LMIJ #1: Netflix (NFLX): Survival and Success of an One Trick Pony

Posted on 21. Aug, 2011 by TheFreeInvestor in General, Investing Philosophy

I am starting this new series of posts, Lessons from My Investing Journey (LMIJ), to share the lessons I learned from the investing mistakes and successes over the years. One of the motivations behind writing this series is that we tend to rationalize in retrospect and give ourselves more credit for than actually due and consciously avoid memories of the investing mistakes we made in past.

As you can see in my portfolio page, I built my Netflix (NFLX) position between January and July of 2007 and sold a bit in Jan’11 as Netflix was becoming more than 10% of my entire portfolio. Still Netflix is the #1 or #2 holding in my portfolio. Though in rear view mirror it looks like a genius decision to buy Netflix stock in 2007, I want to trace back to the thought process at the time of purchase.

Simple DVD by Mail Model

The original investment thesis was based on the simple yet disruptive business model of DVD by mail with no late fees. I liked how Netflix was disrupting the rental video king at that time — Blockbuster (BLOAQ.PK). Long before I was an investor in Netflix, I was a happy customer. It was a small company at that time. So, it fit perfectly in my small cap portfolio. The investment thesis was predicated primarily on simple DVD by mail model with NO late fees, great understanding of customer preference due to the movie queue and ratings system, first mover in the online movie rental business and smart/nimble management led by Reed Hastings.

However, I had a long list of worries about the company — Blockbuster can offer online rental and cut prices and big players can move in and offer the same (as we saw later Walmart started a similar service). Can the company survive a price war with Blockbuster?

Finally, I was worried about Netflix being an one-trick-pony. What is the likelihood that a niche player like this can survive alone for long? Over the years, it will probably be taken over by a larger giant like Amazon (AMZN) or Walmart (WMT) etc. The same thinking led me to pass on Google (GOOG) — with online search as their only business, their future prospect doesn’t look that bright. I guess, that decision didn’t work out too well for me

Hold and Learn

During the price war with Blockbuster, I held on to my stock, not because of great confidence in the company, but because Blockbuster was going from bad to worse condition. It seemed like Blockbuster was fighting for last few breaths. When you own stock in a business that you love, you will be more interested to learn about the details of the business drivers and risks etc. So, with over time, more I read about the business catalysts and Reed Hastings, more I liked the company.

Change in Investment Thesis because of Strategic Course Change

When the company announced free streaming video to its DVD-by-mail subscribers, the investment thesis changed dramatically — it was no longer a DVD-by-mail innovator. It was clear that the business is transitioning from DVD to unlimited streaming video. Initially, the online streaming collection was pretty bad. But, overtime the company kept adding good content to the streaming collection.

The lesson I learned was that in case of technology or small cap companies, you have to closely monitor for the change in investment thesis. Anytime the investment thesis changes, you need to re-evaluate whether the investment still makes sense. Investing in these type of companies is completely opposite of the way Warren Buffett invests — he likes to invest in companies that are likely to stay the same for years or decades.

Recently, the company announced expansion of its streaming service to 43 Latin American countries ! That’s not a drastic change in investment thesis. But, definitely something to watch — to see how the expansion is executed.

Final Thoughts

After more than 1000% gain over the years, Netflix grew into more than 10%-15% of my portfolio. In general, I don’t like to sell if the investment thesis is still intact. But, just to make sure I sleep well at night, I sold a small portion to recover my initial investment while I let the rest of it run. In the rapidly evolving digital entertainment world, Netflix can still run into road-bumps. But, so far, the story looks good.

Next in the LMIJ series — I will write about a miserably failed investment and the lesson I learned from that investment.

(Disclosure: As of the publication of this post, I hold long position in NFLX and AMZN. Please read the full disclaimer on the blog.)

Tags: AMZN, BLOAQ.PK, GOOG, LMIJ, NFLX, WMT