The Company is Not the Stock

 
By Chloe Lutts

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The Company is Not the Stock

Climbing on the Bandwagon

Call of Duty and World of Warcraft

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Last week, I had the following exchange with a close friend:

Him: I think we should buy Netflix stock. Look at how much it went down!
Me: Now that's a terrible thing to say before buying a stock.
Him: I have the utmost faith in the company.

If you've been reading Investment of the Week for a while, you can guess what I said next.

Me: The company is not the stock!

You've probably heard that before--I know I've heard my father say or write it hundreds of times--but my friend isn't an investor, so I had to explain a bit. Assuming that good companies must have good stocks is probably one of the most common investing misperceptions among non-investors. And while you probably know better, it's such a common fallacy that I thought a reminder was in order. (If you're an experienced investor, this might be a fairly simplistic explanation. If you don't learn anything, consider forwarding this to a less-experienced friend who might, and help destroy the myth that good companies have good stocks.)

NFLX is down about 70% from its July highs. Does that mean the company is doing 70% worse than it was in July? No!

That's because share prices represent investor perception of a stock ... not the stock's intrinsic worth, or the company's worth, or even perception of the company.

Share prices represent investor perception of a stock, period.

And as perception of a stock improves, more and more investors want to own it--causing the price to increase. Up until July, perception of NFLX had been improving for years. The stock gained 90% in 2009, and over 200% in 2010. I'm sure that first 90% annual gain convinced loads of investors that the stock was an outperformer, and they soon bought some for themselves--causing that 200% annual gain. Perception was improving!

So why didn't that 200% annual gain cause even more investors to climb on the NFLX bandwagon? Because there weren't any more!

Eventually, all stocks reach what is called the point of peak perception. On a chart of NFLX, you can see this point clear as day back in July. The point of peak perception marks the moment when a stock's perception can't improve any more: everyone already likes it.

NFLX Chart

Picture, if you will, a bandwagon. (The term comes from vehicles used to carry bands in parades, if you're not sure what to picture.) This bandwagon is infinitely large--everyone who wants to fit on it can. However, there are a limited number of people around this bandwagon. These are all the people in the world who have money to invest in NFLX.

Back in January 2009, when NFLX had been trading around 30 for a year, there were a handful of people on the bandwagon, but most people were standing on the ground milling around. Gradually though, investor perception of the stock began to improve, and people began climbing on the bandwagon. By the end of 2009, the density of people on our metaphorical bandwagon was probably about the same as the density of the crowd around it. Picture that.

In 2010, the people who still weren't on the bandwagon started looking up at those who were, and how much money they were making. Being on the NFLX bandwagon looked pretty good. The bystanders started clambering on in droves--and NFLX went up and up.

By the end of 2010, there were more people on the bandwagon than off it. But there was still a decent crowd down on the ground.

But as 2011 went on, those people who were still on the ground started to feel left out--everyone else was up there on the bandwagon, raking in 200% gains! Eventually, the folks on the ground couldn't take it any more, and they climbed on the bandwagon too. Sometime in July 2011, the very last one clambered on up. Now everyone was on the bandwagon, and there was no one left on the ground.

Unfortunately, that meant there was no one left to climb on. To get back to the source of our metaphor, that meant there was no one left to buy NFLX--everyone already owned it. If someone on the bandwagon wanted to sell a little NFLX, there was no one on the ground to snap it up. And so with every sale, the price went down. Soon, people were clambering off the bandwagon, and walking away. And NFLX went down and down and down... until we got to where we are today.

Will NFLX eventually rise again? Probably. But there are still plenty of people on that bandwagon--including people who bought in recently, for $200 and up--and NFLX isn't going anywhere until most of them get off. And since most investors don't enjoy taking large losses, I wouldn't hold your breath.

Do I still think Netflix is a good company? Absolutely. I stream most of the TV and movies I watch from Netflix, and I would pay twice as much as they charge for the service. But would I buy Netflix stock here? Not if you gave me $1,000 to do it with.


So, what should you buy today? To my friend--the one who wanted to buy Netflix--I suggested the Spotlight Stock from the latest Dick Davis Investment Digest: Activision Blizzard (ATVI).

Activision Blizzard owns and publishes three huge video game titles--Starcraft, Call of Duty, and the enormously popular World of Warcraft--in addition to many smaller games. The titles have been popular among gamers for ages: Call of Duty is on its eighth version, and World of Warcraft is the world's most popular online multi-player role-playing game. But the stock is just being discovered by investors ... as attested to by the fact that ATVI has recently been recommended by (or put on the watch list of) no fewer than four of the investment newsletters we review for the Digests. If you picture the bandwagon of this company, it would have few people on it, but many climbing on board.

And the company is in a great spot (the stock is not the company, but good news from the company can make investor perception improve). Many of its games require subscriptions, and subscription revenue is growing as a percentage of Activision Blizzard's income. That's good news because the profit margin on subscriptions is higher than the margin on the initial sale of the game (the game DVD or download itself).

But the real story here is one of investor discovery. Like Netflix back in 2008, Activision Blizzard is already a great company--that most investors haven't given a second glance. But I think they'll be taking a good look soon--and now may be the time to get on the bandwagon.

You could buy ATVI here and hope for the best or you could read the full write-up in the most recent Investment Digest by clicking here now.

Wishing you success in your investing and beyond,

Chloe Lutts
Editor of Investment of the Week

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