'If I Take Netflix Out of My Portfolio I Lose One of My Biggest Winners'

Some thoughts on the conflicts of interest for an investment adviser between running their business and making intelligent long-term decisions for their clients

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I recently listened to an episode of the QTR podcast that featured Ross Gerber, an investment adviser with the firm Gerber Kawasaki. During the podcast, Gerber discussed his investment in Netflix (NFLX). As you might suspect, he has made a killing for his clients since he bought the stock (it’s up more than 100% since the start of 2018). After some prodding by the host about the stock's current valuation, Gerber bluntly stated that Netflix shares are “ridiculously expensive.”

He put some numbers on that, saying that he believes the business deserves to trade at 6x to 7x sales. For context, Netflix should generate somewhere around $16 billion in revenues in the current fiscal year (using Goldman’s estimates). Against a current market cap of roughly $175 billion, that’s a forward price-sales ratio of roughly 11x. Relative to 6x to 7x sales, the stock is roughly 60% above his estimate of fair value. That’s a pretty big gap.

When asked about why he continues to own the stock if it’s clearly overvalued by a wide margin, here’s what Gerber said:

"If I take Netflix out of my portfolio, I lose one of my biggest winners."

I give Gerber a lot of credit for his sincerity. I think most investment advisers, whether they would admit it or not, think similarly when they buy or sell individual stocks for their clients. There’s an unwillingness to sell stocks that have done well, particularly if they’re widely perceived as being a company that will be dominant in the future (the FANG stocks come to mind).

On the other end of the spectrum are the companies that have fallen from grace and that have seen their stock prices lag the S&P 500. It’s ten times worse if the stock has lost money. When you sit in a client meeting, it often feels like these are the only stocks that clients want to talk about. As a result, advisers hate these stocks, particularly if the name has been a loser for a long time and if the situation is complex (which makes those conversations uncomfortable). I think the current posterchild for this group is General Electric (GE). Most advisers avoid that kind of stock like the plague.

The reality is that many people in the investment advisory business make decisions for their clients based on considerations that have nothing to do with the attractiveness of the security in question. Their primary concern is career risk. And that risk for one adviser is an opportunity for others to win new business. As Gerber explained during the podcast, continuing to own a "ridiculously expensive" but widely loved stock like Netflix also presents a substantial opprtunity for advisers:

“We see accounts and we go ‘Oh, your adviser didn’t buy you Netflix? Your adviser didn’t buy you Google? What are they doing?’ And everybody’s like ‘I don’t know.’”

When the host retorted, “Maybe they’re looking at the valuation.” here was Gerber's reply:

“Right, but the problem is that the clients are seeing the gains [on TV or in the financial press] and they’re not getting it. And we’re taking those clients from those advisers.”

Again, I applaud Gerber for his sincerity. I think the sentiment he has shared is quite common in the investment advisory business. If this is a path to assets under management, there's no question (some) advisers will do it. Again, the primary objective isn’t to generate the highest risk-adjusted rates of return for your clients. It’s to keep clients happy and reduce career risk -- even if that means doing things that are not in their financial interest over the long run.

In Joel Tillinghast’s “Big Money Thinks Small,” he shares a vivid example of what an investment manager can face when they take a contrarian stance and refuse to engage in activities that they view as harmful to the long-term financial health of the end client.

In the book, Tillinghast discusses the tech bubble of the late 1990s and some of the insane price action he witnessed. One example is Sycamore Networks, which went public at $38 per share. By the end of the first day of trading, the stock had climbed an astounding 384% to $184 per share. Crazy, right? Well, over the next four months, the stock tripled again. At its peak, Sycamore had a market cap of $44 billion – compared to peak sales of less than $400 million. Tillinghast did not find value in these kind of situations and largely avoided tech stocks during the late 1990s. The result?

“Roughly half of my funds went out the door during the internet bubble.”

A decision we all view as rational and good for investors in the fund (at least in hindsight) cost Tillinghast half of his assets under management. I don’t know how his compensation worked at Fidelity, but if you own an independent investment adviser business the entirety of those lost fees come directly out of your pocket. The reality is that an adviseer has a real incentive to stick close to the herd, even when he or she has reason to believe it’s not in the best interest of their clients.

This is a really difficult problem to address, for a reason that Gerber captured succinctly during the podcast appearance: “We’re dealing with humans.”

In a perfect world, advisers would spend more time on upfront education to ensure clients at least understand the basics of their investment philosophy. From there, the client would keep a watchful eye, but would leave the decision-making up to the adviser. They wouldn’t nitpick individual decisions or judge them against the noise of short-term market fluctuations. Sadly, in my experience, this is a mile away from how this actually works. I think there’s blame to be shared by both parties.

I don’t have an upbeat conclusion: Whatever side of the table you’re on, you should do what you can to encourage long-term thinking and rational decision making. If your adviser isn’t willing to openly discuss their process, find somebody else to work with. I would do the same if they rarely say “I don’t know” or if they are not open about the challenges of navigating the current investment environment.

At the same time, you should come to the table with realistic expectations about what your investment adviser has to offer. At least understand the basics. Considering that you’re talking about some of the most important financial decisions you’ll ever make in your life, it’s worth your time.