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The Rich Investor’s Secret to Buying Low

“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.”                                                               

-Warren Buffett

Eight months ago, investors had essentially written off Netflix (Nasdaq: NFLX).

The company lost 3 million subscribers and angered many others in late 2011 after a series of mindboggling missteps by founder and CEO Reed Hastings. The bad press that ensued took a serious toll on Netflix’s stock, and the company took more than a year to recover. But as history has shown, great companies temporarily beaten down by bad press can have tremendous upside potential.

You see, investors tend to think rosy thoughts when times are good.  And when bad news in is the air, they are quick to expect the worst.

The fact is that most investors get things wrong. Even the experts on Wall Street were wrong in telling investors to SELL Netflix shares when the stock was trading in the $65-$75 range.

Not to single any particular firm out – but San Diego based investment bank Caris & Company downgraded Netflix on December 6, 2012 – when the stock sold for $86 a share…

Instead of listening to the “experts,” I advised subscribers of my $100k Portfolio investment newsletter service to BUY Netflix in early December 2011 when the stock was trading at $71 a share. I also told Daily Profit readers that Netflix was my very favorite investment idea for 2012.

Eighteen months later, the result is a 239% return.

Netflix’s business model hadn’t changed – just its stock price. The company’s wounds were self-inflicted, the product of near-comical lapses in judgment.

First, the online video giant jacked up its prices by 60%. Then the company proposed splitting its DVD-by-mail and online streaming businesses into two web sites, only to scrap the plans in a poorly conceived late-night email from Hastings.

Seemingly overnight, Netflix – a stock-market darling up until July 2011 – was virtually left for dead. From July 13 through the end of November, the stock fell 79% – from a mid-summer high of $304 a share to a post-Thanksgiving low of $63.86 a share. Its market cap plummeted to $3.84 billion in early December, less than one-quarter of the $16 billion market cap the company briefly touched over the summer.

As I wrote then, however, I thought the stock had a chance to double over the next six to 12 months.

I wrote, “When a company gets this beaten down, the result is usually a huge gain over the following months.”

At first, it looked like the rally would be instantaneous. Within two months, the stock had almost doubled, rising to $129 a share in February 2012 on the strength of better-than-expected earnings in late January.

That turned out to be just a temporary rebound. By last summer, Netflix shares were back below $70, and by late July, the stock had dropped below $60. I held onto the position, maintaining my belief that the correction was just a short-term blip brought on by a series of questionable decisions. That turned out to be a wise decision.

Since August 2, Netflix shares have more than quadrupled. The stock is up an astounding 346%, closing Monday just below $240 a share. I bought the stock at $71 a share, netting my $100k Portfolio subscribers a whopping 236% profits since.

Given the company’s impressive history, a bounce-back was inevitable. Netflix is a pioneer in the video rental business, inventing the DVD-by-mail concept that essentially put Blockbuster out of business. Additionally, the company’s rapid expansion of its online video streaming business has made it the cable company of the 21st century, with more video streaming subscribers than any other cable or satellite company in the U.S.

All the bad news surrounding Netflix caused the company’s stock to become grossly undervalued. With a $4 billion market cap, Netflix’s market value was just two times annual revenue from its streaming video business, without even factoring in its profitable DVD-by-mail business.

The company made some poor decisions in 2011, resulting in some serious public humiliation. But at its core, Netflix’s underlying business hadn’t changed. Most of its customers are still there, and many more are on the way as the company expands into Latin American and the United Kingdom. Netflix is still a very solid company.

The lesson of Netflix’s recent revival is one we’ve seen before. The steep decline in the company’s stock was very similar to the one BP (NYSE: BP) experienced in 2010 after its disastrous Deepwater Horizon oil spill in the Gulf of Mexico. BP’s stock price was slashed in half – from $60 to $30 – in less than a month, as public backlash against the oil giant reached a boiling point.

The general public may not have forgiven BP for the environmental havoc its oil spill wrought in the Gulf area. But the stock has since rebounded and is now trading at $43.40 a share.

Value investors can find profits by looking beyond the headlines, ignoring the conventional advice of Wall Street analysts, and by taking a contrarian investment view. While many of my colleagues – and subscribers – thought I was nuts for recommending Netflix after the stock had plunged 79%, its amazing performance since clearly highlights the value of thinking differently.

Not all stocks are great bargains after their share prices fall. But there are always a few gems that are misunderstood and are great values after falling from grace.

Full Disclosure: I currently own shares of Netflix.