Navigate Tough Markets by Investing in Optionality

Editor's note: Today, we're turning to Rob Spivey – director of research at our corporate affiliate Altimetry – to learn what distinguishes the best long-term investments... the ones that can survive (and even thrive) through any market environment. In this article, recently published in the Altimetry Daily Authority free e-letter, Rob highlights a key quality that has driven huge gains for shareholders...

Netflix's (NFLX) streaming success was 10 years in the making...

Today, it's a household name and an obvious "go to" for binge-watching our favorite TV shows and movies. But it didn't get there overnight.

Netflix was founded in 1997. And in the beginning, it was renting out DVDs by mail...

It focused on DVDs for nearly a decade, gradually building its customer base. It eventually offered a subscription model where customers could rent up to three movies at a time.

It wasn't until 2007 that Netflix introduced its groundbreaking streaming service. Suddenly, users could watch movies and TV shows online for a low monthly fee.

By 2010, Netflix had grown its annual revenue to $2 billion. A year later, its revenue surpassed $3 billion. By the end of only its second decade in business, the company had increased its revenue 10-fold.

Anyone who saw its exploding streaming business in 2010 would have thought the company was just in the right place at the right time...

But as I'll explain today, a lot of hard work in those early years set the company up for success. And this "keep your options open" approach is still crucial to businesses that come out on top...

Netflix experimented with different business models for years.

It tried everything from changing its delivery methods to offering multiple types of subscriptions. This gave it a better idea of what customers wanted... and allowed it to meet those needs.

And it meant Netflix quickly secured its position as a leader in the industry.

Netflix's willingness to test out new ideas is what helped build it into the streaming giant it is today. For 10 years, it worked hard to ensure its customers could watch as many movies as they wanted... Then, when it ventured into streaming, it was an overnight success.

It all comes down to something called "optionality."

Netflix could have failed many times since 1997. Had the company never experimented with streaming, it likely would have faded away around the turn of the 2010s.

And if it had never launched its own production studio in 2009, it would have been blindsided when other media companies like Disney (DIS) and NBC pulled their titles off the platform and launched their own competing services.

But Netflix focused on its real competitive advantage – what we call a company's "genuine assets."

In short, knowing your customer is essential to succeeding in business. Once you know what your audience wants, you can use that edge to deliver more of those options... and bring in more customers.

And no one understands what folks want to watch better than Netflix...

The company has been studying customers' tastes since it began. When it was mailing out DVD rentals, it kept tabs on what customers ordered... and what they didn't. That helped it stock the best titles and save money on less-popular options.

And when it launched its streaming service, Netflix didn't have to guess. It used years of data from the DVD model to offer the best streaming content and attract the most customers.

When the big media houses left Netflix's platform, it was ready. It had spent years building its own studio to create content customers really wanted.

The competitive landscape is changing fast – not only across streaming, but plenty of other industries...

Companies never know when they might need to lean on their options.

Google parent Alphabet (GOOGL) is another great example of this. Google started as a revolutionary search engine in 1998. It allowed users to easily find information on the Internet.

The company became profitable by selling online advertising space and tapping into its vast pool of user data. But Google's success doesn't come from its original search-engine model.

As the company grew, it explored different avenues. It experimented and found new ways to harness its data assets... And it seized those opportunities.

Google added services like Google Maps, which transformed how we get around. The goal was to bring its search and advertising expertise to navigation.

It moved into language services with Google Translate. It already had a powerful understanding of how to catalog information around the world... And it used that to improve communication. It even entered the travel industry with Google Flights, an airline booking widget.

And all these ventures increased its ad business.

In 2015, Google combined all these ideas under one holding company – Alphabet. And many of Alphabet's pursuits follow the same pattern. The company uses its genuine assets – its user data – to continue growing.

That gives it plenty of optionality.

The benefits show up in the numbers. At Altimetry, we analyze a company's earnings based on Uniform Accounting. And as you can see, Alphabet's Uniform return on assets (''ROA'') has more than doubled the 12% corporate average for most of the past two decades...

Even at the start of the pandemic, when countless companies trimmed their advertising budgets, Alphabet's Uniform ROA stayed above 20%.

That's the power of knowing what you do best... and using it to create options.

Optionality reduces risks and fosters stability. Ultimately, it helps a business succeed for the long haul in a changing market.

In times of uncertainty, investors should focus on businesses with multiple revenue streams. You want to look for companies that know their own genuine assets... and understand how to turn them into profits.

This strategy is far less risky than relying solely on one core product or market. Companies with optionality are less likely to fail. And since they have plenty of ways to make money (and appease investors), their shares are likely to hold up well.

We may see a recession within the next year. So make sure you're investing in companies that prioritize optionality...

They're less likely to take a punch they can't recover from.


Rob Spivey

Editor's note: Even a bull market will have winners and losers... And Altimetry founder Joel Litman has a track record of highlighting the moves that count. He predicted the 2008 crash, the 2020 crash, and the energy run-up last year. Now, he's warning that a startling shake-up in U.S. stocks is underway – an event that has only happened twice in the past 15 years.

The last time this happened, it set up multiple opportunities for triple-digit gains. But it could cost you dearly if you're holding your money in the wrong place... Get the full details here.

Further Reading

"Crown jewel" businesses may show other kinds of flexibility and optionality. And with that advantage, they can sometimes generate unexpected assets – the kind that can grow profits for years to come... Learn more here.

If you're looking for investments that can survive a tough market – or an unpredictable economy – one quality stands out. This secret weapon is especially useful when inflation is high. But only dominant businesses with "sticky" customers can use it to their advantage... Read more here.