Analyses and investment views

Amazonization of the market

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Sometime back in 1996, I was sitting in a bar in Manhattan with one of my clients, discussing music. He told me one of his former colleagues had an on-line store where a person could buy music CDs. That was the first time I had heard about Amazon. I soon became its customer, and sometime in 1998 also its shareholder when the share price was $20. Prior to the bursting of the bubble at the end of the 1990s I sold the stock because it had seemed really expensive. Since then, I have remained a regular and satisfied customer, but never again a shareholder. Throughout those 20 years, I’ve always found the shares to be too expensive.

Inasmuch as I sold my Amazon stock 20 years ago at a price of around $40 and the stock’s price today is 50 times higher, it of course would have been better had I never sold the stock. Things always seem clear in hindsight, but was the stock ever truly cheap in the past?

Amazon was founded in 1994, had its IPO in 1997, and recorded its first, albeit small, profit in 2003, no sooner than in the tenth year of its existence. We have always heard the same mantra from the company – that current profitability is not a priority, that it is sacrificed on the altar of long-term growth, and when one day the company will be sufficiently large it will become highly profitable. So, what investors were buying back then was a vision of large profits at some future day when the time would be right.

Now, it is clear that one cannot always expect immediate profitability from a newly established company, and a certain open-mindedness and patience on the side of investors is necessary. In the case of Amazon, however, it took more than 20 years before it generated substantial profit. During 1994–2014, the company was continually loss-making or only minimally profitable, it could not earn enough even to cover its cost of capital, and in 2002 it even was teetering on the brink of its possible demise. Profits began to grow substantially only in 2015, and that was due almost solely due to its new Amazon Web Services segment. Its original retail business continues to be troubled by low profitability. Does this situation exist by the company’s choice, or is it a harsh reality imposed by competition? After 25 years of Amazon’s existence, I would not reject the second possibility…

Because we now have access to more than 20 years of history, we can back-test to determine whether the profits actually achieved have justified the past prices per share. For this purpose, we will use a very simple method. We will take the profit per share achieved in a given year, assign it a multiple of 16.5 (long-term average of the US market) and we will then discount this value back 5 years at a rate of 10% p.a. Finally, we will compare this result with the price per share 5 years earlier and see to what extent it was justified by the profits actually achieved.

For example, at the end of 2003, Amazon’s price per share was $52. Profit per share 5 years later, which means in 2008, was $1.39. If we assign it a P/E of 16.5, we get $23. But that is the value in 2008. To convert it to the adequate value in 2003, we discount it at a rate of 10% p.a. over 5 years. That brings us to a price per share of $14 in 2003. So, if the share cost $52 at the end of that year, it was overpriced in the market by almost 4 times. (If you consider this method either too hard or soft, or not rigorous enough, use your own. You will see in any case that the valuation parameters would have to be very generous for you to come to a value per share substantially higher than its price.)

If we perform the same exercise for all the years up to 2013, we will find that the stock was substantially overpriced at the end of every year. The price was always at least double the calculated value, and often much higher than that.

Today, Amazon’s shares cost on the order of $2,000. Is this cheap or expensive? We cannot use the same method we used for the previous years, because we do not know what Amazon’s actual profitability will be over the next 5 years. We can, however, think about what fundamentals are implicit in that share price. If its fundamental value today were indeed $2,000, then the fundamental value in 2024 (using the same discount rate of 10% p.a.) would have to be $3,221. At a PE of 16.5, this would correspond to earnings per share of $195. This means that Amazon’s net profit in 2024 would need to be $100 billion. That seems not very likely if we consider that the total profit of all companies in the S&P 500 today is approximately $1,100 billion.

Thus, once again, Amazon’s stock seems to be greatly overpriced. A market capitalisation of $1,000 billion really cannot be justified by Amazon’s net profit last year of $10 billion. As in the previous 20 years, investors are betting on a large increase in profitability in future even though the actual profitability achieved by Amazon over the past 20 years has never fulfilled the expectations implicitly contained in its share price.

The fact that there can be a company whose stock price is growing phenomenally without the company itself being notably profitable has not escaped the attention of many other businesspeople. Therefore, Bezos’ mantra about sacrificing current profitability in order to achieve rapid growth and great future profitability is today intoned by lots of people, and in many cases the market swallows it whole. I call this phenomenon the Amazonization of the market. I do not recall another time when we had so many (sometimes hopelessly) unprofitable companies in the market whose share prices are rising at staggering rates (specifically, 40% of companies in the Russell 2000 index are loss-making). The argument is usually similar. Any demand for profitability is ridiculed, and visions of bright tomorrows are promoted. In fact, a great many of these companies will probably never achieve profitability, and once they lose the market’s favour and its willingness to continuously finance their losses, they are headed for a swift demise.

This Ponzi scheme will work only for so long as there are more and more investors who will be willing to “hold the bag”. There is another name for this state of affairs, and it is called the “greater fool theory”. This Amazonization of the market is manifested most notably in the SaaS (Software as a Service) sector. There are more than 50 such companies on the market (e.g. Salesforce, Workday, Splunk, Square). Their revenues collectively total approximately $60 billion and their market capitalisation around $600 billion. Considering just the larger half of those, we can calculate a combined market cap that is approximately 15 times their combined revenues and a P/E of almost 300×. Their stock prices, however, are mostly skyrocketing despite their having miserable cash flow and returns to capital deep below the costs of that capital. Investors apparently do not mind that value is being destroyed in the companies they are holding. Amazonization of the market often causes profits to be penalized and growth in sales to be valued most without regard to the amount of losses this carries with it.

This brings us to an interesting question. Can a company be called prosperous if it is not profitable over the long term but its share price continues soaring skyward? Or, to view it in the inverse, is a company unprosperous if it achieves high and growing profits but its share price does not increase? Would the answers to these questions change if the company’s shares were not publicly traded but only its financial results were available?

Investors’ perception of reality is greatly influenced by the movements of share prices themselves. Investors often believe share prices present a picture of reality, and they forget the crucial fact that they themselves create this image through their own behaviour. They contribute to generating the feedback upon the basis of which they make their decisions, even though history provides many examples of how much behaviour of the majority can be mistaken, how quickly it may change, and how this also brings about a rapid change in the feedback investors receive.

Amazon is an exceptional company in many respects. It has changed and is still changing the way business is done in various sectors. Its example also has influenced the behaviour of businesspeople and investors, and this is causing the stated Amazonization of the market. If it worked for Amazon (this combination of low profitability and staggering share price growth), why shouldn’t we try it too? That is what managers of many companies and their investors are thinking. In the managers’ case, this can often be coldblooded and calculating opportunism. On the side of investors, it often manifests itself either in unreal expectations of the future or conscious speculation with plans of getting out before the trend breaks. Neither of the two variants is likely to come to a good ending.

I am aware of the fact that the weak spot of my approach may be that I try to apply logic to everything. A logical approach requires a relationship between a reason and an action, whereas the psychological approach does not. A great many of those invested in stocks afflicted by the Amazonization of the market seem to apply the psychological approach. So, while logic says 1 + 1 = 2, psychology says 1 + 1 = 2, or more than 2, or less than 2, depending upon who makes what decision. Each investor must consider for himself or herself which approach he or she prefers. One should bear in mind, however, that if psychology changes in relation to stocks whose prices are not supported by the fundamentals, then the harm will not be just psychological but also material. And that is only logical. Invest with care!

Daniel Gladiš, August 2019



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