Seeking Alpha
Recommended for you:
, Think Finance (804 clicks)
Long/short equity, arbitrage, event-driven, research analyst
Profile| Send Message|
( followers)  

Today, TheStreet.com had an article by Jim Cramer titled "Cramer: You Buy Netflix for One Reason". In this article, Jim Cramer explains how investors - or more aptly, speculators - have diverged from focusing on Netflix (NASDAQ:NFLX) earnings. Jim Cramer explains that for now, only subscriber numbers matter. If they're above expectations, you buy. If they're below, you sell.

All fine and dandy. But the really interesting stuff came at the very end of that article. This is how Jim Cramer closes it (bold is mine):

Yes, it does feel like 2003. Yes, this has become the ultimate caveat emptor stock. But yes, because of the way momentum investors evaluate stock, this one's good until its bad, it soars until it crashes. Remember, there are always a couple like this in the stock market, except this one's lasted far longer than most. Now that it is too big to be taken over by almost anyone, as opposed to when I wanted Apple AAPL to buy it for $12 billion, you buy the stock for once reason: because someone will buy it at a higher price than you.

What is wrong here? Well, that last phrase is the very definition of the "Greater fool theory". This is how that theory is defined (Source: Wikipedia, bold is mine):

The greater fool theory describes a situation where the price of an object is not be driven by intrinsic values, but by expectations that irrational bidders for limited assets or commodities, will set the price. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price. Or one may rationally have the expectation that the item can be resold to a "greater fool" later.

As we can see, this is the exact same definition. Jim Cramer basically said that when it comes to Netflix, "the greater fool theory" is in play. I agree, but this has consequences.

Consequences

Sometimes the market is seen as a "zero sum" game. For some to win, some others have to lose. Such is not true. Since companies produce earnings, it is possible for every long to win, as long as their winnings come from those earnings.

But that dynamic breaks down once the greater fool theory takes hold. Here, the winnings of some will be the losses of others, because:

  • The company's profits cannot possibly justify the market capitalization, now or in the future;
  • The shares do not disappear at the top of the market. Someone must forcibly be holding the shares on the way down, and that "someone" will be chosen from amongst those willing to participate. There's a reason why the theory is that of the "greater fool".

Worse still, when an irrational pyramid gets built, the losses will exceed the winnings even if the collapse is arrested at the starting point. Why does this happen? This happens because on the way up, the free float increases. It increases due to sales by insiders and sales of equity by the company itself. So more people must be holding stock when it goes down, than when it goes up. There is a slight exception here - if short interest is lower on the way down than it was on the way up, some of the losses are borne by short sellers.

Still, overall what this means is that participating in bubbles (that's what the greater fool theory describes) is a losing strategy overall. Much like buying lottery tickets is a losing strategy. Sure, there are sometimes winners and it's the existence of those that keeps others coming back to try their luck as well. But over time, buying bubbles should lead to sub-par returns.

Conclusion

Willingly or not, Jim Cramer described those that buy Netflix as playing the greater fool game. Here, I explained why doing so is a long-term losing strategy.

Source: Cramer Expounds The Greater Fool Theory On Netflix