The Song Remains The Same

Today is the end of the quarter which means earnings season will soon be upon us and set the tone for stocks once guidance is provided. For the past few months I've primarily been reviewing books and analyzing stocks and want to update you on The Ithaca Experiment Portfolio. If you've been reading this blog, you are well aware I have been out of the market since October of 2008 and have been in leveraged and short ETFs since the Summer of 2009. This self inflicted wound has made me miss a significant ride in the market. To say I don't regret my investing decisions would be sour grapes. However, what's past is past, and, I didn't give up the ghost in regards to my portfolio allocations despite the nice rebound the market has experienced of late.

In examining the S&P 500, you can see that it closed at 1319 on 2/7/11 and was at the same level when the bell rang yesterday. In essence, my short ETFs have treaded water for the last 7 weeks which has kept my game going. I realize my thoughts on market direction are not in vogue at this time. I take the nonconsensus view that not only are we in store for a double dip of the lows in March 2009, but, I believe the market will actually go lower. This is why I'm still short with The Ithaca Experiment portfolio and in my personal accounts am hording cash. I really believe that there will be a much better time to back up the truck when shopping for securities somewhere down the line. The sooner the better, too.

To use that old Wall Street cliché - "the market climbs a wall of worry" - is warranted in describing the market's unbelievable rise the past two years. Nothing seems to be able to derail it. One thing that helps my cause is that I've bought some time the last few months with the market going nowhere. The third year of a bull market tends to be choppy and less vigorous than the first two years of the run. I'm not going to tell you what will cause the markets to reverse course because I've been down this road before with no such luck. What I will say is that I still believe that there are accentuating circumstances that may help me out this year.

Sovereign debt, especially in Europe remains a concern. The same thing goes for local, state and federal debt in the United States. We can't keep printing money forever without some severe ramifications. One third of all mortgages in the United States are underwater. This will deflate consumer spending. Unrest in the Middle East will put pressure to the upside on oil prices which will drag down the economy. There is also the tragedy in Japan where the Geiger counters are at full tilt and supply chains have become disrupted, especially in the semi-conductor industry. These are issues I think about and that I believe will exacerbate the slowdown.

Right now my strategy will remain the same and stay the course. My biggest fear is getting cold feet and selling my short positions right before we get an about face and experience a severe correction. As far as this blog is concerned, I will continue analyzing stocks that are candidates for inclusion in my portfolio once valuations are much more reasonable. Reviewing investment books will also be in the grand scheme of things. Once every so often, I will also cover pertinent financial topics like high frequency trading or dark pools. Take the hands off the clock, we may be here for awhile.

Netflix: From The Sideshow To The Big Top

Netflix (NFLX) is a compelling story, not only because the stock price has appreciated over 200% in the last year, but because its technology is extremely relevant in today's society and will continue to be so for the foreseeable future. This is one of the cocktail party stocks of the past 12 months and rightfully so. Just last week the stock was trading at $210/share, then Credit Suisse placed a $280 price target on it and the stock mushroomed to $240 in only five trading days.

Unless you live in a hi-tech hub like the Silicon Valley or are an avid investor, the average person probably associates Netflix with the 20th century business model of mail order subscriptions. This is no longer the case. A few years ago the company started streaming their video service over the Internet and business is booming. Warren Buffett says to wait for a fat pitch when selecting a stock and Netflix appears to be way out of my wheelhouse with a P/E Ratio of 55 based on average 2011 earnings on Yahoo Finance. However, I obtained a copy of last week's Credit Suisse analyst report and want to take a close look at it in case I am missing something here.

At first glance, it's easy to see that Credit Suisse set the bar very high when assessing the value of Netflix going forward. Their earnings per share estimate for 2011 is $5.16 and boldly moves to $8.35 for 2012. Yahoo Finance pegs the EPS average at $4.39 for this year and $6.29 for 2012 based on the 31 analysts that cover the stock. That's quite a difference in outlook. In fact, out of those 31 analysts, only 11 have a buy or strong buy rating on Netflix. The remainder breaks down as 13 hold, 5 underperform and 2 sell.

I've got to tell you flat out that this stock is too hot to handle and is probably a crowded trade - at least for this week. Only professional traders should own it. Credit Suisse may very well be right that Netflix can move higher because it is one of the most radioactive stocks on the market. It currently ranks 7th on the Investor's Business Daily top 50 stocks for the week and with the market gaining momentum, it can probably probe the upside because stocks on the IBD 50 are conducive to higher prices in the short term. That said, I really believe that the analysts from Credit Suisse that wrote the report did a disservice to their investors by not doing a thorough job. They wrote a puff piece. I don't know what kind of skull session they had when coming up with their numbers, but in my opinion, it was a pretty vacant decision.

The Credit Suisse analysts paint rosy scenarios about international expansion when concocting their earnings and revenue extrapolations. Much of this stems from the fact that Netflix introduced their streaming service to Canada in 2010 and has had a very successful campaign there. Subscriptions are projected to grow 20% a year through 2016 in The Great White North, however, this is a very small client base. The analysts contend that if, and the operative word is if, Netflix expands into one to two international markets per year for the next 5 years, then they will meet their numbers.

I can understand that the research department at Credit Suisse sees a bright future for Netflix because they compete, and I emphasize that word compete, in an area that will no doubt be in hyper-growth mode for the next few years. However, the Credit Suisse analysts were extremely cavalier when addressing the competition. They didn't seem too worried about it, like Netflix will be like Rommel going through North Africa or Sherman marching to Atlanta.

