For almost two centuries, Spain has hosted an enormously popular Christmas lottery. Based on payout, it is the biggest lottery in the world and nearly all Spaniards play. In the mid 1970s, a Spanish man sought a ticket with the last two digits ending in 48. He found the ticket, bought it, and then won the lottery. When asked why he was so intent on finding that number, he replied, "I dreamed of the number seven for seven straight nights. And 7 times 7 is 48.
- Michael Mauboussin, 'How to think about Outcomes - Past, Present, Future'
When Netflix (NFLX) shares crashed last quarter, a friend of mine started buying the stock. When he mentioned it to me I told him I liked what he was doing as an aggressive trade, but that as a long-term investment he was wasting his time. The conversation could have stopped there, but my friend is no speculative trader and thus wanted to explain that in his mind Netflix was the future and that he would hold it for ten years and make 20x his money.
Now, I found this interesting because the one thing I felt I could certainly say about Netflix was that it wouldn't ever get the chance to be a stand alone organic growth story again. As far as I am concerned, the company will either be acquired or it will succumb to the inherent limitations in its business model. And for it to be acquired it would need to trade at an attractive enough valuation to make a premium suitor willing to step up. So, when I hear Mr. Tilson arguing:
But these are all much bigger companies, with 10x-100x Netflix's market cap, so if they wanted to make a serious push in this area, it would be logical for one of them to buy Netflix, rather than spend billions trying to dislodge it.
I start to wonder whether or not he appreciates what is going on. If you account for unexercised in the money options and the outstanding convertible bond, Netflix's market cap is closer to $8 billion. Assume a minimum 30% premium and you end up with a $10+ billion cost to acquire a company that generated a $180 million in non-gaap free cash flow last year, and whose free cash generating prospects are deteriorating. Furthermore, at a $10 billion valuation, Netflix's potential suitors are trading at 7x-20x with only Apple (AAPL) as an outlier at 43x. If you are Google (GOOG), Apple, or Amazon (AMZN) this is not a tough decision.
You have the platform, infrastructure, and global brand recognition in place so go spend your $10 billion on content. Because once you buy Netflix, you are going to find yourself competing with the other three major tech players on content, and not the niche companies Netflix is competing against today. Or even worse, you might discover you are not competing against these companies, and that your Netflix acquisition becomes the cable equivalent of acquiring the Starz network. Not the end of the world if you spent $2 billion dollars, but definitely a problem if you spent 5x that for something the content owners want to limit to a niche service.
Anyway, back to the story of my friend. He's an investor. He buys 'good' companies at 'cheap' prices and holds them for the 'long-term'. Suffice to say when someone tells me that I wonder if they have thought about how entertaining it is for those of us who eat, sleep, and digest markets to hear such a statement. But in markets you are always going to run into people who feel they have a 'system' down which pretty much covers just about everything. More often than not they have had success, and thus conclude that this past success validates that their system works.
So they seek to fit most, if not all, decisions they make in markets into their system. Then they will buy a new car, mansion, or whatever else they think their system will continue to produce for them in the markets. Regardless of what happens, they are probably not thinking too much about the fact that every company that ever filed for bankruptcy was at one point or another considered a 'good' company or that the words 'cheap' and 'long-term' have meant so many different things to so many different market participants over the years that their effective meaning in the investment world has been diluted to the point of rendering them useless.
But if you are someone who is professionally involved in markets, and who provides analysis/advice, you are destined to have a life filled with these conversations. See, there are few people out there that would sit down next to a vascular surgeon talking about a recent case, and then challenge him how he handled a ruptured aneurysm based on some article they have just read about heart surgery. Yet, there are plenty of people out there willing to dismiss even the most accomplished of market professionals solely based on the past success of their 'system'.
So, my friend buys the stock, and eventually the stock rallies. When it hits $100, I let him know that this is the point I would bail as risk/reward is now balanced and it is a good time to close this trade and start looking for a short opportunity. Of course he is wise and doesn't listen to me, and the stock pops another 20%. Then the next day he sends me this:
Am sure you have seen the latest Netflix numbers. Significantly better than I expected. Wait and watch where this business goes in 10 years.
Now when I get something like this I can't but help smile. I have not gone near the stock since late last summer, and I have not recommend that anyone else get short the stock since well before the Q3 collapse. As far as Netlfix is concerned, I am only paying attention to it because my friend has opened up the subject matter. But I am no Netflix slouch. I was regularly long the stock between 2004-2006 while I was simultaneously shorting the video rental chains. The stock was also my favorite pick in tech in early 2009 as I felt its model would thrive in a recession. Basically, I loved the stock and company until the transition to streaming became the whole story.
