Deconstructing Pop Culture

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Quantification of Investment Risk in Single-Purpose Companies

February 7th, 2007 by David Kronemyer · No Comments

For some time I have believed single-purpose companies in the entertainment industry are far riskier than any other type of firm, or combination of firms. By “single-purpose company,” I mean those doing one thing, for example, releasing movies, or records. I hypothesized these ventures particularly were risky, because they uniquely are subject to the whims and vicissitudes of public taste. Further, they lack the covariance, or even counter-cyclicality, provided by other corporate operating divisions.

Sony Pictures Entertainment Inc., and Sony BMG Music Entertainment, for example, both are subsidiaries of Sony Corporation of America, which in turn is a subsidiary of Sony Corporation. Sony’s other business interests include manufacturing audio, video, communications, and information technology products. It also has a computer entertainment and online business.

NBC Universal is 80% owned by General Electric and 20% owned by Vivendi. General Electric, with which NBC Universal consolidates, is one of the largest and most diversified industrial corporations in the world. Its products include everything from electrical distribution and control equipment to locomotives and jet engines.

Universal Music Group, which formerly was affiliated with Universal Pictures, still is owned by Vivendi, which also owns (among other assets) Groupe Canal+, a leading producer of pay-TV channels in France; and, SFR, the number two mobile telecommunications operator in France.

Because of the diversification of their various operating units, these companies fundamentally are unlike Warner Music Group, formerly a division of Time Warner; and DreamWorks Animation SKG, formerly a division of DreamWorks SKG, now owned by Viacom.

All Warner Music Group does is put out albums by recording artists signed to the label, and manage various other music-related assets, such as digital applications and music publishing. WMG therefore is subject to, for example, the delivery schedules of its mercurial and idiosyncratic recording artists. All DreamWorks Animation does is release animated movies. DWA therefore is subject to, for example, the dynamics and exigencies of the movie production process. Both firms lack other divisions to dynamically buffer, or insulate, these businesses.

A good illustration is what happened to DWA. When it announced DVD sales of “Shrek 2” and “Shark Tale” were less than expected, thus its earnings would be lower, its shares tumbled 13.2%, Fabrikant, G., “Animator Warns On Profit,” New York Times (Jul. 12, 2005).

Is there a way to quantify this risk, and compare it with a blended portfolio comprising, say, the Dow Jones Industrial Average (“DJIA”), or the Standard and Poor’s 500 Index (“SP500”)? As early as 1984, a colleague and I devised a measure we called the “risk-return index” (“RRI”). While this certainly was original work, we made no claim of priority; indeed, at the time we believed it was inevitable others had made use of the concept earlier, because it was so stupidly simple. Others have taken credit for it, since, and made it sound like one of the greatest inventions in the history of financial analysis.

To calculate RRI, first pick a sample period. Then, calculate mean (“m”) results over the period. Then, calculate standard deviation (“std”) of results over the same period. Because they’re derived from the range of the sample, these numbers can’t be compared with other data. To make them comparable, simply express them as a ratio: std/m. The result, RRI, is a reasonably good proxy for volatility, or riskiness, over the sample period.

Here’s how to put this into practice. I established a sample period from May 11, 2005 (the date of WMG’s IPO) to February 2, 2007 (the date of this note). I then downloaded closing prices for DJIA, SP500, WMG and DWA over the same period. I then calculated both m and std for all four series; and, RRI. Here are the results:

DW
std: 2.62
mean: 25.85
RRI: 10.12%

WMG
std: 4.08
mean: 21.47
RRI: 19.00%

SP500
std: 68.70
mean: 1279.74
std: 5.37%

DJIA
std: 648.58
mean: 11121.55
std: 5.83%

Because it is the broadest average, it isn’t surprising the SP500 was the least risky. Because the companies it represents comprise such a great volume of activity, it also isn’t surprising the DJIA only is slightly riskier. In comparison, both DW and WMG are considerably more risky – at least twice as risky, in the case of DW, and almost four times as risky, in the case of WMG. The reason for this riskiness can be attributed to the factors we earlier identified> I was surprised by how much riskier WMG is, in comparison with DWA. This means the market assesses the risk DreamWorks will make crappy movies, as less than the risk the record business is tanking. Since much of DreamWorks’ results are driven by DVD sales, another way of looking at this is, DVD sales still have some mileage left in them; whereas, for record companies, CD sales are plummeting, at a time when digital downloads haven’t yet made up the difference.

There are several variations to this approach. For example, if riskiness is less important than price, then std can be discounted by the applicable percentage. It’s also possible to analyze individual stocks on a quarterly basis, then discern the movement of each stock’s RRI – not only against prior periods, but also vis-à-vis competitor firms, or other industry groups, or the components of those groups.

In conclusion, my hypothesis that stocks of single-purpose entertainment-industry companies are riskier than broader averages was supported by the data and approach utilized in this brief note.