Netflix Bears: Right in Theory but Still Losing Money

Feb.18.11 | About: Netflix, Inc. (NFLX)

The recent excitement over the mercurial rise of Netflix (NASDAQ:NFLX) and other high-flying momentum stocks brings back a lot of unpleasant personal memories.

As I have a naturally skeptical personality, I always tend to focus on the risks and downsides of any potential investment, and demand a decent margin of safety before investing in anything. However, during raging bull markets such as this current one, the traditional value-investing framework is thrown aside. Invariably, we value investors are labeled dinosaurs and growth stocks continue stoically marching higher with each passing day, with only a tangential connection to fundamentals. Every three months, management of these growth companies magically manage to beat on earnings, and their stocks gap up to new heights without looking back.

I became painfully aware of this phenomenon in 2007 during the last great bull market. I've been an interested market watcher since 1999, but 2006-7 was the first real late-stage out-of-control bull market I took part in. In late 2006, I abandoned all hope of finding reasonably-priced companies to purchase at acceptable valuations and moved aggressively into oil and gold, as there wasn't anything else left to buy that fit my investing framework.

But this wasn't enough to satisfy me. By early 2007, having recently been motivated by a recent reading of Benjamin Graham and David Dodd's writings on value investing, I declared the entire stock market to be widely overvalued and started buying puts left and right.

But my targets, naïvely, were Jim Cramer's so-called “Four Horsemen” of the great tech market boom. These four -- Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG), Research In Motion (RIMM), and Apple (NASDAQ:AAPL) -- continued to soar with each passing quarter, disconnecting farther and farther from any connection to their much lower true value. It was obvious; these stocks just had to go down. Every time CNBC pumped these four stocks, I became more convinced that I was correct. Graham and Dodd wouldn't let me down, right? I knew for a fact that these companies were widely overvalued and they were, at best, “priced for perfection.”

And so, nearly every month, I rolled profits from my successful positions in commodities into puts on either a technology ETF such as the Powershares QQQ trust (QQQQ) or directly into puts on the individual horsemen. 2007 was, as a result, a lost year for my investing. From the time I shifted into heavily bearish positions, the S&P rose merely 40 points more to its all-time high and closed the year in the beginnings of a slump; however, the Nasdaq, as defined by the QQQQ, surged another 20%, and momentum stocks I'd bet against, such as Research In Motion, doubled.

I've had few investing heartaches greater than watching the financial sector continuously tank throughout 2007, as I'd predicted, while my own short positions lost value because Amazon or Apple had magically blown out its latest quarterly results yet again. The more vulnerable sectors, such as financials, industrials, and homebuilders, had already shed more than a third of their value by the summer of 2008, when the tech sector and the “Four Horsemen” finally started their long-overdue swan dive. By then, it was far too late for my beleaguered put positions.

I bring this up as a caution for all tempted to short the high-flying momentum stocks of this latest bull market. As I learned the hard way, there is no valor in shorting the momentum names as they continue surging higher. No one will give you a medal for having shorted the top. There's no awards ceremony for the bears that held out the longest in the face of high-powered short squeezes and CNBC's bloviating. All too frequently, these momentum stocks turn into religious battlegrounds, with longs claiming their beloved company will change the world and shorts having faith that the market will snap out of its stupor and learn to read a balance sheet. Both of these intellectual positions make for stupid investing strategy. The market won't revalue a stock because you have a logical Excel model.

Presently, Netflix (NFLX) is wildly overvalued. With a forward P/E of 40, for the stock to rise, you're having to bet that the company will continue to grow earnings at absurd rates for many years while not coming under cost pressure from the media providers, other competitors such as Coinstar (NASDAQ:CSTR), which announced a new streaming competitor just this week, or from the Internet service providers who have to be rather annoyed at the amount of bandwidth Netflix is sucking up. Customers are fickle and there's little moat.

Netflix bears have a wonderful academic argument -- but their timing is entirely wrong. Netflix is not trading on fundamentals anymore. It is a gambling vehicle that swings up and down on the fluctuations of crowd psychology. There is a whole class of these momentum stocks whose share prices are determined by the daily mood swings of gamblers rather than the allegedly efficient market.

When you bring up a stock quote page on Yahoo (NASDAQ:YHOO), it displays a dialog saying “People viewing [ticker] also viewed:”. For most companies, the also-viewed tickers are close competitors within the industry. For example, my recent query showed that people who viewed Marathon Oil (NYSE:MRO) also viewed Conoco-Philips (NYSE:COP), Exxon (NYSE:XOM), Chevron (NYSE:CVX), BP, Occidental Petroleum (NYSE:OXY), and Chesapeake Energy (NYSE:CHK).

This is the case for almost all companies I've searched for on Yahoo. However, let's type in Netflix. It's also-viewed tickers include Amazon, Chipotle (NYSE:CMG), Priceline.com (NASDAQ:PCLN), Baidu (NASDAQ:BIDU), Apple, and F5 Networks (NASDAQ:FFIV). Obviously, these companies are not alike in many ways. Their common thread, however, is that they all have wildly overpriced shares that have soared in the momentum of the latest bull market, and as such have become the go-to names for retail investors wanting to gamble on a high-flyer.

While most, if not all, of these momentum stocks will crash during the next bear market, there's absolutely no reason to short them now. Just as I suffered large losses shorting the overvalued and overhyped “Four Horsemen” in 2007, value-minded investors have gotten killed shorting these new momentum stocks for the past couple quarters. And if history is any guide, these priced-for-perfection (and then some) stocks will be the last to tank when this bull market inevitably expires.

While there's no need to be actively trying to find short ideas during the blow-off stage of a gigantic bull market, if you must take short positions (for example if you run a 130/30 hedge fund), don't short momentum stocks until they crack on a bad earnings report. In 2007 and 2008, it became safe to short the momentum stocks only after they had missed on an earnings report. My personal target of contempt among the “Four Horsemen,” Research In Motion, stayed wildly overpriced until it missed on earnings by a single penny in June of 2008. It then gapped down 10% the next day and proceeded to relentlessly drop another 70% by the spring of 2009. My academic valuation argument was right; my timing was all wrong.

All these momentum names, led by Netflix, will eventually miss their earnings projection one quarter, lose their sheen of invincibility, and most likely drop 50% or more. But there's no need to rush your short entry. For today and the forseeable future, the short squeezes will continue as gamblers and momentum traders keep reaching for new 52-week highs. There's no award for shorting the top. Don't make the mistake I did and start shorting before the bear emerges from hibernation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.