TCS Daily


Come Fly With Me

By James K. Glassman - December 5, 2003 12:00 AM

The problem with investing is that, done right, it's not all that much fun. It requires virtues for which you will probably be rewarded in heaven but that won't provide you and your friends with much entertainment on earth: equanimity, restraint, moderation, discipline.

 

On top of that, investing can be painful. You have to slog through the dark, miserable bear markets, enduring anxieties and hardships. And when you emerge into bright bullishness, what's the reward? If you are a conscientious buy-and-hold investor, you have to keep your money at work still, and the worry only increases as stock prices rise and you wait for the next decline.

 

The best way to understand investing is as a means to an end, a road to a destination -- a comfortable and productive retirement, a new house, college for the kids, a trip around the world. Most of the time, it's the end that provides the pleasure, but there are ways to derive some joy in the journey. One is to take a flier. Invest in an idea that strikes you as altogether wonderful. In other words, feel free -- with constraints I will explain -- to fall in love with a stock.

 

That's what I do every year or two. It happened last spring with Netflix (NFLX), a company that rents movie DVDs -- and a company I can write about now that I no longer own the stock. I read about Netflix -- I still don't remember where -- and realized at once that it was a brilliant idea. You pay a flat fee of $20 a month to rent all the movies you want from a library of 15,000 titles. You order on the Netflix Web site, and DVDs are sent to you by first-class mail. There are no late fees, but there's a strong incentive to return each movie because when you send it back, Netflix sends you the next one on a list you maintain online.

 

Of course, a brilliant idea does not necessarily make a brilliant business. Could this company make money? It was not hard to find out. The business was absurdly and elegantly simple: one product at one price. This was no General Electric or Cisco Systems. To determine how profitable Netflix would be, you had to make a guess about how many people would sign up for the service. A quick look at the financial statements showed that with a little more than 1 million subscribers, Netflix should break even. At 2 million, it should be making a nice piece of change.

 

Before I bought the stock, however, I wanted to try the product. I purchased a subscription to test the service. It worked as advertised. Within two days of sending back a DVD, I got a new one. The Web site was easy to navigate, and, like Amazon, it suggested movies based on my previous choices.

 

I also realized that if I ordered, say, eight movies a month from Netflix, I would get 96 pieces of mail a year, mail that I had to open to get at my DVDs. Netflix could use the mailer to advertise other products -- its own or another company's. What an incredible direct-mail marketing vehicle! And the single-minded managers of Netflix were so focused on building the firm's core business that they hadn't exploited this obvious asset. But surely they would.

 

There were, however, risks. Competitors emerged -- giant retailers like Wal-Mart Stores (WMT) and movie-rental chains like Blockbuster (BBI). Cable and satellite will almost certainly become more aggressive in marketing video on demand. Broadband will spread, and Web sites will offer easy downloads of the latest hits. All true, but Netflix, meanwhile, was out in front, building a brand, and the company could become very profitable with only minor market penetration -- just 5 percent nationally (a rate Netflix has already achieved in the San Francisco Bay area) would do the trick.

 

As with most take-a-flier stocks, Netflix had a great story. According to Business Week magazine, as a student 16 years ago, Reed Hastings listened to his computer-science professor at Stanford describe how "a station wagon filled with old-fashioned data-storage disks held more information than the entire fledgling Internet. The message was clear: Sometimes low-tech solutions work best."

 

The low-tech idea behind Netflix, Hastings said, was that "the most cost-effective way to distribute movies was by mail" -- about one-tenth the expense of transmitting videos by Internet. Hastings used the Internet to distribute information about his movies, not to distribute the movies themselves.

 

With prices for DVD players plummeting, Hastings launched Netflix in 1999 and went public on May 23, 2002, at $15 a share. Within a few months, it had lost more than half its value. By the time the stock caught my eye, in February, it had recovered and was back trading at about the price of the initial public offering.

 

I did some quick-and-dirty arithmetic. If the company could acquire 4 million subscribers, it would gross about $1 billion a year and, I guessed, produce at least $100 million in profit. Since Netflix at the time had a market capitalization (number of shares times price) of only $350 million, it looked like quite a potential bargain. Of course, there were risks -- big ones -- but I had two trajectories in mind for Netflix stock. First, it might soar quickly as the economy recovered and investors flocked to tech shares they had shunned. Second, with a few ups and downs, Netflix might rise slowly and strongly as a good long-term buy.

