You'll never hear me recommend buying shares of a richly
That's because my cardinal rule as a value investor is to buy
undervalued stocks. I know that if I'm buying a stock well below
value, I'm getting a bargain. It's a strategy that creates
meaningful upside, even if the company's performance falls short
of my expectations.
While I never buy overvalued stocks, I don't mind owning
richly priced stocks. It might seem like a contradiction…
but it's not. Let's use a well-known stock to show the
When I bought
Netflix (Nasdaq: NFLX)
in December 2011 shares were deeply depressed, trading in the
$70s. The stock had fallen from $300 in a matter of months, and
the market value of the company had dipped to just $4
Some readers thought I was crazy when I recommended the stock
in my issue of
titled, "Buying the World's Stupidest Company".
Shortly after my recommendation, shares quickly rallied … and
then crashed back to $70 on a quarterly earnings shortfall.
So, in May 2012, I sent this dispatch to my readers:
"When great companies are selling at a discount, it's time
to buy more. Netflix was a great buy back in December 2011 at
$73 per share. Today, the market has decided to give us a
second opportunity to buy more stock at the same price. The
fundamentals of the business have improved.
"In my opinion, buying Netflix below $80 a share is one of
the best investments available to investors today. With the
stock market up considerably in recent years - and thus far in
2012 - there aren't a lot of values available to investors.
Netflix appears to be one of the better values that I've seen
in a while."
Since then, shares of Netflix have taken off. In January, I
sold some of my Netflix shares in my real-money
account. I cashed in 25% of my stock at a 130% profit, and
also sold one call option at a 284% gain. At that time, Netflix
shares traded at $163. (You can read all the details in
How I Profited 130% on This Game Changing
Shares have since risen even more. The stock now trades at a
mind-blowing 180-times this year's expected earnings. But I
continued to hold a large position in the stock, despite the big
profits and the very rich valuation.
The reason was simple. Richly priced and overvalued stocks can
defy gravity and continue to rise for prolonged periods of time.
When a stock is hot and investors are clamoring to buy shares,
the price can continue to rise and sustain lofty valuation
multiples. Selling too early may lock in gains, but it also
limits the profits.
Netflix is not unique. Just look at
- two huge growth stocks that have been trading at more than
100-times earnings for years. Despite that, the share prices of
both have soared 200-250% over the last five years.
Amazon & SalesForce:
Proof That Even Overvalued Stocks Can Soar for
I would never buy a stock like Netflix at its current
valuation. However, I know that this particular stock could
continue to soar for years to come.
By selling a little bit of my stock, I've locked in some
profits and protected my capital. But by "letting it ride" and
holding onto some of my stock, I'm continuing to profit as more
investors pile in.
With Netflix shares now at $269, my original position is now
up 268%. I'm unlikely to call a top on Netflix when I
eventually sell the stock.
But I know that over the years, I've made a lot more money
holding onto my winners rather than cashing in on my early
profits. And that's a strategy that I'll continue to use, even
when a stock becomes grossly overvalued.
Full Disclosure: Ian Wyatt's $100k Portfolio is an
investment newsletter with a real-money portfolio. In that
account and a personal account, I own shares of Netflix.
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