Seeking Alpha
Long/short equity, value, contrarian, special situations
Profile| Send Message| ()  

For those of you that have read my previous articles, you know that I am a value oriented investor and not a momentum guy, so for me to be writing an article about Netflix (NFLX) is a bit out of the ordinary. That being said, I am also a capitalist, and when a trade presents itself, I can't help myself but to act.

In 2013, the S&P 500 rose almost 30%, with Netflix leading the charge to help propel the index to such heights. Netflix ended the year up 271%. I have to admit, that kind of return in a year would make any head turn, even if the firm's fundamental metrics makes me want to run the other way. Netflix, much like Facebook (FB), Twitter (TWTR), and Amazon (AMZN), are growth companies, and investors are used to paying up for growth, even if the valuations are in the triple digits, which make a value guy like me sick to my stomach.

During the first full week of trading this year, Netflix was downgraded by Morgan Stanley on concerns that Netflix might have difficulty continuing to lead in the video streaming business due to growing competition from Amazon Prime, Hulu Plus, and HBO Go. Morgan stated that increased competition could lead to lower/slower subscriber growth and increased content costs which would weigh down on Netflix profits.

This downgrade of course resulted in a strong selloff in the stock. Netflix sold off some 8.5%, and now the stock has started the year off in the red. Given the number of shares currently short on this name, the number of perma-bears associated with this stock, and number of price estimates that continue to suggest pricing in the $65 - $80 per share range, it is no wonder that this stock sold off as violently as it did on a single downgrade. Not to mention, it was a downgrade that basically told the investor community something that everyone already knows.

This selloff has presented, in my opinion, an opportunity for an excellent trade. There are several factors that I have highlighted below that I believe create a compelling risk/reward trade in this name.

  • Short Covering: There are really two different types of shorts in Netflix right now. There are those that have been short the name for a very long time and continue to lose money as the stock continues to march higher. Then there are those that are new shorts that are currently trading to capitalize on the negative press and momentum. The latter are pushing a nice 10% return in a short period of time and most likely will close out their position by buying back their shares, resulting in the stock moving back up. The longer shorts have a decision to make here. Given that it is a new year, they can close out their losing position, take their nicks, and move on, which I believe some will do, or they can continue to hold out for their overly pessimistic price targets that most likely will not occur this year. I believe that there will be a high degree of covering that will occur in the next few weeks, helping to prop shares back up.
  • Mutual Funds/Institutional Investors: Netflix currently is the most popular stock in the index. It is widely understood by the masses, it is regularly used by the masses, and it continues to outperform every other index in the market. Thus, Netflix is a must own for any mutual fund that strives for growth or technology exposure. Mutual funds know that having this stock in their portfolio will not only help returns, but will also generate crowd appeal and demand for that fund. Retail investors love to own something that they know and understand, and Netflix is both of those things. Making the stock almost impervious to traditional downgrades, fundamentals, and logic.
  • The Trend is Your Friend: When I first started investing and trading about 12 years ago, I read in one of the many, many investing books that you read when you first start investing that the trend is your friend. I always thought that it was a bit of a funny play on words and was more of a blanket statement, but Netflix has proven time and time again that the trend is indeed your friend. It is foolish to try and go against the tide on this one. For that very reason, and just knowing the amount of positive momentum that is out there, Netflix really only has one place to go, and that is back up.

Given, the above mention reasons, I think it makes perfect sense to get long Netflix here at its current levels and ride the stock back up toward $400 a share, which given current price targets and technicals, should be the next logical resistance point for the stock. Buying the stock outright at these levels can be quite expensive and ultimately create the potential for larger loses, if my thesis happens to be wrong. I would suggest using call options to get long the stock here. Using the calls here helps keep the risk of the trade much more defined due to the limited amount needed to buy the call. Additionally, the upside is much higher when and if the stock does rebound, due to the leveraged nature of the calls.

Lastly, let me say that this recommendation is a trade to me and not a position that I would recommend holding longer term. I like Netflix's services (and use them myself), but unfortunately Netflix does not meet my longer term holding criteria. That still does not mean that I can't try to make a little money on the level of volatility that this stock generates.

Source: Does Netflix's Recent Downgrade Have A Silver Lining?