Why I made the big call to cover my Netflix short; My speech in New York City this coming Wednesday

1) In a company response to a short-selling thesis, you would be hard-pressed to see one that called the short seller "a great investor and a wonderful human being."

In fact, out of all the ones I've seen over the past two decades, I only recall one with that kind of language.

It was from Netflix's (NFLX) then-CEO Reed Hastings personally... and it was directed at me.

I'm glad he did it – otherwise, one of the biggest winners of my career might have ended up as one of my biggest losers...

"Whitney Tilson: Cover Your Short Position. Now" was the headline of an article that Reed (I use his first name because I know him personally) posted publicly on Seeking Alpha on December 20, 2010.

It was in response to an article I had published four days earlier about my hedge fund's short position in Netflix: Why We're Short Netflix. In it, I wrote:

Our favorite shorts generally involve some or all of the following characteristics: outright frauds (our very favorite), industries in decline or facing major headwinds, lousy or faddish business models, bad balance sheets, and incompetent, excessively promotional and/or crooked management.

In general, we prefer to short businesses with these traits, even when their stocks trade at seemingly low valuation multiples, rather than shorting the stocks of good businesses with strong managements, even at high valuations.

Sometimes, however, the valuations become so extreme that we will short the latter, but generally only when we believe there is a catalyst that will impact the company and cause the stock to fall.

As I explained, Netflix had fallen into the latter category:

We acknowledge that the company offers a useful, attractively-priced service to customers, is growing like wildfire, is very well managed, and has a strong balance sheet.

So why on earth would we be betting against this stock?

In short, because we think the valuation is extreme and that the rapid shift of its customers to streaming content (vs. mailing DVDs to customers) isn't the beginning of an exciting, highly-profitable new world for Netflix, but rather the beginning of the end of its incredible run. In particular, we think margins will be severely compressed and growth will slow over the next year.

I had shorted the stock earlier that year at around $11 per share ($80 per share at the time, but it has since split 7:1) and had seen it more than double to $26 per share.

This big move higher had naturally cost me a lot of money and was weighing on my mind.

Was I wrong? Or was I just early?

The answer to that question determine if I held on, added to my position, or exited.

As I always do when a stock is running against me – see my previous three e-mails for case studies of the A-class shares of Berkshire Hathaway (BRK-A), McDonald's (MCD), and CKE Restaurants – I put aside my feelings of pain and regret, cleared my mind, and took a fresh look at the company.

In particular, I looked at my short thesis and asked myself if I had missed anything. That meant doing some extra leg work.

My experience with Netflix is an excellent example of why it's critical to always gather more and more information on your investments.

In particular, you must avoid "commitment bias," whereby you block out anything that's contrary to your thesis. This is a natural human tendency, so you need to make a conscious effort to (as the saying goes) be prepared to change your mind when the facts change. It makes all the difference in avoiding big losses and it can even uncover new opportunities...

At the time I was short Netflix, the company wasn't doing anything fraudulent or illegal. I didn't have anything bad to say about Reed. These are two keys I look for in companies when I bet against the stock.

I just thought Netflix was wildly overvalued. And it faced a lot headwinds – most notably increased competition, weak streaming content, and market saturation.

But in the nine months I had been short the stock, Netflix's revenue and operating income had risen by 25% and 31%, respectively. And the stock had run up 125%. So both the company's performance and the market were telling me I had made a big mistake.

As such, I decided to publish the details of my short thesis. I hoped that my friends and readers would poke holes in it.

I didn't expect the CEO himself to do the hole poking...

A company responding to a short seller wasn't that unusual, even back then, before activist short reports were the near-daily occurrence that they are today.

A company usually just issues a press release full of vague denials about the short-seller's claims and accusing them of spreading lies and engaging in market manipulation to make a quick profit...

But Reed's tone shocked me. Rather than attacking me, he praised me! As I said earlier, I don't recall a single other one that called the short seller "a great investor and a wonderful human being."

I had met Reed briefly because of our shared passion (which for both of us continues to this day) for improving public education for disadvantaged children.

Our paths had crossed at an event hosted by the KIPP Foundation, which funds a national network of charter schools. Reed served on the national board, and I was on the New York one. He referenced this in the two opening paragraphs of his response:

A great investor and a wonderful human being, Whitney Tilson recently posted an article about why he is short Netflix. Whitney, who is a major co-donor with me to charter public schools like KIPP, writes that he has lost money betting against Netflix, and that he is still short Netflix in a big way.

At Netflix we mostly focus on building our business and letting the numbers do the talking. But Whitney is such a big-hearted donor to causes that I care about that I am writing this open letter for him to try to get him to cover his short now. My desire is to increase his odds of making money next year so he can donate even more to the charter public schools that we both think are important to our country's future. For the record, I think short sellers are a positive force in capitalism, and I acknowledge that CEOs are generally biased in their bullishness on their respective firms.

