, The Value Police and Multiple Markets

Nov.13.09 | About:, Inc. (AMZN)

Describing (NASDAQ:AMZN) as an overvalued stock, which I’ve often seen, is about as sensible as criticizing the New York Yankees for never having beaten the Pittsburgh Steelers.

Case in point: The November 13 Seeking Alpha article entitled Amazon-Sized Craziess, wherein Anthony Davian goes through a long recitation on Ben Graham and Mr. Market (if you’re unfamiliar with the latter allegory, Davian summarizes it well) and how he wound up sticking with AMZN despite its exorbitant valuation. I like his conclusion, I like AMZN (though I don’t own it right now), but feel a need to address the pat on the back the author gave himself for having stuck with AMZN despite warnings by the value police, as well as the misplaced attitude of the latter.

From a valuation point of view, AMZN is off the charts and has been since the day of its IPO. Money has been made in it. Money has been lost in it. But not a penny has come or gone based on AMZN’s valuation characteristics, just as the New York Yankees’ fortunes, for better or worse, have never had anything to do with any aspect of the National Football League.

In sports, there is no crossover. The Pittsburgh Steelers will stay in the National Football League. They will not transition to Major League Baseball. And in sports, it’s one or the other. A team will play baseball or football but not both.

In stocks, it’s different. There may come a time when AMZN becomes a value stock, or even a multi-faceted situation that could be at home in both universes (as is the case with so many other stocks). The possibility of such crossovers is what leads to confusion, such as why anyone might take the trouble to actually think about AMZN’s valuation ratios. But right now, AMZN is not in the value universe. Whether Davian succeeds of fails in his decision to hold AMZN has nothing at all to do with its valuation ratios. I think it has everything to do with whether the company will continue to grow as expected or better.

Think plural, not singular

This issue involves a lot more than just AMZN and the value police. It involves a major mis-perception about there being one correct way to approach stocks.

The phrase “the stock market” is convenient but grammatically erroneous. Strictly speaking, it should be “the stock markets” (plural).

Although we talk about the stock market as if it were a singular phenomenon, in truth, we’re looking at a collection of completely different marketplaces that simultaneously exist the same time, place and cyberspace.

Disciples of Ben Graham and Warren Buffett see the market in a particular way and approach it with a particular set of principles. Disciples of, say, William O’Neil see the market in a different was and approach it with a different set of principles. Who is right? Both of the above!

I’m not saying this just to be touchy-feely. I actually have some data to support this suggestion.

Figure 1 shows performance data for these models as presented on StockScreen123 Friday (11/13/09). The results are sorted on the basis of five-year return:

Figure 1

Click to enlarge

Notice the top two: the Graham model and the O’Neil model (based on his CANLIM principles). These are about as opposite as any two models can be, yet the long-term performance difference is minor.

Buffettologists might point with glee to other time periods wherein the O’Neil model has been less impressive. Bear in mind, though, that a disproportionate portion of the recent past five years has been characterized by conditions that are quite hostile to O’Neil-style investing which works best when people are least antsy (even the rallies we’ve seen since last March were characterized by more jitteriness then proponents of this style would want to see).

Let’s go beyond the big names and look at the performance records of a collection of pre-set screens I created based on style specialization, mainly to demonstrate how users can screen under different sets of investment philosophies and to provide starting points for their own efforts (they can save any of these screens and then edit). But even this collection of demo models can help shed light on today’s topic.

I work with four styles: growth, value, quality (good corporate returns, margins, finances, etc.) and sentiment (estimate revision, etc.) and each style is available in four different flavors: Basic (where I use numeric thresholds, like growth is greater than such-and-such percent), Comparison to industry Peers (i.e., growth is in the top 20% relative to others in the same industry), Comparison to the Market (i.e., growth is in the top 20% relative to all other companies), and Comprehensive (i.e. growth is in the top 20% relative both to others in the same industry and the market as a whole).

In all cases, performance is measured by picking the top 15 stocks from each screen based on a stylistically balanced ranking system. Although this does provide a certain element of commonality to the selection process, there are extreme differences in the screening filters stocks must pass in order to be considered under the sort.

Figures 2 through 5 show the performance records of all these models (again, sorted by five-year returns).

Figure 2

Figure 3

Figure 4

Figure 5

So what’s the “right” way to invest. Does the value crowd (Figure 5) have a monopoly on wisdom? Compare them to the Sentiment bunch, Mr. Market and friends (Figure 4). Beauty is in the eye of the beholder, but I think you can argue that value has a bit of an edge. But remember: these are stylistically rigid demo models. Is the gap so wide as to preclude us from suggesting that a more thoughtfully constructed sentiment screen would always trail a well-built value model? I can’t say that. Note, too, that among these demo screens, value gets walloped by growth.

When all is said and done, none of us, regardless of how we like to approach stocks (investing versus trading, long term versus short term, fundamental versus technical, value versus growth, Ben Graham versus Mr. Market, etc.) has the right to speak of our styles with a holier-than-thou tone. We all occupy the same time, place and cyberspace and are all equally “right.” And each sphere offers plenty of room for success or failure (we have legendary value investors as well as those who lose their shirts, we have legendary swing traders as well as those who lose their shirts, etc.).

Investors should follow the lead of sports fans all of whom know what sport they follow and how to evaluate the teams they see. First, figure out what kind of investor you are (as with sports, it’s OK to go back and forth from one universe to another as long as you recognize what you’re looking at when you’re looking). Then, evaluate the stock based on the universe to which it belongs. So for AMZN, evaluate its growth prospects, not its valuation metrics (just as you’d evaluate the Steelers’ pass defense rather than try to figure out who the cleanup hitter is).

Disclosure: No positions