"Net neutrality" is often portrayed as a matter of consumer rights, cyber rights or free speech. But while it may be all that, it is it also "in good part a business negotiation being conducted in a policy arena" (NY Times). Some recent developments on the subject on both sides of the Atlantic prompted me to undust some old work I did in my MBA days.
First, a very condensed introduction to equity market theory:
According to the efficient market hypothesis, a stock price should reflect all the information there is to know about its underlying company's prospects. If the prospects improve, the stock should go up; if they worsen, it should go down. Of course, much of a company's prospects are down to the broader economy and are shared with the stock market, but the extent to which this is so can be determined (this is a stock's beta, as distinct from its alpha). This makes it possible to separate a stock's performance into its "normal" return (which reflects the market's performance) and its "abnormal" return (which is "idiosyncratic" to it).
Now, if something happens that (a) is unexpected by the market and (b) affects a company and not others, its stock may change by more than its beta would suggest. So, say you believe that a company (or industry) is about to be positively affected by such an event. You can take a market-neutral position by simultaneously going long the company and shorting the entire market so that your net beta (i.e. market exposure) is zero. If something happens to the economy you should not be affected (your two positions should move in opposite ways). But if the event you were expecting happens, you win.
Enough theory. You don't need to buy the EMH (I'm not sure that I do), but for the argument's sake please do.
Now consider the advent of "over the top" video – i.e. companies like Apple, Google, Netflix, Microsoft, and Amazon providing TV and films straight to your TV box over the internet, without talking to your ISP. Will a day arrive in the not-too-distant future when these products supplant your cable provider's TV offerings?
That is the multibillion-dollar question. Whatever the answer may be (and nobody knows), it will depend on:
- The infrastructure being there. Among other things, this means that everybody should have at least a 2mbps broadband connection (for a single standard-definition stream)
- The technology, products and business models developing and achieving enough take-up
- Cable operators being unable to prevent this, either because of competitive pressures or regulation – specifically, net neutrality regulation
Now, say that at a given point in time the market thinks that there is a certain chance (say, 30%) that these three things will happen. The stock prices of all relevant companies should reflect this. But suppose that then something new happens – e.g. the FCC signals its support for net neutrality, or Google announces Google TV – that makes the market change its mind, so that now it thinks that the probability is 40%. What should happen? A reasonable guess is that:
- The stocks of cable operators and (to a lesser extent) telcos should go down
- The stocks of over-the-top companies like Apple, Google, Netflix etc should go up
Suppose you took the view that these surprises are likely to happen and wanted to build a portfolio to reflect this. One way to do that would be to have a market-neutral short position on telecoms, and another market-neutral long position in over-the-top companies. Of course there's a myriad of other factors that could affect your investment, but if you mix enough stocks you could expect these effects to cancel each other out through diversification.
If you had done this a year ago, this is how your portfolio should have performed:
This chart is normalized so that today's value = 100. What it says is that your market-neutral long "over-the-top" portfolio would have gained a 28% return over a year, while your M/N short telecom portfolio would have been essentially unchanged.
It seems that while the market has been steadily willing to believe more and more in over-the-top video, it does not think that this will be at the expense of telecom companies (which here means both cable and telcos). This could mean that the latter are expected to be able to make enough money as pure-play ISPs to make up for their losses in pay-TV. Or, perhaps more realistically, the market thinks that over-the-top may compete with cable's video-on-demand offerings (which are marginal) but not with its linear channels.
The fluctuations are also interesting.
- The over-the-top portfolio suffered losses between June and August: this may be a reaction to Comcast's court victory in April and the FCC's subsequent announcement that it would consider Title II reclassification of broadband (which was politically troubled)
- The turnaround in August may have been a reaction to the breakdown in FCC-sponsored industry talks aimed at finding a compromise solution, which some observers interpreted as a preamble to the FCC taking a harder line
But of course, these are just interpretations – there are lots of other possible ones, and mine is good as the next.
Disclosure and disclaimer: in the past I have held small derivative positions designed to profit from variants of this trade. Although I currently no not, I may do so again in the future. This post is not intended as a recommendation for this or any other investment strategy.
A postscript for financial types: the chart above reflects cumulative abnormal returns against a full Fama-French regression, using synthetic SML/SMB portfolios based on combinations of Russell indices as per this paper. Accuracy may suffer for distant dates, and my calculations may be wrong. The long stocks are AAPL, AKAM, AMZN, GOOG, LLNW and NFLX, all equal-weighted. The short stocks are CMSA, CVC, T and VZ equal-weighted, plus Q and S half-weighted on account of their more limited exposure to pay-TV.