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How the Heck Did I Miss This 10-Bagger?

Toby Shute
December 14, 2010

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 relativel