When it comes to identifying stocks for potential investment, I focus primarily on qualitative factors. Before I even look at the valuation, the business needs to make sense to me, and it must have an advantage compared to peers.
For me, Netflix (NFLX -0.40%) fits the criteria of a high-quality company. And the market thinks so, too, as the stock is up 64% this year at Tuesday's prices.
I'm a firm believer that historical winners can continue their success longer than we think. Netflix is no different. Here are three reasons why I'll soon be buying shares of the streaming pioneer.
It's the leader in streaming
With nearly 200 million paid subscribers in more than 190 countries, Netflix is the clear leader in streaming entertainment. Co-founder and CEO Reed Hastings was ahead of his time in recognizing the disruptive power of the Internet on media consumption, which is why his company introduced streaming video on demand in 2007 -- even as it was disrupting the video-rental industry with its DVD-by-mail service.
As the first mover, Netflix spent massive amounts of cash on content with the goal of attracting subscribers as fast as possible. This was undoubtedly the right strategic move early on because the company faced no competition in streaming. Now, Netflix is able to spend more than its peers while spreading the cost over a much larger subscriber base.
From 2017 through 2019, Netflix spent just under $37 billion on content. At this scale, no other pure-play streaming company can compete with that. Those that are large enough have other business lines in addition to their streaming services, in particular Amazon Prime, Apple TV+, and Disney+.
Another factor supporting Netflix's dominant position is its ability to attract the best and brightest talent in the entertainment industry. Hastings runs his company like a sports team, where top performers are rewarded and mediocre employees are sent packing. While this might not be the appropriate work environment for everyone, it has worked so far for Netflix.
The shows have cultural influence
Spending tens of billions on content would mean nothing if viewers didn't like the shows and movies produced. But this year has provided multiple examples of how popular Netflix originals can be.
A recent case is The Queen's Gambit, which was released in late October. The scripted limited series was watched by 62 million households in the first 28 days after its release, a record for Netflix. What's more impressive is the exploding interest in chess thanks to the show. Google searches for "how to play chess" hit a peak in November not seen since 2011. The eponymous book that the show is based on made its way onto The New York Times best-seller list, 37 years after it was first published!
Additionally, Chess.com, a social network for enthusiasts, added 2.8 million members in November alone. This was compared to just 1 million in the prior month.
We saw this kind of public frenzy earlier in the year as well. As lockdowns were implemented in March to stop the spread of the novel coronavirus, Netflix released Tiger King to wide fanfare. This documentary series was talked about all over social media, and it was the inspiration for many Halloween costumes.
Netflix has clearly shown that creating popular content is a core competency, and subscribers have come to view the streaming service as a place to find captivating entertainment. This will help sustain its lead as competition heats up.
The valuation doesn't bother me
As the economy continues to shift from one based on tangible assets to one built increasingly on intangible assets, the price-to-earnings (P/E) ratio doesn't do a good job capturing the essence of these new-age digital companies.
In Netflix's case, it can be accurately assumed that a large portion of its marketing and technology and development expenses in any given period actually benefit the company in future periods. Instead of being capitalized and expensed over time, these costs show up fully on the income statement, which understates the real profit of the company.
This would mean that the true P/E ratio for Netflix is really lower than the reported 86, making it more attractive from a valuation perspective. Combine this with its first-mover advantage, its ability to spend more on content than peers, and its top-tier workforce, and you have a stock worth adding to your portfolio. In a few days, as soon as Motley Fool trading rules allow, I'll be adding it to mine.