Wednesday, May 23, 2012

Should You Buy Companies You Know and Love? Evaluating Apple, Amazon and Netflix

Peter Lynch's old adage advises average Joe stockpickers to "invest in what you know." If you eat Big Macs, buy stock in McDonald's (MCD). If you binge on Diet Coke (CCE), load up on the company's shares. Over the years, this strategy could have paid off. Had you applied this thinking to three of the past year's biggest gainers -- Apple (AAPL), Amazon.com (AMZN) and Netflix (NFLX) -- you would have made out quite nicely.

  • AAPL shares skyrocketed from a February 23, 2010, closing price of $204.62 to a February 22, 2011, close of $338.61.
  • AMZN stock shot up from a $118.40 close on February 23, 2010, to a February 22, 2011, close of $180.42.
  • NFLX shares more than tripled from a closing price of $66.05 on February 23, 2010, to end the day on February 22, 2011, at $221.60.

If you had invested $30,000 -- $10,000 in each of these stocks -- you could have sold for a $35,336 profit on February 22, 2011.

Can AAPL, AMZN, and NFLX Keep Delivering?

My mailman could be the poster child for Lynch's strategy. The cart he pushes around my Santa Monica neighborhood is stacked with boxes from Amazon.com. He drops at least one of them at my doorstep per week. His bag overflows with those ubiquitous red Netflix movie envelopes. He picks up no less than three a day from my 8-unit building's outgoing mailbox. And he stops every once in a while to send a text or take a call on his iPhone, while cranking out the jams via a separate iPod.

A mailcarrier friend of mine told me several years ago that she took all of her vacation time just prior to election time to avoid toting a bag made heavier by the informational booklets outlining races and initiatives. I should give her a call -- one iPhone to another -- to see if that plan even makes sense anymore given the daily Netflix and Amazon load she simply didn't carry 10 years ago.

Apple, Amazon and Netflix have become more than omnipresent. In their own way, each company, through innovative products and services and imaginative approaches to their markets, enjoys cultural icon status, at least for the time being. It's easy to look back and wish you had gotten into these high-fliers a year ago. The bigger question, however, surrounds whether or not you should get in now.

Potential AAPL, AMZN, and NFLX Positions

Simply put, given the recent market downturn, I would be a buyer of AAPL stock and call options, but, even at these somewhat depressed prices, AMZN and NFLX concern me in the near- to mid-term. I don't live and die by P/E ratios, but sometimes they prove instructive. As of February 23rd, AAPL's P/E stands at 19.04. AMZN and NFLX sport relatively high P/E's at 69.96 and 71.32, respectively, even amidst a significant correction in the share price of both stocks. When deciding how to position myself in these companies, I simply consider the unknowns surrounding each.

AAPL Unknowns

I believe investors have come to terms with the major unknown surrounding AAPL. While the shares will certainly take some hits on future Steve Jobs news, I think any slipup proves temporary. Rumor and innuendo ultimately cannot take AAPL down. When the dust settles, reality comes through with analysts reiterating the company's seemingly unstoppable growth. AAPL is dirt cheap no matter how you slice it. Getting AAPL shares in the $336 to $350-something range represents a potential bargain basement long-view windfall.

AMZN and NFLX Uncertainty

The battle between AMZN and NFLX intrigues me. As somebody who uses Amazon.com frequently, but has subscribed to NFLX only on and off, I am partial to AMZN. This bias, however, is telling. One of the biggest criticisms of NFLX is that people view it as a luxury, an additional expense to cable or satellite TV. They pop in and out of free trial periods and may not be willing to stick around for the long-term.

Amazon, meantime, has an amazing platform to compete not only with NFLX, but the likes of Wal-Mart (WMT), Target (TGT), and other retailers. The Wall Street Journal reports that media sales (e.g., books and DVDs) accounted for less than half of AMZN's revenue in 2010. AMZN's price advantages over brick-and-mortar retailers gives it an amazing edge. People can buy staples and other products from AMZN with consistency. Now that AMZN has tossed a salvo at NFLX by offering online streaming to Amazon Prime customers, it has the opportunity to strengthen not only revenues, but brand and customer loyalty. AMZN can parlay a consumer's desire to watch a movie for "free" into a $79 annual Prime membership. While the person streams the movie, AMZN can target them with products and other site features designed to cement loyalty, such as "Subscribe and Save." NFLX simply does not have this type of platform, nor do I think it can make the investment to develop one or innovate itself into a better competitive position versus AMZN.

While I am more bullish on AMZN's long-term prospects than NFLX's, AMZN's recent investments in the business could continue to drag on the bottom line and negatively impact share price. Additionally, AMZN's foray into online streaming could backfire because of competition from NFLX, Coinstar (CSTR), and others. AMZN could face the same cost challenges for acquiring content that worry investors with regards to NFLX and other "streamers."

At this point, I would not open a position in NFLX, even with the stock's recent plummet. Barring amazing innovation, I see NFLX hitting a wall. I don't see channels for long-term growth potential, at least not enough growth to justify the stock's valuation, as evident.

If I were to play AMZN today, I would not buy the shares. I would look for short-term swing trades on volatility using ATM and slightly OTM call and put options. Over the longer-term, however, I believe a potentially successful strategy involves selling AMZN put options. I would look at OTM puts between 1 and 2 months out with attractive premiums, but only at a price I would be happy owning the shares at. Of course, different investors have different answers to this question. I would be comfortable selling AMZN March $170 puts on the recent weakness at around $3.10. If the put expires worthless, you keep $310 per contract sold. If the stock drops below $1.70, particularly to the put buyers' breakeven of $166.90, you run the risk of having to buy 100 shares of AMZN for $170 each for each put option exercised. I would look to replicate this strategy at different strikes with different near-term expirations for the foreseeable future, moving up the strikes as my confidence in the shares increases.


Disclosure: I am long AAPL, CSTR.

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