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Netflix's growth potential justifies its sky-high valuation

By Banu Simmons

After the share price declines in April, calm returned to markets in May and battered small-cap and growth stocks started to recover. The S&P 500 Index (SPX) has rebounded 5.9% since April's sell-off and the Nasdaq 100 Index (NDX) climbed 4.3% in May.

US unemployment has been steadily coming down in May as indicated by the downward trend in the seasonally adjusted weekly numbers. According to the press release of US Department of Labor, seasonally-adjusted initial jobless claims fell to 300,000 in the week ending May 24, down by 8% from the previous week.

Furthermore, the seasonally-adjusted consumer confidence index rose 1.6% in May, and the Conference Board's seasonally-adjusted leading economic indicators index has accelerated since the beginning of the year, reaching a reading of 101.4, the first time since the year 2007.

Although the housing sector seemed to be somewhat sluggish, most economic indicators were on the positive side in May. Especially the leading economic indicator index is known to have a causal correlation to stock returns, which increases our confidence in the near term performance of the stock market.

Another sign of the US economic recovery is the annual inflation rate recorded in April. According to the report by U.S. Bureau of Labor Statistics, over the last 12 months, consumer prices in US increased 2.0%, the largest increase since July of 2013.

With the inflation rate below the Fed's 2% target, investors generally don't expect an interest rate increase before the summer of 2015. However, a recent increase in the inflation rate, coupled with the downward trending unemployment, in my opinion Fed policymakers might increase the Fed funds rate sooner than expected.

While the US economic fundamentals are improving, economic data in Eurozone have been less strong as unemployment remains record high and inflation is well below the target rate of 2%. This leaves room for action either in the form of quantitative-easing or rate cuts by the European Central Bank.

The U.S. is tied into the global economy through exchange rates and trade, among other things. So if European growth gains momentum, this would benefit US companies which trade with Europe.

The positive effect of monetary stimulus in Eurozone might be offset by a weakening Euro versus strengthening US dollar, as goods of US companies become more expensive. Nevertheless, I believe that from the US producers' point of view, the economic growth (demand) benefit of a Eurozone revival would outweigh any headwinds caused by currency movements.

Among the recovering stocks in May, Stratasys (SSYS) and 3D Systems (DDD) perked up after some positive news with regard to the demand for 3D products from business.

Although the technology hasn't been subject to significant consumer demand up to now (and the percentage of shares sold short has been high for 3D producers), I continue to believe that the sell-off in April in this sector reflected a short-sighted approach of investors, possibly an overreaction to the sub-par first quarter earnings of some of these companies..

In May, I made only one change to our portfolio. After the share price of of Netflix (NFLX) tumbled in April, I took advantage of the lower share price. And in my opinion, I thought it advantageous to add the stock to the Long Only Sector Rotation portfolio.

Netflix is an internet television network provider with more than 44 million streaming members in over 40 countries. Although NFLX has a high P/E ratio (around 150), it has a very impressive record of top-line and earnings per share growth according to its last quarter numbers (year on year, 24% and 500% respectively). Given that the company is just starting to exploit its market potential outside the US, I expect growth in the next few years to justify a lofty valuation.

DISCLAIMER: The investments discussed are held in client accounts as of May 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.

Banu Simmons

Banu Simmons

I have a decade of financial sector experience as an econometrician/quantitative analyst. Furthermore, I conduct academic research on equity analysis

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