Posted in Trading on January 27th, 2017
The following article covers trading financial securities, such as stocks. The world of trading often comes with rises and declines of securities, and most things do not rise or fall in a straight line. By the time this article is published, circumstances involving what we mention may have changed. Often, changes in securities can be to the detriment to the traders – seldom is it beneficial. A person should only trade with money that they’re willing to lose because losses are guaranteed. By reading this post, you agree that you’ve read our disclosure.
David Einhorn of Greenlight Capital has recently published a letter outlining their Q4 performance and prospects for the future of 2017. Greenlight has underperformed in 2016 compared to the S&P 500. However, he offers some insight into what may occur under the new President of the United States. It is a fascinating read and I atend to agree with most that is presented. However, I disagree with the reasoning to short Netflix. In this article, I will follow the letter and use the abbreviation of the current US presidency as TP.
David Einhorn has written a great book, Fooling Some of the People All of the Time: A Long Short Story. Here lies one example of market inefficiency. The book is describes the interactions with Allied Capital. It is controversial to be negative about a well regarded company that pays great dividends, especially when speaking at an investment conference. Einhorn’s speech must have been very compelling, because Allied stock dropped 25% the next day. Einhorn demonstrated that there were accounting irregularities and mispriced assets. Where fraud comes into play, the market has erroneously priced Allied Capital high. Even with evidence of misconduct, the SEC did not investigate thoroughly Allied Capital, but instead investigated Greenlight for stock manipulation. The battle waged on for five more years, until Allied cannot hide any longer their misdeeds. Allied Capital were crushed by the financial crisis in 2007-2008 and later on was bought out for measly $5 per share by Ares Capital.
Although it was not highly publicized in the likes of financial fraud, WorldCom and Enron, the failure of Allied Capital should highlight the perils of wall street investing. Companies tend to maintain the status quo. Before its final demise, Allied was a 50 year company. I consider this a significant milestone for any sized company, let alone a billion dollar company. To provide growth and dividends, Allied took on more risky loans. But in order to look good for shareholders if the loan assets went bad, Allied used financial engineering to make things look good on paper. I believe all companies operate this way in some level. If things were more straightforward, there would be no write-offs, various ways to recognize sales, double irish dutch sandwich, etc. Where a penny in earnings per share could adversely affect the stock price, many public companies will operate in the grey area of finance to report financials. Because of the 2007-2008 financial crisis, Allied could not hide any longer. Like mortgage backed securities, financial crisis exposed bad practices and should have cleaned house. Instead of starting with a clean slate, the bailouts given will cause a greater crash in the future.
I have written about Netflix last year before FinTekNeeks. I was impressed with the direction Netflix is heading, where they had 8 nominations in the 2016 Golden Globes. Netflix has become a major investor in original content. As more people are cord-cutting, they are relying on streaming services, YouTube first, Netflix second, and Amazon Video third. With increased subscribers every quarter, things are looking up for Netflix. I firmly believe competition is healthy for the consumers. With other original content providers, Netflix and Amazon have also been purchasing distribution rights for independent films. With Sundance Film Festival being held this week, I expect many news reporting increased investment in films from Netflix and Amazon. This will upset the status quo, where films normally sold for a couple of million, are now being sold in the tens of millions at the festival. But, the benefit is that these often ignored films can reach broader audiences.
In the letter, Einhorn mentioned that he is bearish against Netflix, because:
I can understand the negativity behind Netflix. The P/E is 326, which is high, similar to tech companies in the 2000’s heyday. Netflix has a significant amount of debt and continues to pour more than $1 billion dollars into original content every year. I cannot completely disagree with the arguments laid out in the letter.
However, I am looking mainly at price. The stock is currently above the 50 day and 200 day moving average. I understand that hedge funds have large amounts of money to invest. In order for them to make significant investment, they may have to invest early before their prediction is confirmed.
Fundamentally, Netflix is still growing. They are adding subscribers, and with original content, they are adding new viewers every quarter. If I started to see flattening of subscribers or a decline quarter over quarter, then I would turn bearish. Netflix competitor is mainly Amazon. Amazon is bigger and can throw large sums of money on content. To compete, Netflix is continuing to provide more original content, which draws in more subscribers.
Greenlight Capital, in its letter, have admitted to taking some losses. This means that they have been wrong several times. However, they have had significant gains offsetting those losses. The important lesson here is that sometimes one can be right about a company. Other times, the market does not act accordingly to predictions. So, the individual investor has an advantage to be more nimble than a large hedge fund, and get out of losing trades quickly. Learn to “cut your losses quickly.”