Without a doubt, Netflix (NFLX) is one of, if not, the most volatile stocks on the S&P 500 sometimes moving as much as 5 per cent in a single day on zero news. In a good week, a blind and lucky trader can easily beat the average annual return of a mutual fund or broader index. Traders gravitate towards volatile stocks like Netflix for good reason. In the last 365 days, the stock rose from $57.40 to $389.16 - a 578 per cent increase. The stock hit that $389.16 the morning after it posted fourth quarter earnings on October 21, 2013, that beat the estimates. An hour later, the stock crashed and was trading below the previous close of $354.99. And many, many lessons were taught that day.
1. Valuations Matter, Eventually
Along the way up, naysayers claimed the stock would crash. At $100, it was an expensive speculation. At $200, it was overpriced. At $300, it was exponentially absurd. It was $400 that finally raised all eyebrows and got people thinking about valuations. Don't expect shares to fall back to $50 again. It can't be that easy, but the stock has a P/E of 266 compared to an industry average of about 16.4. Value traders would have avoided Netflix entirely with fundamentals and expectations that would never be met, knowing it would one day fall, but while all that happened, the irrational traders booked huge gains.
It is probably a little unfair that those who invested against all logic ended up with the profits. The reality of the market is that a stock price might not make sense based on its fundamentals, but there are so many other factors involved. Back in 2011, the stock also charged to $300 and fell to $50 on, yes, fundamentals. The company's prospects of huge growth became an issue when it decided to split up its DVD-rental and streaming businesses, jacking up prices, and creating turmoil with both traders and customers. What we now understand is that Netflix won't ever be able to raise prices without backlash or the potential for customer cancellations, and that proves bad for Netflix shares in the long-run.
Over the course of a company's public history, share prices will be buoyed or deflated by news and expectations to irrational levels, but over the long haul, valuations and fundamentals will eventually take over. You may argue that an investor missed out on as much as 500 per cent gain, but if you believe in valuations, you won't need to rely on luck and the demand of others to make money.
2. 95% Institutionally Owned
So, how did the shares continue to rise with fundamentals so out of whack? It could have been an issue of supply. At the moment, almost 95 per cent of Netflix shares are owned by some institution held in some fund, not by individual investors. Apple (AAPL), the largest technology company in the world, has just 62 per cent of its shared held by institutions. Based on the latest filing prior to this week, it was known that billionaire Carl Icahn held 9.4 per cent of Netflix shares in one of his funds. So why is this important?
When a stock has just 5 per cent of its shares being traded by retail investors like you and me, it means that there can be a liquidity problem. If supply is limited and demand is hot, then we see rises like Netflix that become irrational and alluring to trade. So, when news came out on October 22 that Icahn sold half his holdings or about 3 million shares over the last week, it meant that there was a sudden explosion of supply. And when 3 million shares hit the market at once, the price goes down. Of course, no fund manager would allow a price shock like this, so he could either purchase put options or sell them in chunks to allow the share price to withstand massive volatility. The news of the sale triggered more selling after hours. It told people that big money is leaving the proverbial table, and rich people do not like to lose money, so follow suit.
An investor should be diversified in their stocks, but stocks also need a diversified number of investors as well. Warren Buffet, considered the most successful investor ever, has his own general rule of thumb and invests in companies where institutions own under 30 per cent of the float.
3. Chasing Momentum is a Gamble
The rise that we saw, that conflicted with valuations and defied logic, is known as momentum and can be chased in either direction. Traders chase momentum hoping to catch any energy that is left in the direction of the stock's movement. When you chase momentum, you are always late to the party. But like a real party, you hope that there's some dancing, drinking, and socializing left. Of course, the club eventually closes and the window of opportunity shrinks every second. Momentum trading is a calculated risk - a gamble not on the prospects of the company's profitability, but on the belief that there are enough people out there that still want to buy. And unless your school replaced history with mind-reading, your speculations might be a shot in the dark.
Nobody buying after a rise of 450 per cent justifies their decision with "This stock is so undervalued." They are what we call the envious trader, trying to make a fraction of what the others made before the move. But timing is so important. There is a saying that the stock market "rises like an escalator, but falls like an elevator" so being wrong is a very distinct, painful event that unfolds in a short period of time. So for the trader that was the last to enter the club or forgot to leave altogether, they should learn the fourth lesson of trading.
4. Always Take Your Profits
If Icahn perfected his trade, he would have sold after hours on the day of the earnings report. The stock had traded above $394 in the after-hours market. Of course, nobody is perfect, and when he learned that he quintupled his money in a year, it was probably time to get out. In a situation like Netflix, where prices rise exponentially, become irrationally valued, and look unstoppable, then it's time to take your profits even if it is just 5 per cent of the 578. The point is that prices fall faster than you can make the order to sell when things finally turn. In this example, Netflix actually fell hard, but was still worth more than it was at any time prior to last week, but that is not the point. The issue here is that there were millions of people that also bought it at $390 after hours and the open, then saw their investment fall by 15 per cent the next day. Can you afford to lose that?
On October 21 at 1 PM, stock at $348, I "knew" the stock would fall so I did a debit put spread costing me just over $1000. At 4:05 PM, stock at $385, I "knew" my $1000 was gone. I wrote it off as a gamble worth taking. The profit was $1,500 if it fell 8 per cent or more. But I chose the wrong direction. Then I woke up and saw the stock at $345 and by day's end, $322. My friend asked me if I sold, to which I answered no but I realized that if I wait to try and make the full $1,500, I risk losing my original investment. So, on Wednesday, after seeing the shares were revived and up to $328, I closed both legs and made $330. That worked out to a 30 per cent gain in two days. Yes, if the stock stays at $328, I would have made more money by Friday, but that was not the point. The biggest lesson I learned from years of trading is always take profits. You can not predict the price of a stock so easily and with it being so volatile, there's a chance that for a brief moment which can occur on a Friday afternoon, the stock could be at a price unsuitable for profitability, and I will tell you that too many times I have become greedy and tried to make an extra dime or nickle and it has backfired.
5. Forget The Stock, Don't Be An Envy Trader
I was taught the moment you sell a stock, delete it off your screen. Nobody ever buys at the low or sells at the high. So when you remove it from your watch list, you extinguish the potential for the "I knew I should have waited" and "Why did I sell so soon?" statements. I heard it all the time working at the investment firm when my clients or colleagues traded and I would remind them they made more than a day's pay. Whether you are a trader finding opportunities or just a regular investor, get those names off your list when you are done.
When Netflix posted earnings, the uncertainty of the financials were no more, then it fell hard an hour after the open the next day. So what happened? Prior to the earnings, an institution knew it was time to sell as valuations became the correct rationale. He booked his profits and announced, required by law, that he sold a large chunk of his holdings in the first 12 days of October. Those that bought after the earnings in the after-hours market were clearly gambling the momentum. In fact, if you had tracked the trades, you would have seen it go from $380 to $394 rising ever so steadily. But who were those people? Nobody in their right mind would buy their first share of Netflix near $400, so it was definitely former Netflix traders still clinging to the stock envious of the gains others had made. In less than 24 hours, these five huge lessons were learned by anyone that lost any money on Netflix this week. And I'm sure there will be more lessons learned tomorrow.
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