Netflix (NFLX -3.67%) is one of the greatest growth stocks of this generation, and I've been lucky enough to own shares along the way. What's more, the company could still have a bright future ahead: Concerns about competition are overblown, and there's a much wider moat surrounding Netflix than bears would have you believe.
And yet I recently sold all of my Netflix shares. Read below to find out why, and to figure out whether or not you should do the same.
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A lesson from Moneyball
But before we get to my reasons for parting ways with Netflix, let's revisit a lesson from Moneyball.
Michael Lewis's book-turned-movie is about the Oakland Athletics finding success on a shoestring budget. The premise of the story was that baseball traditionalists were too focused on certain statistics, including batting average, home runs, and RBIs. Players who produced such numbers were paid big bucks.
Billy Beane, the general manager of the A's, discovered there were other, less-appreciated stats that better predicted success. These included things like a player's on base percentage (OBP), which can be significantly aided by walks. Because others weren't looking at OBP, Beane could find players such players and afford to pay for them.
But in the story, Beane has a tough time convincing the team's coach to sit first baseman Carlos Pena (a power hitter) and replace him with oft-injured catcher and relative nobody Scott Hatterberg (who drew a lot of walks). Beane eventually traded Pena away to force Hatterberg into the line-up. The ploy works, with the A's almost immediately climbing the standings. But here's the thing: Pena ended up doing quite well, becoming an All-Star and home run leader. Hatterberg never reached such heights.
The lesson: No matter their talent level, players have to fit in with the philosophy of the team for the team to be successful.
Designing one's investment framework
Now I'll take that lesson and apply it to Netflix.
Last month, I detailed how I've constructed my own investing schema, dubbed "The Antifragile Framework." Over the past decade, it has tripled the market's return. It selects for three characteristics in companies:
- A barbell technique -- This involves devoting 80% of resources toward a solid business protected by a wide moat, and the other 20% toward high-risk, high-reward ventures.
- Financial fortitude -- This means having lots of cash, little debt, and strong free cash flows.
- Skin in the game -- I like investing in companies that are founder-led, where insiders own lots of stock and employees are happy.
When I recently ran Netflix through this framework, I realized it no longer did so well. I ardently believe that once Netflix snags a user, they are highly likely to stay with the service for the long-haul -- but I no longer see any possibility for the company to explore new forms of entertainment.
That's because Netflix has taken on enormous amounts of debt to create original content. Over the last four-and-a-half years, the company has lost $8.3 billion in free cash flow. It currently has a net cash position of negative $7.6 billion.
And I don't think this was even a bad move: Creating original content snags in users. You can only watch Stranger Things, for instance, if you subscribe to Netflix. Its roster of subscribers has ballooned in recent years, especially internationally.
But that comes at a cost: There's no way Netflix could try and enter new forms of entertainment like sports or news. There's no high-risk, high-reward part of the barbell. And having that much debt does make a company vulnerable should something calamitous happen that would cause mass cancellations of the service.
Again, I'm not saying that will happen. But if it did, it would cripple the company. There are other companies out there that would could easily weather such a storm with their war chests of cash on hand.
Furthermore, while Netflix is run by a brilliant founder, Reed Hastings, insiders together own just 3.7% of shares -- a relatively low figure by my standards for a founder-led company.
Should you sell your shares?
Put those things together and my decision to sell might make more sense.
On the one hand, I believe Netflix is an excellent company and service. It also has a stock that I think could appreciate markedly over the next decade. And I'm not alone -- Morgan Stanley believes Netflix could capture over 300 million subscribers by 2028 (it's currently at 151 million).
But I can believe that wholeheartedly and still acknowledge that the company doesn't fit in my framework. I like investing in companies that won't be devastated by a negative Black Swan (like the Qwikster debacle) and can surprise me with new lines of business I can't even imagine today.
That could be Netflix at some point in the future, but it doesn't describe the company right now. You have to let your own criteria help you make such decisions. But if the optionality of the high-risk, high-reward part of the barbell is important to you, it might be worth taking a second look at how Netflix fits in your holdings.