 

Netflix, in short, was the perfect flier -- a truly fun stock, with a good story, a simple business and excellent prospects. In addition, it had the support of institutions I trusted, such as Fidelity Contrafund, which, as of June, owned 3.5 percent of the outstanding shares.

 

Still, investing in fliers requires a certain discipline. You must be prepared to lose nearly everything you invest. Don't put serious retirement money into fliers. Such stocks are really side bets, pleasant diversions.

 

What's difficult about fliers is deciding when -- and if -- to sell. Fliers can develop into buy-and-hold stocks, but they don't start out that way. The default position is to get in and out quickly. A good rule is to sell a flier that does not fly within a year. But that's the easy part. What happens if a flier really takes off?

 

That's what happened with Netflix. I bought shares in March, when the stock was $17 a share. By August, the price was over $30, and I was thinking about selling when I had doubled my money. Why be greedy? But I held on. In early October, Netflix broke $40; a few weeks later, it was over $50; shortly thereafter, it hit a high of $61.

 

Why the increase? Almost certainly, investors had become convinced that Netflix was a real business. In the third quarter, revenue was up 77 percent compared with the third quarter of 2002. Profit was $3.3 million versus a loss of $2.9 million. Netflix had 1,291,000 subscribers, up 74 percent in a year. Operating expenses per subscription were dropping as economies of scale kicked in.

 

I couldn't believe my good luck. That was certainly what it was. I had learned never to connect a stock's tripling in a few months with my own genius. But what to do? I had three choices: 1) sell the stock, offsetting the gain with certain losses that I had in my portfolio so that I wouldn't have to suffer adverse tax consequences; 2) hang on for the long term, with the understanding that shares, now trading at a price-to-earnings ratio, according to Yahoo Finance, of 9,700, were likely to take a dive, at least temporarily; or 3) effect a combination of the first two alternatives.

 

I chose door No. 3, selling half my holdings. My timing was good, and Netflix began to fall. A week later, shares rebounded a bit. I had had enough and sold the rest at $51 -- a "three-bagger," in the jargon of Peter Lynch, the former manager of the Fidelity Magellan fund. I promised myself I would buy shares back at $35 or so and hold those forever (but don't take that as a recommendation: I reserve the right to change my mind).

 

Fliers don't get better than Netflix and, the law of averages being what it is, I don't expect many winners of this sort. But I keep searching -- in newsletters, at malls, in articles in the mainstream press. Here are some potential winners -- with a strong warning to do your own research and realize that the risks are very high:

 

Rocky Shoes & Boots (RCKY): Jim Collins, editor of OTC Insight, has a superb record, especially for selecting small-caps on the rise. He liked Netflix early and, in his latest issue, he lists Rocky among a dozen "exceptionally attractive stocks." The company sells rugged footwear mainly to people who have to work on their feet, such as police officers, security guards and postal and construction workers. "Competition is intense," Collins warns, but the company recently signed a key contract with the military and sales were up 36 percent last year.

 

Tellabs (TLAB): This company, which makes optical networking systems for the telecom industry, was crushed by the sharp slowdown in capital spending in its industry. The stock fell more than 90 percent in two years. But with a strong cash position and no debt, it appears to have weathered the storm. John Buckingham, editor of the Prudent Speculator, made Tellabs his "stock of the month" for November. By the way, according to the latest ratings from the Hulbert Financial Digest, the Prudent Speculator ranks No. 1 among all newsletters for stock picking over the past 20 years; OTC Insight is No. 1 over the past 15.

 

M/I Schottenstein Homes (MHO): LJR Great Lakes Review, the highly regarded institutional research service that concentrates on undervalued companies in the Midwest, recommended this small-cap home builder just last week. It's well capitalized and largely undiscovered, trading at a P/E ratio, based on estimated earnings for the next 12 months, of 6.7. The story on home builders it that, while their shares have risen in a low-interest-rate environment, investors still can't quite believe that the gains are real and long-lasting.

 

But rather than listening to the experts, find your own fliers. Just remember: Don't invest more than you can safely lose, adopt an exit strategy, and don't confuse taking fliers with long-term investing.
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