have a huge lead, they have a scale, and they have the management team and a very unique culture that we believe is going to keep them there. So that's kind of the big picture view. But you know, the value has to be there, right? We're value investors.

16:40In 2017, when this was originally presented as an idea and was purchased, the most glaring signal of that hidden value you're not seeing on the income statement was in the price of its product. And one of the most memorable comments our analysts made at the time was, we all have SiriusXM in our cars and know how much value we think that provides us. Think about your Netflix. Well, it's priced much lower than your SiriusXM. If you just priced it there, Netflix was trading at 14 times earnings. Pretty good value, right? And not apparent when you look at the income statement, but there. And shortly thereafter, they started catching up on price.

17:17Meanwhile, reinvesting in content and building their user base across the globe. And so today what we're tracking is this continued growth in users and subscribers and the margin leverage. And they're beginning to lever the margins and profitability on this globally. And you're starting to see the benefits of that scale. I pulled Netflix up on our TIP finance tool, and I was definitely impressed with the top line growth, as you mentioned, and brought it up in 2017. And since then, you've had revenues of$15 billion in 2018,$20 billion in 2019,$25 billion in 2020, and nearly$30 billion in 2021. Obviously, growth machine.

17:55I came up with an annualized growth rate of 26 % since 2012 for the top line. Is it just the international growth that will be the driver going forward? Or what do you expect there? Yeah. So the way I would break this down is we know where the growth won't be. Okay. Let's start there. Process of elimination. The US market, while there'll be some price and they'll continue to invest and deepen those relationships, the US market is pretty well penetrated. Internationally, very underpenetrated. And some of the markets are more mature than others. And they, from time to time, give us some view of the scale there.

18:28But as you deepen the content and deepen the relationship with customers, you can charge more. And they invest ahead of that to get users and subscribers. So that's sort of the model. And what you have is you have 220-ish million global subscribers. And the way we're thinking about the opportunity here is for growth is you've got roughly 800 million globally broadband connections. And so what is that? A little more than a quarter penetrated. So the growth, you're right, has been terrific, but we see more upside from here. And it's going to be a combination of leveraging markets they've entered and entering new markets and building those markets out.

19:03Some will be invested ahead of and some will be more in harvest mode like the US. It's interesting to think about the international business as many areas of the world won't be priced as high as the US market for their subscriptions. As far as the price action on the stock, it's been a bit of a rollercoaster ride. The stock was around$380 a share pre-COVID in February 2020, rose all the way to$690 a share in November 2021. And now we're back down to$360. So below the pre-COVID share price. What do you make of the rollercoaster ride of the shares over the past couple of years? Yeah, good question.

19:44There's a lot in there. I think just to keep it brief, what we saw and part of the reason the stock did what it did in those periods was this was a COVID beneficiary. It pulled forward subscribers that may not have come in in 2020. They may have been a 2021 or 22 event for Netflix, but they got over the hump because they were at home with nothing to do. And so they pulled forward subscribers at the same time. And the income statement and cashflow statement, you see a temporary positive of you could not develop content as fast as you could pre-COVID because there's all these rules. You got to wear masks.

20:17You got to be in this room. You got to isolate and blah, blah, blah, blah, blah. So they slowed down production. At the same time, they accelerated their subscriber growth. And what that did was they've been growing margins roughly 300 basis points a year, and they grew almost 500 basis points in 2020. Meanwhile, subscriber growth also accelerated. And on the capital side, there was less new content creation. So the free cashflow exploded. And so you had a very temporary bolus of profitability pull forward and subscriber pull forward. And today we're dealing with the hangover of that. And then there's some other things compounding it and scaring people.

20:53Like we've had this clockwork increase in margins. And one of the things you should be tracking, it's not just user growth, but also profitability. And we're going to have a setback in the margin trajectory this year. And part of that is because we had a above average last year. So if you smooth look at this business over multiple years, like you said, it looks like just a machine, a clockwork. But, you know, we've had these extenuating circumstances which have led to some volatility in that trajectory. And that's fine. As a long term business owner, you wouldn't be too worried about it. But again, another thing going on this year is currency.

21:24And this is something that they can adapt to over time. It isn't a long term impact, but it's had a real impact on the margin. Something like two-thirds of the margin impact this year is going to be a result of currency translation between producing in dollars and selling in euros and realizing your subscriber revenues in euros, but you're producing in dollars. That has a negative impact translationally on the income statement. That's not permanent, but it's having an impact. And I think people are confusing the cyclical with the secular. Yeah. It's funny you mentioned that a lot of that growth was pulled forward in 2020, I look back April, May, I was watching a lot of Netflix because there really wasn't anything else to do.

22:01All my gyms were closed and I couldn't go out and see all my friends and everything. And when I think about Netflix in my own life, I'm chatting with my friends. You got one new show coming out on HBO. You got another new show coming out on Netflix. So there's almost this fragmentation of the market. And it makes me wonder what sort of moat Netflix has and if they're able to stick around and keep people paying for their services, what is the competitive advantage or moat that Netflix has that maybe others don't? Yeah, well, it starts with their lead, right? You have the scale and they're in a position today where they can afford to provide more content value by having a big content budget at a lower price.

22:43That's really powerful, right? That's a true benefit to the consumer. And as long as they continue to keep that relationship in a good spot, they're going to continue to grow the consumer base. And that's a very powerful thing. And they have a great lead. As for competition entering, very cognizant of that, understand that. On the other hand, think back to the cable industry. We went from three channels in this country to 150 or something on average, right? And it was a great industry the whole time. And it's a very large industry. And it's something people like entertainment, they're going to want to be entertained.

23:17And it's not going to be one company providing their streaming in the future, just like it wasn't in the past. It fragmented, there was lots of channels, but it was still a very good business because the pie was so big. And the pie here with the transition from not being as local, but being more global, and back to everything we talked about with the growth opportunity, there's just a very long runway and there's a lot of room for more than one company to win. You mentioned that you like to analyze the quality of the management pretty closely. What are some of the things you're looking at for Netflix in assessing the management?