I was then quick to identify the major structural challenges ahead, and point out that the stock would never come close to filling the pair of shoes Wall Street had given them. Furthermore, the stock is still down 25% from where I first recommended shorting it, a good 50% from where it was when I personally chose to buy puts on it, and 60% from where I recommended to everyone on my distribution list that you could now short the stock and still be able to sleep soundly. Add in that I have read every 10-Q and 10-k they have filed over the last six years, and you will probably understand why I like to think I have put in the requisite time needed to speak confidently about this company.
Yet, here is my friend who just showed up to the Netflix party telling me that their numbers are significantly better than he expected. You might think my friend is moonlighting as a sell-side analyst, but he is not. He actually is a pretty smart entrepreneur. So where did these projections come from? Was he modeling domestic streaming content spend for Q4 or net free sub additions in his spare time? The easy answer to this question is he wasn't. Saying they did 'significantly better than I expected', sounds a lot smarter than just saying 'the damn thing keeps going up you fool'. Though I will say I prefer such a comment over the extensive tea leaf reading display exhibited by Mr. Tilson in his note to investors and the press. But better than expected? According to Mr. Tilson the earnings report convincingly proved Netlfix is back because "subscribers are flocking to" their streaming service again.
I am not sure what qualifies for flocking these days, but last quarter Netflix's streaming service lost 358k paid domestic subscribers. They also lost 2.77 million paid domestic DVD subscribers. Yet, they managed to add 15k total paid unique domestic subscribers. How does that happen? The answer is that most hybrid customers decided to ditch the DVD plan and trade down to streaming only. Not exactly what you would call awesome news. I am skeptical of the business model relative to the current share price, and I still expected them to add between 400k-500k unique paid subs this quarter. So these sub numbers are not something to get fundamentally excited about let alone to cite as evidence of Netflix's robust growth prospects.
In fact, if you break down the numbers pretty much everything came in line with their very tepid guidance except the contribution profit on domestic streaming. It is here were Netflix management obviously has the most accounting flexibility when it comes to content expensing, and thus most likely 'manufactured' a 'beat'. As for the headline sub growth, it came from adding 600k free subscribers (I've received a couple of offers from them over the past couple of months) in the quarter. Compare that to the last quarter in which Netflix shed roughly 400k free subs and you start to appreciate why some us who have followed the company for years got a kick out of the press and guys like Mr. Tilson celebrating this quarter.
But what is really interesting about Netflix is that the whole price increase/Qwikster debacle really has not done much damage to the domestic business. They lost a few hundred thousand paid subscribers, and are now viewed as a company that stumbled. But for those of us that remember the 2012 pre-stumble forecasts we can see how the earnings growth that was expected has not come close to materializing even if you back out international expansion costs. One does wonder what management's explanation would be for the lack of earnings growth if they were not expanding internationally and had not raised prices. But these quarterly results are not what interests me.
What if I told Mr. Tilson and my friend that the earnings were meaningless, and that right now the stock's rise has very little to do with anything other than a general tide sweeping through the market.
In the last month, all the dogs of 2011 have had some fantastic runs. Solar stocks are on tear, Sears Holding (SHLD) is soaring, LED is back, Unicredito is up over 60%, Greek bank stocks are doubling and tripling in a matter of a few weeks, and every speculative Chinese stock is on fire. When Renren (RENN) is up 90% and Dangdang (DANG) is up 100% in a month that tells you something about the market you are in. At the end of 2011 Renren was getting close to a negative enterprise value. Literally another couple percentages and you were better off shutting it down and redistributing the cash in the bank back to shareholders.
In fact, that is probably what they should still do as I see no future for their current model, but with over $1 billion in cash to play with don't hold your breath. This management team will probably wake up on a Tuesday morning and decide they want to invest in a hog farm or even worse buy a daily deal site, and there won't be anything you can do about it. Which is probably why the stock got so depressed that it traded down to cash value despite the company's relatively benign cash burn rate. But now that Facebook (FB) is on its way Renren is back in vogue.
This is very typical crowd behavior. Markets go through phases where buying the worst crap on the exchanges is the easiest and most lucrative way to make money. It is a sad and pathetic aspect of the game, but you can't deny it. But I assure you no self-respecting fund manager would ever come out and argue that he had a great quarter because he made some amazing long-term investments in Renren, Alpha Bank, Unicredito, Tudou, Sears, and DangDang.
Instead he'd probably say we bought some trash and were lucky enough to make some fast cash. Rallies like this remind me of the example of someone buying Fannie Mae (OTCQB:FNMA) shares at their November 2008 low of 30 cents. By July of 2009 that person would have made 7x their money despite no fundamental change in the underlying equities prospects of becoming worthless. However, if he didn't sell there he is not a happy camper today because Fannie shares are now trading a good 25% below his initial cost.
