How the Heck Did I Miss This 10-Bagger?

Six years ago this week, Netflix (Nasdaq: NFLX  ) shipped me my first two DVD rentals. The movies were Shrek 2 (my girlfriend's pick) and Ghost in the Shell (my pick). I rated each movie three stars out of a possible five.

I know this because I'm still a member today, and Netflix maintains a full record of my activity. My girlfriend has since become my wife, and we've since lived in six different apartments in three different cities. Our career paths have totally changed, too. One of the few things that's remained relatively constant in our lives (save for a brief deactivation of our account while living abroad) is our Netflix subscription.

Now, I can't fairly kick myself for not buying shares of Netflix in late 2004, when shares traded around $12.50, because I wasn't even investing in individual stocks at that point. My interest in David Lynch far exceeded my interest in Peter Lynch.

By the summer of 2005, though, it's safe to say that I could have picked up shares of Netflix. By then I'd rented about 50 DVDs, and I was totally hooked on the service, whose underlying economics were easy enough for even a newbie investor like me to understand. It's around that time that I also made my first stock purchases. I very realistically could have purchased shares for around $17 during that summer.

At today's price, that's more than a tenfold return that I've missed out on. Worse still, the market offered up another bite at the apple much more recently. On several days in late 2008 -- the sorts of days in which anything with decent liquidity was sold indiscriminately by portfolio managers meeting margin calls -- Netflix shares closed below $20.

By that time, I think even my parents had subscribed. And we didn't even have a microwave when I was growing up. The late adopters had officially arrived. Netflix was growing like a demon and clearly eating the lunch of rental chains like Blockbuster, which recently filed for bankruptcy. And yet, I still did not buy.

Just to underline the fact that all the above is not some theoretical exercise, I'd like to point out that my colleague Jim Mueller actually did land this particular 10-bagger. So, kudos to Jim for swinging at the fat pitch.

Simple, but not easy
Let's go back to those two guys named Lynch (no relation). The famous director's films tend to tackle elements of the human psyche that are too complex for words. The famous money manager's books advise investing in businesses simple enough that they can be illustrated with a crayon.

There is often tremendous value to be found in securities as complex as Mulholland Drive. Bill Ackman's investment in General Growth Properties (NYSE: GGP  ) comes to mind, as does Bruce Berkowitz's huge bet on AIG (NYSE: AIG  ) . Ackman paid under $0.50 a share back in late 2008 for General Growth, which has since entered and exited bankruptcy. Unlike many bankruptcies, shareholders were not wiped out in the restructuring. On the contrary, the very same shares now trade for $15. Berkowitz, who also cashed in on General Growth, has made the extremely opaque AIG his fund's largest position. Here's what he had to say about the insurer in a recent Fortune feature:

"For a mere mortal with an average intelligence, it takes a long time to try to put all the pieces together. It's all there to be put together, it's just that you need to have no social life and not too many investments."

If you have the time and the motivation, this style of investing could work for you. For most of us, though, the Peter Lynch approach of keeping it simple and sticking to what you know makes a lot of sense.

Today's Netflix, and the next Netflix
In my view, the Netflix story is getting less simple as the company shifts to digital content delivery. There are intelligent investors out there arguing that the content licenses Netflix needs to acquire to stream digital content will get much more expensive and compress future margins. The current valuation doesn't appear to leave much room for error. (Then again, this stock never looked cheap, did it?)

For turbocharged returns, I think investors are much better off looking for situations akin to Netflix circa 2005. That's to say, an understandable business with demonstrated success and compelling economics, but which is still at an early stage of market penetration.

I actually bought a business like this back when I started investing. The company was Intuitive Surgical (Nasdaq: ISRG  ) , a maker of robots used in minimally invasive surgical procedures. Unlike Netflix, I had no connection to this business. I didn't have to personally go under the knife to understand the compelling investment case, however. As demonstrated by my colleague Brian Richards, Intuitive passes the crayon test: Sell the machines at a slim margin, then cash in on the recurring revenue from instrument sales and service agreements.

When I invested, Intuitive was doing $175 million in annual revenue. That figure is now $1,347 million. Importantly, the firm's free cash flow margin has also more than doubled. With a relatively large installed base now in place, those higher-margin recurring revenues have turned the afterburners on cash earnings.

I've really gotten away from this style of investing in recent years, focusing more on special situations and companies trading at deep discounts to tangible assets. Buying dollars for $0.50 is pretty satisfying, but I'd be lying if I said I didn't miss the sort of multibagger returns that a well-chosen growth stock can produce. I'm not interested in boxing myself in as an investor, so I'm officially keeping my eyes open for another Netflix-like opportunity.

