How I snatched an ultimate defeat from the jaws of victory with Netflix

Sure, a setup in Netflix (NFLX) more than a decade ago created one of the greatest investment opportunities of my lifetime...

But you might be surprised to learn that I made a colossal mistake that probably prevented me from comfortably retiring and sipping piña coladas on a beach somewhere.

Today, I'll finish the Netflix story where I left off in yesterday's e-mail. But to quickly recap, in that e-mail I explained how I came to make what should have been the best investment in my career – buying NFLX shares below $10 (split adjusted) in late 2011 after they had fallen 75% in the wake of the Qwikster debacle.

After the stock traded in a range for the next year, it finally bottomed at $7.78 per share by October 1, 2012.

That day, I had pitched it as my favorite idea to the 500 attendees of my Value Investing Congress (you can see the slides I presented here). And immediately afterward, I appeared on national television on CNBC to pound the table on it.

By the end of 2012, the stock had soared to more than $13 per share and was a 5.4% position in my roughly $100 million fund.

Shortly thereafter, the stock really took off... and has gone on to be one of the greatest performers of all time.

From the low of $7.78 per share when I pounded the table on it, it rose more than 90 times in less than nine years to more than $700 per share intraday by late 2021. And even after a big pullback in 2022, the stock has nearly fully recovered – closing yesterday at $644.50.

Take a look at the incredible move higher...

As the stock doubled and then doubled again in 2013 – soaring to more than $50 per share by the end of the year – I had a high-class problem: a 5% position was ballooning in size.

So what's the right move in this situation?

The answer is that it depends on a number of factors – the most important of which is valuation.

If you buy a stock for $10 per share that you think is worth approximately $20 per share, and the stock quickly rises to $20 per share without any change to your estimate of its intrinsic value – meaning it's now fully valued – it's probably a good idea to sell at least half of your position.

But this wasn't the case with Netflix...

In my October 1, 2012 presentation, I acknowledged that the stock was difficult to value. But I showed that it was extremely cheap based on a widely used valuation metric for subscription-based businesses like Netflix, cable companies, cell phone companies, etc.: enterprise value ("EV") per paying subscriber.

At the time of my presentation, the company had a market cap of about $3.2 billion and roughly $400 million in cash and no debt – giving it an EV of about $2.8 billion. It had 28.3 million paying subscribers, so if you divided these two numbers, Netflix was trading at $99 per subscriber.

At the time, cable and cell phone companies were trading at $1,000 or more per subscriber... but those are very different businesses, so I decided not to make this comparison.

But there was one perfect comp, which I highlighted in my presentation at the Value Investing Congress:

In April, Disney and News Corp. bought the 10% of Hulu owned by Providence Equity Partners for $200 million in cash, valuing the business at $2 billion – and each of Hulu's 2 million paid subscribers at $1,000.

In other words, in a cash transaction involving sophisticated players, a far inferior business to Netflix was valued at 10 times the per-subscriber value of Netflix.

Assuming this is a valid way to value to company – which it was (and I knew it was) – the answer to the question above is very different.

What should you do if you own a 10-cent dollar and it quickly doubles?

At the very least, hold on – and, if you're really smart, buy more!

So what did I do when Netflix first doubled in early 2013 to around $15 per share? And then when it doubled again later in the year? I sold another half.

By February 2014, with the stock at $58 per share, one of my smartest friends – a well-respected short seller – e-mailed me to tell me he was short the stock and asked me to justify continuing to hold it. As I replied:

Well, I still own it. But not with huge amounts of conviction. It's in the 3-4% range, which is where it's been pretty much the entire time I've owned it.

When I bought it in the $8-10 range, I said it's nearly impossible to value, but there's a lot of open-ended upside optionality. To the company's credit, it's executed superbly and the extreme upside scenario of a $50-$100B market cap in 5-10 years is no longer as remote as it once was.

And as I continued:

Netflix is an insanely great business with a light business model and a huge moat – I think it could end up being a global winner-take-all business. If so, a $22B market cap and [multiple of] 5.3x sales will prove to be really cheap.

But even if you don't buy any of this, with so many crappy companies out there with far worse business models trading at even higher valuations, why short Netflix?

I don't think I would own it today if I didn't have a very high-beta short book. But anyone short this is nuts [in my opinion].

A few months later in July, with the stock at $62 per share, I had another e-mail exchange with another bear, Wedbush analyst Michael Pachter. As he wrote:

I talk to absolutely everyone who owns in size, and confidence is beginning to waver. I think WHEN it goes down, it's going down hard.

The big thing to me is cash flow. It can't lag net income forever, so it's a growing issue. The action that will take it lower is competition from Amazon, which I am convinced is happening this year. Amazon is spending $2 billion on content annually, including $350 million annually for the most recent HBO exclusive. Ask yourself why they obtained an exclusive – it must be because they intend to beef up Prime Instant Video, and I think they intend to offer a standalone plan.