Then, instead of just dismissing everything I had written about Netflix as wrong, he carefully and dispassionately addressed every pillar of my thesis. He acknowledged the stock's high valuation, invited me to meet with him, and called himself my "ally and admirer":

To wrap up, I have to agree with my friend Whitney that there are many risks ahead for Netflix, that our valuation is substantial, and that it is possible that one could make money shorting Netflix today. But shorting a market leading firm as it is driving a huge new market is a very gutsy call. On balance, I would rather have my co-philanthropists on the long side of this particular bet.

Whitney: Short or long, I look forward to dinner and drinks together in the New Year.

Respectfully, your ally and admirer,

– Reed

You might think I would cover my short immediately after reading his response. I didn't...

But I did want to learn more... so I e-mailed him to take him up on his offer to meet. We arranged to have brunch near his home in the San Francisco Bay Area.

We sat outside under some trees at a popular local eatery. I was dressed up in my usual hedge-fund business casual attire, while Reed rode in on his bike – dressed in a T-shirt, shorts, and sandals.

Over the course of a couple of hours, we got to know each other and found many commonalities beyond KIPP and education reform.

We had both gone to private school in Massachusetts… Reed's first job out of college was serving in the Peace Corps, teaching math to high school students in Swaziland (now called Eswatini) from 1983 to 1985... My parents met while working for the Peace Corps... My first job out of college was helping start Teach for America from 1989 to 1990... We both spent time hitchhiking across Africa living on a few dollars a day.

Eventually we started talking about Netflix...

Reed knew my critique, so I mostly asked questions and listened as he talked about the culture of the company and his vision for Netflix's streaming service.

It had launched in 2007 as a free add-on for the subscribers to Netflix's core DVD-by-mail business, and four years later it was still in such an early stage that Netflix was still giving it away.

But Reed was bullish on its potential. He knew customers preferred to access content instantly on all of their devices rather than waiting for a DVD to arrive days later and being restricted to watching on a TV.

He also discussed his goals to develop original content and expand internationally.

Reed didn't share anything that wasn't already public knowledge, but both he and his vision were so impressive and compelling that I finally realized that shorting Netflix was a terrible idea.

So I covered the position the next day and publicly admitted that I had been wrong – publishing this article on Seeking Alpha on February 11, 2011: Why We Covered Our Netflix Short. In it, I wrote:

In mid-December, we published a lengthy article on why Netflix was our largest bearish bet at the time. With the stock up nearly 25% since then, one might assume that we'd think it's an even better short today, but in fact we have closed out our position because we are no longer confident that our investment thesis is correct.

I then explained the three primary reasons behind the decision. A strong quarter had weakened key pillars of our thesis, especially questions about its margins. In addition, I note that a survey of more than 500 Netflix subscribers showed significantly higher satisfaction with and usage of Netflix's streaming service than we anticipated. And the feedback to my article – including Reed's open letter – caused us to question a number of our assumptions. And in summary, as I explained:

[We] now believe that it is an even better business than we gave it credit for. The company has enormous momentum and substantial optionality (for example, international growth), and management is executing superbly.

In particular, we tip our hat to Reed Hastings, whom we had the pleasure of meeting last weekend. In addition to his success building the business and navigating the transition from DVD-by-mail to streaming media, he's also one of the most down-to-earth, honest and straightforward CEOs we've ever encountered.

To be clear, in covering our short and writing favorable things about Netflix in this article, we are not recommending purchase of the stock. Many things will have to go very right for the company to justify its current market valuation, but we no longer think it's wise to bet against Netflix.

It was initially a great call... The stock, then at $33 per share, rose to a high of $43 per share by July. "Phew," I thought to myself... "Dodged a bullet!"

The lessons here are similar to the ones I outlined in my past three e-mails...

When a stock runs against you, you need to figure out if you're just early (in this case, you should hold or even consider adding to the position) or wrong (in this case, you should exit immediately). Whatever you do, if you come to realize that you've made a mistake, don't hang on to the position in the hopes that it will recover to your initial entry price so you can escape with your ego intact – get out!

To get it right, you need to set your emotions aside, pretend like you don't own the stock, and reexamine your investment thesis with a fresh set of eyes.

And you need to do more work: Speak with a franchisee, like I did with McDonald's... call or visit stores, like I did with CKE Restaurants... or publish your work, invite criticism, conduct a survey, and meet with management, like I did with Netflix.

The goal is to gain information and/or insight that gives you an edge over other investors, whose collective views determine the price of the stock at any given time.

Most of the time, "the herd" is right. So to make money, you need to have an edge that leads to a "variant perception" that allows you to catch an "inflection point" – concepts that I discussed in my e-mails earlier this week.

In this coming Monday's e-mail, I'll continue this story as Netflix's stock, after peaking in July 2011, crashed by nearly 80% to $9 per share only three months later.

That created one of the greatest investment opportunities of my lifetime, so stay tuned next week!

2) And this coming Wednesday evening, from 6 p.m. to 8 p.m., I'll be sharing my latest investment insights in person at an event hosted by the Harvard Business School Club of New York.

It's open to the public and tickets are $50 – if you're interested, you can find out more and register to attend right here. I hope to see you there!

Best regards,

Whitney

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