Not an obvious successor
Some people see that potential today in OpenTable (Nasdaq: OPEN  ) , a service that I use occasionally, but which doesn't register terribly high on my game-change-o-meter. Fellow Fool Rick Munarriz calls this company "the real deal," and points to its moves to duplicate Groupon's success with social coupons in the future. I'm trying to keep an open mind on valuation, but even setting aside the fact that the stock's trading more than 65 times next year's expected earnings, the opportunity here is just not obvious to me.

OpenTable could be a huge winner in the years ahead, but the potential seems to require a shift in the business model. I want a company that's already got the winning formula in hand, and just needs time to let the domination unfold. Something like Chipotle's (NYSE: CMG  ) killer unit economics (and delicious burritos), which put those of competitor Qdoba to shame. I'm talking Peter Lynch crayon simple.

I'm certainly open to suggestions. So, which stock in your portfolio is a future 10-bagger? Make your best case in the comments section below.

The best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. Check out this special free report on 3 Stocks Warren Buffett Wishes He Could Buy.

Chipotle Mexican Grill, Intuitive Surgical, and OpenTable are Motley Fool Rule Breakers recommendations. Netflix is a Motley Fool Stock Advisor pick. Chipotle Mexican Grill is also a Motley Fool Hidden Gems selection. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitter or RSS. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool owns shares of Chipotle. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 14, 2010, at 2:00 PM, langco1 wrote:

    a strong buy on nflx! this stock just dropped over comments made by a desperate short seller who bought in at a much lower price and is desperately trying to get his money back!nflx is now a lot better priced in the 170's and will be right back over $200....

  • Report this Comment On December 14, 2010, at 4:40 PM, zbouck wrote:

    I wake up in cold sweats thinking of 2006 when I decided netflix was "just to expensive."

    The one candidate I have right now is LPL, check out my CAPS bull pitch for details.

  • Report this Comment On December 14, 2010, at 6:26 PM, MichaelHamilton wrote:

    netflix is too expensive for me at this time too high a p/e

  • Report this Comment On December 14, 2010, at 6:35 PM, paulplamb wrote:

    In view of Time Warner's Jeff Bewkes negative comments about Netflix's future (New York Times, Dec. 12) are you still bullish on its prospects? Other entertainment industry commentators note that because the movie studios and program makers are now focussing on Netflix and internet distribution, Netflix will soon face a huge increase in costs.

  • Report this Comment On December 14, 2010, at 9:47 PM, Wade32ru wrote:

    Excellent post. Thanks

  • Report this Comment On December 15, 2010, at 2:39 AM, imkul2003 wrote:

    How about Chipotle? CMG. It sounds to me like you are missing another obvious Netflix. The way you talk about Chipotle you are obviously familar with it as a consumer. Peter Lynch loves companies that you or your daughter and her friends or your grandmother or someone you know loves. If you are the consumer, you have a great insight into whether or not the company/enterprise sucks or not. Well, Chipotle doesn't suck. Passes the crayon test. Proven concept. High growth rate of earnings and everything else. It might come down a little more from here, but as a long-term investment, it's a no-brainer. It may not be a 10-bagger in six years, but it will almost undoubtedly be awesome.

  • Report this Comment On December 15, 2010, at 5:59 AM, Stender89 wrote:

    LHCG.

    HUUGE potential.

    Most effective operator in a very fragmented industry.

    Great company, great stock.

    GARP (growth at reasonable price) Very reasonable I might add. Baby boomers generation makes this a very attractive buy

  • Report this Comment On December 15, 2010, at 10:36 AM, Usnzth wrote:

    Agree with LHCG. One of my major holdings in my RMP (Real Money Portfolio)

  • Report this Comment On December 15, 2010, at 11:09 AM, TMFHelical wrote:

    I missed it as well.

    But my wife didn't. So at least I did something right.

    TMFHelical

  • Report this Comment On December 15, 2010, at 1:33 PM, davfoo wrote:

    I'm betting on A123 Systems (AONE) and IRobot (IRBT) to be multi-baggers. Buy now and hang on to them for a few years. They are both in my RMP.

  • Report this Comment On December 15, 2010, at 1:34 PM, OrangeIcon wrote:

    Speaking of stocks that Buffett would buy, for individual investors what about stocks that Mr. Buffett already owns--Berkshire Hathaway. As I type, Berkshire Class B shares are at $79.65 and they trade with a P/E of 0.01. The stock is trading at earnings today meaning that if the whole company was liquidated today (without tax considerations) you might get a check in the mail for about $79.65 per share owned. There are no future earnings priced into the stock.

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