This post was motivated by a conversation I had recently with my dad, who is the source of nearly all of my common sense. Before I get started on my point, this post has prerequisite reading: this article about tech stock fundamentals.
Now that you’ve seen the numbers, would you be surprised to learn that two of the stocks included in this analysis are the top two best performing stocks in the entire S&P 500 in 2015? If you guessed Apple and Google, you’d be wrong. Apple and Facebook? Wrong again.
Apple and anybody? Nope. Try the company with the double-digit PEG ratio and the only one of the bunch that has somehow managed to lose money in the past four quarters. That’s right: Netflix and Amazon are the two top performers in the entire S&P 500 so far in 2015.
GAAP rules the current market
Are Amazon and Netflix overpriced? I absolutely believe so. Yahoo Finance columnist Michael Santoli recently discussed the performance of “GAAP” stocks, such as Amazon and Netflix:
“Amazon is in the very elite of this group, and also represents what’s been a very ‘GAAP-y’ market, so to speak. This isn’t just GAAP as in generally accepted accounting principles – according to which Amazon posted an uncharacteristic net profit.
GAAP can also stand for ‘growth at any price,’ which appears to be a preference of this market, rewarding the stocks already sporting the highest valuations with still more value.”
The PEG ratio that the market is currently paying for Netflix’s stock is about 10 times the market average. Don’t get me wrong- I’m a big fan of growth. I’m a big fan of Ben & Jerry’s ice cream, too. But at any price? I think if the grocery store were charging 10 times what it normally charges, say $40 for a pint, I would have to pass on the ice cream.
Company vs. stock
I love Netflix, and I love Amazon. Their products, their services, and their growth are very impressive. But the current valuation of the stocks is, in my opinion, irrational.
Economist John Maynard Keynes once famously said, “The market can stay irrational longer than you can stay solvent.” In my opinion, irrational mass behavior is actually one of the market inefficiencies that allows investors who are patient, disciplined and opportunistic to profit over time.
Staying disciplined
My teeth were gritted when I recently covered a small short position in Amazon near all-time highs for the stock following its Q2 earnings report. I still fully believe that the stock will trade significantly lower than its current levels at some point in the future. Unfortunately, my timing for this trade was off.
Due to the nature of short-selling, undisciplined/stubborn traders can allow bad trades to get out of control quickly. When you are long a stock, your losses are capped and your potential gains are unlimited. However, the advantage is flipped to a disadvantage when shorting stocks: limited gains but unlimited potential losses.
I decided if Amazon’s share price reached $550, I would bail on my short position, and I remained disciplined and stuck to my plan. Sure, Amazon may trade back down to $350 in a few months, but it could also trade up to $1000 because the very nature of irrational market behavior is that it makes no sense whatsoever and is therefore hard to predict.
Risk management
The other thing that saved me when it comes to Amazon is that, since I was well aware of the disadvantages of short-selling, my position in Amazon was pretty small. I knew it was a risky bet, and I predetermined my risk tolerance and decided on a position size and exit point way before I entered the position. Even the best traders in the world don’t get every single trade right, but they do limit their risk and stay disciplined.
For now, here’s my take on Netflix and Amazon in a nutshell: they look like great targets for short selling. However, I’m not short either of the stocks anymore because there is too much irrational “GAAP” buying in the market right now. If you choose to go ahead and short either of the stocks, I believe the extremely high valuation metrics discussed in my fundamental analysis post are good indications that you have a good chance at success. However, make sure you know the risks, have a plan, and remain patient and disciplined as well.
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