If you are a long-term investor, you need to be careful about what you add to your portfolio. Not only do you have to make sure you're buying something that is reasonably priced, but you must also understand the business and trust the people running it. Finding that sounds a lot simpler than it really is. Here are three big names that fail these simple tests for me: Netflix, Inc. (NASDAQ: NFLX), Tesla, Inc. (NASDAQ: TSLA), and Kinder Morgan, Inc. (NYSE: KMI).
1. Way too expensive for this flix
My family enjoys using Netflix and has since the days of renting DVDs through the mail. It was and remains a disruptive force in the media and entertainment world. From that perspective, it is a very exciting company and appears, for the most part, to be well run.
Fellow Fool Anders Bylund recently laid out the case for a positive outlook, noting that the company continues to grow its subscriber base (up over 25% year over year in the second quarter) and expand its already-impressive portfolio of company-generated content. Financially speaking, operating income was up a huge 262% year over year in the second quarter.
I see three problems. First, as Anders admits, Netflix is burning cash as it spends heavily to create content. That won't end for at least a couple of years. Long-term debt is making up the difference, up nearly 30% in the first six months of this year alone. Second, the content it's creating is also building something of an arms race in the media industry, which means competition remains fierce. And then there's the price of the stock. With a price-to-earnings ratio of more than 150, investors are clearly pricing in a lot of success. This third reason borders on the absurd for anyone who believes in value investing.
Maybe someday I would be interested in Netflix, but not while it's burning through cash in a competitive media market and trading at extreme valuation levels.
2. Great cars, but too hot a stock
Tesla is another stock I wouldn't be interested in for some very similar reasons. There's no question that the company has been influential in pushing the auto industry in a new direction. Or that CEO Elon Musk is a visionary who is capable of seeing things in a way that I will probably never understand. And, to be honest, the electric cars Tesla makes are pretty darn cool.
But Tesla operates in a very competitive business. Automakers aren't sitting still allowing this upstart to own an important new industry segment. Moreover, Tesla is still in the growth phase, spending heavily to build its business. Cash burn has been huge, with debt funding much of the recent spending because the company keeps running low on cash, which is, in the end, the lifeblood of every business. To put a number on that, long-term debt was $2 billion at the start of 2016 and $9.5 billion at the end of the second quarter.
Meanwhile, Tesla has yet to turn a full-year profit, though it promises it will be in the black in the second half of the year. But Musk keeps adding aggressive new projects to the to-do list, like building electric trucks (which will supposedly come after the company manages to smooth out the troubles with the Model 3), turning "sustainably profitable" into a far more difficult task.
In the meantime, Tesla's valuation is extreme relative to peers. Since earnings are negative, let's look at price to sales. Its P/S ratio is just under four times, while its giant auto peers trade at less than 0.4. I wouldn't mind owning one of Tesla's cars, but at these prices, I certainly don't want to own the stock. And none of this even takes into consideration the unusual situation surrounding Musk's tweets about taking Tesla private. No thanks, I'm not up for this volatile ride.
3. It's a trust thing
Kinder Morgan is the kind of boring business I would usually find very attractive. It owns midstream energy infrastructure that would be hard, if not impossible, to replace. Much of its business is fee-based, providing a reliable stream of cash to support its generous 4.4% dividend yield. It also has big plans for dividend increases, with the goal of upping the annual per-share payment from $0.50 in 2017 to a projected $1.25 in 2020.
Although the path to that higher dividend isn't as clear as it used to be because of troubles with a growth project in Canada, Kinder Morgan is a huge company with many levers to pull to replace that big development. The real problem I have with it stems back to 2016, when the company slashed its dividend by 75%. Even after all the increases, the dollar value of the dividend in 2020 will still be lower than it was prior to the cut.
The drastic dividend decrease came at a time of industry weakness that limited Kinder Morgan's options for raising cash to sustain its growth spending. It chose to trim the dividend, which was probably the right choice even though it was a painful one for income investors. That decision, however, was partly driven by the company's heavy use of leverage compared to peers -- it put itself in a position where it simply didn't have a lot of options. It continues to make relatively aggressive use of leverage.
The biggest concern I have, though, is that just a couple of months before the 75% dividend cut, Kinder Morgan's management team was telling investors to expect as much as a 10% dividend hike in 2016. With leverage still relatively high and a history of going back on its word, I won't be investing in this midstream giant anytime soon regardless of its plans for growing its dividend.
The whole picture
When you look at a company you want to invest in, you should look beyond just the stock price. Netflix is not only expensive today, but it's increasingly using debt to support a media arms race in a very competitive industry. Automaker Tesla is also relying heavily on debt as it builds its still money-losing business in a competitive industry, and it's priced at a huge premium compared to more established peers. My issue with Kinder Morgan is a little different. The company's heavy use of leverage is a concern, but the big issue is trust, since management was telling investors to expect a dividend increase in 2016 just months before clipping its dividend by 75% instead. In the end, these are three stocks I won't be touching.
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