The stock price of the over-the- top (OTT) streaming major Netflix has fallen ~68% from it's all-time high price of US$695/share in November 2021. The current price is lowest since December 2017. At the current price (US$226/share), the stock discounts trailing twelve months earnings by 32x. The company makes a healthy ~31% return on equity and ~11% return on assets. The revenue, operating margins and net profit margins achieved during the past twelve months are higher than the past 5yr average. The company has been generating healthy operating cash flows, but not yet generated free cash flows.
The reason for the latest US$150 fall in Netflix’s share price is the first ever reduction in its subscribers’ base (which may be largely due to Netflix withdrawing its services from Russia).
Six months ago, numerous analysts and portfolio managers were jostling with each other to justify a PE multiple of over 100x for the stock, citing the exciting business model and growth prospects for the company. Most of them are now rejecting the stock with sheer disdain. The following excerpts from a communication of famous portfolio manager to clients aptly demonstrate the change in sentiments:
“Today we sold our investment in Netflix, which we purchased earlier this year. The loss on our investment reduced the Pershing Square Fund’s year-to-date returns by four percentage points. Reflecting this loss, as of today’s close, the Pershing Square Funds are down approximately two percent year-to-date.
While we have a high regard for Netflix’s management and the remarkable company they have built, in light of the enormous operating leverage inherent in the company’s business model, changes in the company’s future subscriber growth can have an outsized impact on our estimate of intrinsic value. In our original analysis, we viewed this operating leverage favorably due to our long-term growth expectations for the company.”
I draw multiple inferences from this latest popular episode of investment learnings. This episode not only reinforces investment learnings that I have gathered over the past three decades; but also provides some key guidance to the current economic environment. Some of the key inferences are as follows:
(a) The current business environment is as dynamic as it was during the industrial revolution in the late 19th century. Most robust of the business models can become redundant in no time. “Long-Term” investing needs to be defined keeping this factor in mind.
(b) The consumption baskets of consumers are now overwhelmingly aspirational and discretionary. The consumption patterns are therefore susceptible to dramatic change in very short term. Any investment thesis that assumes longevity of the present consumption patterns, without providing for sudden changes, could be ineffective.
(c) Economics and markets eventually converge. Assuming the divergence between economic fundamentals and stock performance to be sustainable over the long term could be fatal to the portfolio returns.
(d) The popularity of a portfolio manager, the size of asset under management and past track record in terms of return generated on portfolio is no guarantee of infallibility. It is important to assess a portfolio manager from the robustness of his investment process; ability to differentiate between “market euphoria” and “investment opportunity”; and most important the strength of conviction in the businesses chosen for investing.
(e) A significant proportion of equity analysts are primarily spread sheet (e.g., MS-Excel) experts. They deftly extrapolate the latest numbers to “long-term” trends and accordingly arrive at their estimates. Their estimates are away from the actual performance in most cases. The investors must learn to distinguish between the “analyst” and “Excelists”.
Netflix is only an example of irrationality in the investment process. There are numerous such stocks in the market that need to return to normalcy. Sooner it happens, better it would be for everyone. Let all the cows return home before it is too dark.
