Thursday, May 3, 2012

Amazing Amazon

From this recent Barron's article:

Somebody needs to explain how Amazon.com's share valuation really works. Because, despite wondering about it for more than a decade, I still can't figure it out. First it was eyeballs. Then it was clicks. Then revenue-per-customer, then wallet-share and now gross margins. Price-earnings-ratios be damned.

I've made more than my fair share of comments about Amazon's (AMZN) baffling valuation.

It is and has been a stock I would not buy at even a fraction of current prices.

No interest whatsoever.

In a prior post, I wrote that it won't surprise me if Amazon continues the process of going from very overvalued to even more overvalued.*

I didn't write that because I had a specific view on the stock's future price action. In fact, I never have a view on where prices are going near-term or even intermediate-term for any stock. (My focus is, instead, always on price versus value and long-term effects.) It comes more from watching too many securities remain extremely expensive, for years at a time in enough cases, especially (but not limited to) during late 1990s and into the early 2000s (back then, it wasn't just tech stocks even if they grabbed most of the headlines). An overvalued stock can stay that way (and get even more so) for an extended period of time. The forces at work practically guarantees it will happen to certain securities from time to time.**

No bubble required.

So I think it's hardly surprising that Amazon's stock seems to continue defying economic gravity. Once valuation isn't anchored by annoying things like proven sound fundamentals (not hoped-for-someday-it-will-all-come-to-be fundamentals), it's a simple matter of whether there's a good story and enough short-term "votes" to prop up the shares.

Hope and enough money can keep a stock high that already seems weirdly disconnected from reality (and from the usual factors that govern valuation) for a very long time.

That doesn't mean Amazon is not a good business with favorable long-term prospects. It may or may not be. In the short or even intermediate term, future business prospects and near term stock price action often have little to do with one another. Occasionally, expensive looking stocks even justify their valuation and then some (and Amazon just may), but I'll let those smarter than I try to separate the pretenders from the real thing.

If you don't pay a premium for promise yet to be realized, you can't lose anything if that promise comes up short.

In contrast, pay a discount for the something proven and durable that can produce a nice risk-adjusted return even if nothing spectacular happens. Occasionally, they may even surprise with something unforeseeable on the upside. So they end up having some latent capacity to produce future returns.

When they disappoint or turn out to be somewhat less fundamentally sound than thought, the discount is there to provide a margin of safety (though things can certainly go badly even with a margin of safety).

Well, that's the only way I know how to invest.

I should point out that, while I don't care for Amazon's stock, it's hard to not be impressed by the company's willingness to pursue big things with longer term outcomes in mind. Lots of intrinsic value may be created but, because of the price paid, that doesn't mean returns -- even though they may be positive and possibly even substantial -- will be sufficient considering the risks. Margin of safety is a fundamental requirement for any investment. Well, at least it should be. At a minimum, that a nice margin of safety exists to protect the investor if things don't quite go as expected isn't, at least for me, at all clear. In other words, much would seem to need to go right just to get a decent investment result.
(Though some will no doubt trade it successfully in the coming years. I never have a view of such things.)

In fact, I will be surprised if Amazon doesn't end up doing very well as a business in the long run but, compared to alternatives, I won't be surprised if long-term investors in the stock (at least those who've bought recently and plan to own it for a very long time) do less well on a risk-adjusted basis.

Adam

No position in AMZN

Related posts:
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks

* I have no idea whether or not enough per share intrinsic business value will eventually be created to justify higher equity prices. In fact, it's quite possible that Amazon may more than justify its valuation someday. Yet investment is not about valuation ultimately proving to be justified (or even being more than justified). It's about getting a satisfactory or better return considering risks and alternatives. So, in some ways, I think a better description of Amazon's stock may be difficult-to-value instead of overvalued. If I can't value something within a narrow enough range, it's pretty tough to decide how much of a discount to that value is needed to protect against future uncertainties. Others may, of course, find estimating Amazon's intrinsic value to be more doable. Those who think they can estimate the company's value (with a confidence that's warranted) will be better suited to invest in the shares than myself.
** This folly is of little benefit to those attempting to buy shares of understandable businesses at a discount with the idea of owning them for a very long time. On the other hand, those in the business of playing short-term price action likely feel otherwise.
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