In response, I wrote:

It's such a small position for me that I don't stress about it too much anymore. I like to let my winners run as long as the story is intact and just manage the position size.

The stock already went down hard in March and April – more than 30% – and then rebounded by more than 50% just as quickly – go figure.

And then I turned to cash flow:

I'm looking at the cash flow tab of the spreadsheet the company released and fail to see the warning flag. The company has been operating and free cash flow positive for the last five quarters and has actually been up year-over-year for each of those quarters, so what's the problem?

Yes, it's tiny, but that's a deliberate decision by the company. 2-3 years ago, they decided to forego current profitability, and try to get very big, very fast, everywhere in the world in an attempt to dominate the streaming area by getting into a virtuous cycle whereby they get the lion's share (80%?) of all new paying subscribers and then use those billions of dollars coming in to buy/build more and better content (and fuel subscriber growth), which in turn attracts the lion's share of new subs.

Lather, rinse, repeat. It was an incredibly bold, bet-the-company, burn-the-boats bet – and by every indication it's paying off big time.

In response to his concerns about emerging competition from Amazon (AMZN), I wrote:

I hear you on Amazon – I'm shocked, frankly, at how much money they're willing to piss away in what, by every measure I can see, has been so far a completely futile attempt to scale up and become a meaningful competitor to Netflix.

After how many years and billions of investment, they don't have ONE PAYING CUSTOMER! That's pretty remarkable. Don't get me wrong – I love my Amazon Prime and didn't blink when they raised their rate from $79 to $99, but that had nothing to do with the streaming video. It's a nice bonus that I occasionally use, but if it went away – or they tried to charge me anything extra for it – I'd likely drop it in a heartbeat.

As I concluded:

Yes, the valuation is stretched and hard to justify – which is why I've been banking a lot of profits – but I think Netflix could be MASSIVELY larger and more profitable in ten years, which would result in a market cap MUCH higher than today's $27 billion.

I totally understand investors who don't want to be long it here – but this is a BAD short. There are SO many other better shorts.

Gosh, it's painful to read these e-mails – I had the story exactly right.

Netflix was firing on all cylinders and performing far better than I ever could have dreamed of when I bought the stock: It was developing hit original content, rolling out its service around the world, subscriber numbers were soaring, and it was raising prices.

So even though the stock had run up eight times in less than two years, it was still insanely cheap and was about to soar another 11 times in the next seven years.

The closest analogy I can think of today is Nvidia (NVDA), but there's a huge difference...

In July 2014, Netflix still only had a tiny market cap of less than $30 billion, only 1% of Nvidia's $3 trillion market cap today, meaning it had far more room to run.

And keep in mind that Netflix was still trading at a huge discount to Hulu, based on an EV-to-subscriber basis.

Despite all of this, I lost my nerve, told myself I didn't want to be greedy (wrong – to be a successful investor, you must be greedy in the right situations!), and sold the last of my Netflix stock soon thereafter.

So what are the lessons here?

I don't beat myself up for trimming the position modestly. It would have been terrible risk management to let such a richly valued, speculative stock become 20% of my portfolio – let's be clear, this was never something safe like Berkshire Hathaway (BRK-B), which could be 50% of my net worth and I wouldn't lose a wink of sleep.

But I was far too conservative deciding to keep the position size in the 3% to 5% range, given how cheap it was on an EV-to-subscriber basis during nearly the entire run-up.

Instead, I should have kept it in the 8% to 10% range.

I struggle to explain the biggest mistake: selling entirely.

I instead should have put in a trailing stop loss – perhaps 30% – and let the position run and run and run...

To repeat what I said yesterday, you must have the courage of your convictions, even if other analysts and investors – including one of the people you most respect – are taking the opposite side of the trade.

Most importantly – and forgive me for being a broken record – but the key to long-term investment success isn't just being smart – and lucky – enough to own a few huge winners. You must let your winners run.

Looking at the math behind long-term investment success, take any portfolio of 20 stocks or more, and you'll see that it isn't usually driven by a high batting average (e.g., 80% of the stocks go up), but a high slugging percentage (a few huge winners) instead.

But of course, this math doesn't work if you sell those winners – that cuts off the long right tail of the distribution.

As an investor, you could maybe sell 10% of a monster position if it has become so oversized that it's disrupting your sleep at night. And you could put in stop losses to protect half of your gains – for example, sell 10% if the stock drops 10%, another 10% if it falls another 10%, etc.

But keep in mind that there's no "right" answer here... It's more art than science.

However, don't make the mistake of taking all your gains just because a stock doubles.

I'll say it again (and I'll keep saying it!): You have to let your winners run.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.