When Netflix chairman and founder Reed Hastings was asked in the last conference call: "Do you expect Google (GOOG), Amazon (AMZN) and/or Apple (AAPL) to be a more formidable competitor in 2011?", he replied: "Definitely, there's a lot of firms, including the ones you mentioned that could be a more direct competitor with us.". Besides Facebook and Hulu.com, there are also large predators on the prowl: "...cable providers like Time Warner (TWC) and Comcast (CMCSK); direct broadcast satellite providers, DIRECTV (DTV) and Echostar (SATS); and telecommunications providers such as AT&T (T) and Verizon (VZ).". That was courtesy of the Netflix 10-K. The hunter becomes the hunted.

One example of how the Credit Suisse analysts glossed over the hurdles Netflix will have to overcome goes back to international expansion, specifically in Europe. Their overzealous projections of potential subscriber growth overseas includes the countries Germany, The United Kingdom and The Netherlands. The big problem here is that Amazon is already established in those countries with its subsidiary LOVEFiLM that they purchased earlier this year. Granted, they only have 1.5 million subscribers, but they have already established a beachhead there and with Amazon's deep pockets, can expand to other countries as well. Credit Suisse doesn't expect Netflix will enter the European market until 2013 at the earliest.

I believe in Reed Hastings and I tip my hat to him. He's created an incredible company with a very bright future ahead of it. Subscriptions are growing at a breakneck pace. However, a company and its stock are two entirely different animals. With a price at roughly $240 and it's 5 year CAGR of 30%, you get a PEG Ratio of 1.8 when you use a P/E Ratio of 55. Not too shabby if you are a momentum investor, but like I mentioned earlier, it's way out of my strike zone. I prefer PEG ratios at one, and even then, it gets a little dicey. The lower the better, especially if they are experiencing growth and its sector is out of favor. A good example are healthcare stocks right now.

Another thing to contemplate when deciding if you want to make an investment in Netflix is considering exactly what kind of a company they are. They are a facilitatior of digital media. A distribution company. Not a hi-tech firm, although they use state-of-the-art technology to dispense their products. They have no significant moat around their business in regard to patents. In fact, their rival Amazon dispenses most of their content with their cloud based server farms.

Credit Suisse posted a disclaimer on the first page of their research report which read: "Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.". That I will do and you should too. Don't believe the hype.

Endgame

John Mauldin and Jonathan Tepper recently teamed up to write Endgame: The End Of The Debt Supercycle And How It Changes Everything with John Wiley & Sons. The subtitle basically gives you the gist of the book, but that would give it short shrift for such a well researched and documented piece of work. They say right at the beginning of the book that: "When we mention endgame, you'll immediately want to know what is ending. What we think is ending for a significant number of countries in the 'developed' world is the debt supercycle...Essentially, the debt supercycle is the decades-long growth of debt from small and manageable levels, to a point where bond markets rebel and the debt has to be restructured or reduced. A program of austerity must be undertaken to bring the debt back to acceptable levels.".

This echos the sentiment of the Republican Party, its sub-set the Tea Party, and, some Democrats, but, I got the impression that the authors were agnostic in their political leanings and came to their conclusions by objectively interpreting the data. As stated: "Common sense tells you that your debt cannot grow faster than your income forever, and at a certain stage, the huge pile of debt becomes unsustainable. All responsible parents teach there children not to let their debt grow faster than their income. It is only the Fed and Congress that are too foolish to get it.".

They pound this theme throughout Endgame and the language they use ranges from academic speak to something a layman could understand: "If you had a neighbor who was always running up credit card bills and who constantly borrowed money from neighbors to help pay the credit card bills, would you conclude your neighbor was a high bankruptcy risk?".

Mauldin and Tepper appear to be greatly influenced by This Time Is Different written by Carmen Reinhart and Kenneth Rogoff, and, in fact, devote a whole chapter to not only deciphering the book, but interviewing the authors, too. I found this section distracting because I'd already read the book and they reprinted long excerpts from it. It couldn't hold my interest. However, if you are unfamiliar with the work, it would be a great place to start examining financial folly going back eight centuries.

In that chapter they quote Reinhart and Rogoff and I will too: "Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! - confidence collapses, leaders disappear, and a crisis hits." The authors of Endgame follow that up with some commentary of their own: "It is the nature of human beings to assume that the current trend will work out, that things can't really be that bad. The trend is your friend until it ends.".

They believe that the current trend is going to end, at least where massive government and private debts are concerned: "...for the most part, debts have not been extinguished, merely transferred. Debt is moving from consumer household balance sheets to the government. While the debt supercycle was about the unsustainable rise of debt in the private sector, endgame is the crisis we will see in the public sector debt.". How bad will the crisis get? They don't give a definitive answer, just some options, and, not all of them bleak. For instance, they don't feel the United States will experience hyperinflation nor do they surmise that the Tea Party will take over and take us back to the gold standard. However, the unwinding of all of the debt on a global basis will take time and the process will hurt.

Both Mauldin and Tepper are investment advisers and have plenty of experience in the field, so you're not getting an ivory tower analysis of the current economic landscape from the Academic Industrial Complex. They're pretty much straight shooters and I enjoyed the book. They give no timetable on when this endgame will occur but do say that higher volatility, lower trend growth and elevated levels of unemployment will be the norm. There are many books that have been published over the past couple of years that cover the same themes that are in Endgame. The authors just put a different spin on the data, and, it's the freshest one hot off the printing press, so you may find new material in here if you are well versed in the subject.