See, here is the thing. There are people out there always looking to pick a bottom in something and more than happy to make themselves some fast money buying any stock that has collapsed regardless of the underlying business. They buy hoping for a bounce. And if for whatever reason the bounce starts to happen plenty of greedy shorts who have been riding momentum in the other direction start to get nervous and cover their positions. This short covering causes the stock to go even higher. At which point many traders step in and buy the stock simply to profit off all the short covering. This causes the stock to go even higher which inflicts enough pain to get some of the even more longer-term fundamentally driven short sellers to cover.
Now the stock is in the middle of a pretty impressive move, and it starts to attract the turnaround guys who believe this move is indicative of a recovery. They are followed by the momentum guys who now conclude the trend is up and worth riding for a few ticks. And if you are really lucky you will also suck in the people who were long the stock before it collapsed, and who now view this rally as a sign that they were right and just got the timing wrong. Meanwhile, the people who were confidently telling you to short the stock at $10 are now telling you at $20 that you need to be careful as the market is being crazy and could push this stock back to its bubble high of $100. Love it or hate it, this is the market.
It is just like the technician who tells you that you should buy a stock at support, that is, unless support breaks down - then you should sell it. You may think he is really saying nothing at all, but since a lot of people are thinking like him you need to acknowledge the fact that these knuckleheads will actually buy a stock you might be shorting at what they think is support. And that when they all collectively do this the stock you are short will rise simply because those reading lines, which takes a lot less time than actually understanding what the hell xyz does and more importantly what most likely will happen to xyz over the next year, far outnumber those individuals who might understand what is going on with xyz.
And then when xyz bounces computers will step in and play that momentum. And then momentum traders will step in and follow the computers. And while all this is going on, you have the ETFs out there simply trying to keep up. This all continues until some tangible new information on xyz or the economy disrupts it or until enough of the participants in this chain get a little nervous about the fact that this move has persisted for so long.
The easy way to sum this up is that markets are not rational, and thus at times make no sense. But if you truly appreciate the animal - that is the market - it all starts to make perfect sense, and you will find order in this madness. Why are the worst possible investments of the last 52 weeks stocks that are still all down over 50%, the greatest trades of the past four weeks? It is crazy to think there are people out there buying companies that they believe are the most doomed long-term just because they think that will be the fastest way to generate outsized returns at the start of the year, but that is what it is happening. Now, this may not make sense to most people, but hang around the market long enough and it starts to make sense if you see it for the way it is.
The conversations tend to go a little something like this:
Investor: Listen, this Dubai World situation is going to get resolved and I think the UAE market will rally on the news. I am going to buy some Emaar and NBAD. What do you think?
Me: Why waste your time, buy UPP and Deyaar instead.
Investor: UPP? You've been telling me to avoid that company at all costs from the moment I met you. Now you want me to buy it?
Me: Yep, and I have not changed my mind on that. If the law existed to facilitate a restructuring, UPP would have taken advantage of it by now. Fundamentally, I see no value in the shares, but I recommend you buy as much as you can.
Investor: That's crazy. If you see no value and the stock is trading at a market cap of $600 million why would I buy it?
Me: Because if you are confident on your prediction on Dubai World that is what everyone else will end up doing, and in that short time period you will do very well.
Investor: How do you stay sane?
Me: Whoever said I was sane?
It takes a big man to look around the market and realize that there is something very suspect about the company he is keeping when he is having great success. A Netflix long simply needs to look around him to realize there is nothing unique about the move in his share price. Every single bad apple of 2011 has experienced similar success. In fact, the extent of the success experienced thus far is inversely related to the amount of misery experienced last year. The outcome may be nice, but as far as I can tell the reasoning leaves much to be desired. And I for one don't celebrate outcomes no matter how impressive they are if the reasoning behind them makes no sense.
If the best way for me to replicate your returns is to try and construct a portfolio of companies whose equity I think will in the long run retain little to no value, you might want to wait a little longer before you take your victory lap on your investment. Now come to me and say I am going to long the Greek banks because the debt haircut is going to be better than expected, long Sears Holding because the short interest is through the roof and it's set up for a fantastic squeeze, and long anything Web 2.0 that was down over 60% in 2011 ahead of the Facebook IPO mania and I will congratulate you on being one cold calculating trader.
Heck, I will probably even join you in the trade, but don't expect me to start advocating that Dryships (DRYS), MGM, Alpha Bank, DangDang, Youku (YOKU), Renren, Sears, Barnes and Noble (BKS), American Airlines, and Fannie Mae are fundamentally attractive equity investments.