There are more things in heaven and earth, Horatio, than are dreamt of in your philosophy - William Shakespeare, Hamlet.
Fear Of A High P/E
Although Twitter (NYSE:TWTR) has done a lousy job of monetizing its utility (as we've mentioned on occasion, e.g., Twitter Jumps The Shark), it's great at capturing pithy market reactions from sharp observers. After shares of Amazon (NASDAQ:AMZN) hit a new high last week following its earnings beat, LikeFolio founder Andy Swan offered the rejoinder above to value investors.
Readers may recall we were bullish on Amazon back in January (Einhorn Shorted Amazon - You Shouldn't), when we argued that although hedge fund manager David Einhorn of Greenlight Capital had shorted Amazon, investors shouldn't follow his lead. On the contrary, we suggested investors consider buying Amazon, which was the top-ranked name on the Portfolio Armor website at the time, provided they hedged to limit their downside risk.
In that article, we noted Amazon's 864 P/E (trailing twelve months) and why we were still bullish on it:
The Bearish Case For Amazon
Greenlight's most recent shareholder letter, reprinted at ValueWalk, doesn't give a short thesis for Amazon; it just notes that it and Netflix were "powerful momentum plays". Presumably though, as a value investor, Einhorn is offended by Amazon's high valuation. And indeed, according to the valuation metrics below (data via Fidelity), the stock does look pricey.
- P/E Amazon: 864; Industry Average: 117.
- P/E (5 year avg) Amazon: 486; Industry Average: 337.
- PEG (5 year proj.) Amazon: 14; Industry Average: 10.
- Price/Sales Amazon: 2.8; Industry Average: 3.5.
- Price/Cash Flow Amazon: 45; Industry Average: 33.
These numbers all look high, and, except for Price/Sales, they are all well above the Internet retail industry average, which look high to begin with. The metric a bearish value investor might focus on most here is the PEG ratio, since it takes growth into account, and even an investor as growth-oriented as Jim Cramer prefers stocks with PEG ratios below 2.
Why We're Bullish On Amazon
The main reason we're bullish on Amazon is that it's currently Portfolio Armor's highest-ranked name when ranked by potential return (and has been one of its highest-ranked names since August; as you can see here, it appeared in a hedged portfolio created on August 11th). Potential return, in our terminology, is a bullish estimate of how a security will perform over the next six months.
In a follow up article, after Amazon reported disappointing 4Q 2015 earnings (Advantage Einhorn?) we discussed courses of action for hedged Amazon shareholders. We concluded that they were likely best off staying the course:
In our view, and in light of Portfolio Armor's updated potential return on AMZN (16%, down from 30% pre-Q4 earnings), staying the course would seem to make the most sense now. Since the hedge doesn't expire until July, you can hold the position through the next earnings release. Given that the cap on the collar is far above our updated potential return, it probably doesn't make sense to buy-to-close the call leg now. This is also consistent with our research as part of our backtesting the hedged portfolio method. We found that, on average, the highest returns came from holding securities for six months, or until just before their hedges expired, whichever came first. Essentially, this gave the underlying securities more time to recover from declines and generate better performance.
Shares of Amazon did just that, after bottoming out in February, as the chart below shows.
If you had bought Amazon and hedged it when we wrote our article on January 22nd, and sold it just before your hedge expired in mid-July, you would have had a gain of 19.74%, net of your hedging cost.
Amazon: Our Top-Ranked Name Again
As of Thursday's close, Amazon was again Portfolio Armor's top-ranked name by potential return net of hedging cost (Priceline (NASDAQ:PCLN), the subject of our previous article, was #8 on the site's ranking), with a potential return of 34% over the next several months (historically, actual returns have averaged 0.3x the site's potential return estimates, taking into account securities that ended up having negative returns).
For investors who are long Amazon and want to limit their downside risk while having a chance of capturing that potential return, here is the optimal collar to hedge 200 shares of it against a greater-than-19% decline as of Thursday's close, while not capping your possible upside at less than 34% by then (screen captures via the Portfolio Armor iOS app):
As you can see above, the cost of the put leg here was $4,620 or 3.04% of position value. But as you can see below, selling the call leg would have generated income of $870 or 0.57% of position value.
So the net cost of the hedge would have been 2.46%. A few notes on this:
- The cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so in reality, an investor would likely have paid less than $3,750 when opening this collar.
- If you were willing to risk a larger decline, you could have entered a larger number than 19 in the "threshold field" and lowered your hedging cost.
- This hedge may provide more protection than promised if the underlying security declines in the near future due to time value. However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook - Facebook Rewards Cautious Investors Less).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.