• Quantitative tests paint a gloomy future for the company.
• Too many uncertainties to warrant an investment at this price level.
While perusing film titles at the local video store, a friend of mine (who is not in the finance game) asked what my opinion was of Netflix $NFLX as an investment.
Naturally, she had read an article or two online that had all but convinced her that Netflix could do only one thing – go higher and higher – and make her a lot of money in the process.
My answer was that as a quantitative investor, the likes of Netflix rarely enter my investing universe, so I could hardly give my opinion on the merits of the company as a long-term investment.
I could tell by her reaction that my answer was less than satisfactory. She was basically saying to me “tell me, should I buy Netflix stock?” and my answer was that I didn’t know.
That evening I decided to take a look at the company and see how it fit’s into my models.
By the end of it, I was convinced that right now, this is a company to stay clear of.
1. 7th most volatile stock
Numerous studies have shown that low volatility stocks earn greater returns than high volatility stocks. Yet most investors still focus on the stocks that are highest in volatility.
Highly volatile stocks are exciting, they tend to have wider news coverage, and they are often in fast moving, possibly game-changing industries.
In short, volatile stocks attract attention – but they do not offer better investment returns.
A simple algorithm that I use to calculate stock volatility currently rates Netflix as the 7th most volatile stock in the S&P 1500 universe.
You can see this from the daily price chart. There are lots of gaps and unpredictable price moves.
(If you’re wondering, the most volatile stock was shown to be PCLN).
To put the volatility algorithm into perspective I ran some tests on the data available.
I found that if you had bought the 50 most volatile stocks in January last year and sold them at the end of the year, you would have made a total annual return of just 3.06%. Quite a way below the benchmark return of 13.48%.
Over longer time-frames the results are even less promising.
Buying the 50 most volatile stocks and selling them a year later, as a strategy over the last 20 years (1/1/1995 – 1/1/2015), would have earned you a total compounded annual return of just 0.75%*. This is a long way behind the total return from the S&P 500 of 9.7%.
High volatility stocks do not perform well. Yet still, investors like nothing better than to chase the returns of the most talked about companies.
*This analysis has been conducted with the Amibroker trading platform using a database of US stocks (S&P 1500 universe) that is survivorship-bias free, provided by Norgate.
2. Financial ratios are worrying
Not only is Netflix a highly volatile stock at present, it is also extremely expensive according to it’s various financial ratios.
Sensible investors know to avoid stocks that have sky-high PE ratios and Netflix currently trades at over 100x future earnings. It’s PEG ratio is 3.14 and it’s price-to-book ratio is 17.90.
But those numbers don’t mean much without context.
So I decided to load up another simulator and test the historical outcome of buying stocks with such expensive ratios.
In the next chart, you will see what happens when you buy a portfolio of 10 stocks (rebalanced monthly) that have the following characteristics:
– PE ratio above 30
– PEG above 3
– Price-to-book above 10
As you can see, the outcome is not promising.
Buying stocks with PE ratios above 30, PEG ratios above 3, and price-to-book ratios above 10, produced an annual return over the last 15 years (red line) of -3.26% compared to the benchmark annual return of 2.54% (blue line).
3. A lot of selling, not so much buying
These historical tests do not look good for NFLX and they extend to other areas of analysis too.
According to the information at Gurufocus, there has been hardly any buying of Netflix stock from insiders over the last couple of years.
We know that Carl Icahn used to have a big interest in Netflix stock but it appears he’s been selling into strength. Filings suggest the investor sold off a decent 20% chunk in the final quarter of 2014,according to this.
Likewise, managers George Soros and Whitney Tilson both exited their positions by the end of 2014.
Whatever you think about the company, the lack of recent buying from any large, notable investors is another one for the negative column.
4. Net neutrality risk
For now, the laws regarding net neutrality are stacked in Netflix’s favor. Last February’s FCC decision was a major boost for content providers like Netflix, Pandora, and YouTube.
However, with an election coming in 2016, there is still a risk that the ruling could be reversed. I’m not saying it’s a big risk but it’s a risk nonetheless and it needs to be accounted for.
Consideration also needs to be made about net neutrality laws in foreign countries. NFLX is doing it’s up-most to gain international subscribers but if foreign governments cling to outdated freedom laws, this could undo a lot of the hard work and money the company has spent on growing it’s overseas customer base.
5. Earnings and currency risk
Netflix reported earnings last week and as you will probably know they weren’t great. But that didn’t stop the stock soaring to new highs, on the basis of record numbers of international subscribers.
The reason for the drop in earnings was largely attributed to the foreign currency factor, with the stronger dollar impacting the company’s bottom line.
Of course, with the Federal Reserve still to embark on the first of a series of rate hikes, the likelihood of the greenback reversing course is slim, so the impact on earnings may not be transitory.
As you can see from the next chart, NFLX stock price has continued to soar but year-on-year % growth in EBITDA has stalled.
6. Competition risk
In today’s Internet driven world where content is king you would think that Netflix would be in prime position.
But it must be remembered that Netflix must pay for it’s content first. And that could prove to be another stumbling block.
In this situation, it is the content creator that is in the driving seat and not the content provider. Unless of course, that content is created by users of the service, at no cost. As is the case with YouTube.
Whereas Netflix must spend millions of dollars curating and showcasing the best content, YouTube has an endless supply of free content uploaded to it’s servers every minute of the day.
In an industry like video, services like Netflix live or die by the content they provide. If the content is not fashionable or well-received, subscribers will quickly turn to un-subscribers and find their content elsewhere.
In short, there is a lot of competition out there and the continued success of Netflix is by no means guaranteed.
When I started this article, I was initially going to write a list of 10.
I was going to mention the negative free cash flow…
And the overbought level on the RSI…
And the overpriced nature of the Peter Lynch chart…
But to be honest, I was out of this stock from reason number one.
I like Netflix as a service and I believe the stock probably does have the potential to go higher in the long term. Who knows, maybe Apple will buy it out some day?
Right now, however, trading at a market cap of $33 billion, this is a stock with a high amount of volatility and irrational exuberance. And I avoid those like the plague.
What do you think of Netflix stock?