Larry’s note: Welcome to Trading with Larry Benedict, my free daily eletter, designed and written to help you make sense of today’s markets. I’m glad you can join us.
My name is Larry Benedict. I’ve been trading the markets for over 30 years. I got my start in 1984, working in the Chicago Board Options Exchange. From there, I moved on to manage my own $800 million hedge fund, where I had 20 profitable years in a row. And, I’m featured in the book Market Wizards, alongside investors like Paul Tudor Jones.
But these days, rather than just trading for billionaires, I spend a large part of my time helping regular investors make money from the markets. My goal with these essays is to give you insight on the most interesting areas of the market for traders right now. Let’s get right into it…
Earlier this week, Netflix shares fell off a cliff.
It wasn’t the first time either.
Shareholders suffered a similar fate just three months ago.
Disappointing earnings results and weak subscriber numbers saw the share price plummit.
With this latest drop, Netflix shares lost over two-thirds of their value since November 2021. And yielded all gains made since early 2018.
In less than six months, over $200 billion of Netflix’s “value” went up in smoke.
For Netflix, a member of FAANG (Facebook, Apple, Amazon, Netflix, Google) – a group of stocks that powered much of the two-year rally ending in 2021 – it suffered a particularly bruising fall.
With a market cap of barely $100 billion, Netflix now trades at just a fraction of its FAANG counterparts. Compare that to Apple, which is now 27 times its size.
There’s nowhere for management to hide after a crash like that.
But there are plenty of excuses.
Netflix’s loss of 600,000 subscribers in the U.S. and Canada was blamed on a minimal price rise in its monthly fee. Rampant inflation was causing folks to cut back on their monthly spending.
Russian President Putin’s actions didn’t help either. The Ukrainian invasion forced Netflix to suspend services, causing another 700,000 drop in subscribers.
This was enough to cause Netflix’s global subscriber numbers to fall for the first time in over 10 years.
To stop some of the bleeding, Netflix is now considering a cheaper subscription model with ads, and a clampdown on people sharing its services.
This strategy might alleviate some of the pain, but it ignores the most fundamental problem…
Netflix shares were overpriced.
With a market cap at over $300 billion as of November, and a price/earnings (P/E) ratio in the 60s, Netflix was trading a long way over its true value.
The market was assigning too much value to its potential growth… Growth that has all but evaporated for now.
But Netflix is not the only over-valued stock. There are sky-high P/E multiples everywhere.
It’s something I wrote about back in October 2021, when I argued that stock valuations had already peaked.
It all comes back to inflation. Inflation affects how the market values companies due to its impact on future cash flows.
As we discussed back in October, when inflation runs at around 2%, $100 10 years from now is worth around $82 in today’s money.
If inflation jumps to 5%, that $100 drops to around $60 in today’s money.
That’s a major difference.
Today, inflation runs at 8.5%!
As inflation increases, the value of future cash flows decreases. This leads to lower stock valuations.
High-growth stocks are especially vulnerable to the nature of cash flows.
That’s because investors are betting on exponential growth, meaning bigger cash flows further out into the future. As a result, a larger part of the current valuation is vulnerable to erosion by inflation.
High-growth stocks are also vulnerable to dramatic falls when the market discovers that a stock priced for growth is actually not growing at all.
That’s exactly what we saw this week with Netflix.
As this year rolls on, you can be sure there will be similar situations to Netflix. Other stocks trading on massive P/Es will be exposed once their growth slows (or evaporates).
The key for investors is to avoid blindly holding on to yesterday’s growth heroes. Even if it takes a while, the market always works out what a company is really worth.
Editor, Trading With Larry Benedict
Which company do you think will be in the same situation as Netflix next?
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