Following Mr. Market Into Amazon: Suicidal Or Sensible?

Oct.26.12 | About:, Inc. (AMZN)

Here's the ultimate journalistic dog-bites-man story (i.e. one that is so mundane as to hardly even qualify as "news"): The third-quarter earnings release for Amazon (NASDAQ:AMZN) amounted to a financial stink-bomb characterized by uninspiring revenues, lower margins, red ink, and bad near-term guidance. Even so, the stock went up in the next morning's pre-market trading and in early regular-market trading!

What the heck is going on here?

There are some (a possibly disproportionate number of whom post frequently on Seeking Alpha and, if they stay true to form, will have much to say in the comment section that follows this article) who suggest Mr. Market is insane, corrupt, etc. Indeed, Seeking Alpha's premier AMZN-basher, in one of many comments he posted in response to my last Amazon article, went so far as to assert that "promoting AMZN is close to a fraud."

The controversy is clear-cut. Amazon has consistently demonstrated a willingness to invest heavily to build its business and has been quite willing to sacrifice near-term results to do it. The detractors do not accept the legitimacy of this strategy and often cite currently-depressed margins while failing and/or refusing to comprehend the difference between margins that are lowered by factors outside the company's control versus margins that are depressed by a company's strategic choices. Detractors also are enraged by Amazon's triple-digit P/E ratios.

I don't intend to rehash the same old arguments at this time. Instead, I'd like to consider a fresh angle, to take a closer look at the disparity we're seeing between Mr. Market's attitude (obviously bullish given the stock's rise in today's pre-market and early trading despite full knowledge of the valuation metrics and the company's seemingly-bad here-and-now numbers and guidance) versus those of detractors who trot out simple textbook-type notions to argue that Mr. Market is nuts. AMZN is by no means the only time this sort of disparity has ever occurred, and there are anecdotal examples of cases where those who followed Mr. Market got their heads handed to them. But I want to go beyond anecdotes. Let's consider a more systematic study.

I went to StockScreen123 and built what may well the most simplistic stock screen I ever created. I look only at S&P 500 constituents (i.e. big-time companies that are covered very heavily by analysts and the financial media) and choose only those whose trailing-12-month P/E (NYSE:TTM) ratios are greater than or equal to 200.

Guess what: AMZN is on the list (yeah, yeah, I know you saw that coming). But that's not what I want to focus on. Instead, I'd like to backtest what I'll refer to as my Suicide Strategy and see what would have happened to any financial and/or emotional misfits that might have actually tried to implement it over the past ten years. (It is assumed that the screen is re-run and portfolio refreshed once every three months.)

Figure 1 shows a comparison between this strategy and the S&P 500 index.

Figure 1

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Before I comment, let's look at Figure 2, which compares the strategy to the S&P 500 Equal Weight Index (the previous comparison was to the more widely consulted market-capitalization weighted benchmark).

Figure 2

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Here's my take on what we see.

This is not a great investing strategy, certainly not one I'd consider implementing with real money. That should not be a surprise. For one thing, the S&P 500 is not my preferred hunting ground (this segment of the market is way too "efficient" for my taste). More importantly, it's a one-factor screen that adds no context to the high TTM P/E (no other valuation metrics, no consideration of company fundamentals). So actually, come to think of it, this screen stinks.

But here's the punch-line: As bad as this screen is, the back-test results were not disastrous. Sometimes the Suicide Screen outperformed the benchmark. Other times it trailed. But over the long-term, the two were more or less neck and neck.

That is completely contrary to what the AMZN haters might suppose. They can't comprehend the possibility that Mr. Market may have legitimate reasons to sometimes allow P/Es to rise very high. He's not always right. But the times he is right, coupled with the fact that his errors haven't on average been catastrophic, means there's been little difference between having passively bought all stocks uncovered by the Suicide Strategy versus having simply parked everything in the S&P 500 SPDR ETF (NYSEARCA:SPY).

I could vary rebalancing intervals and look at more compressed time horizons and produce lesser results (indeed, high P/E stocks did especially badly during major crashes in 2001 and 2008, but so, too, did many other strategies). But that's not the point. You'd think a strategy like this would be all-disaster all the time, but that is definitely not borne out by the data.

Again, I'd never actually follow this strategy and I strongly recommend that you avoid doing so. But the fact that high P/E multiples are not inherently fatal should open the door to further company-specific study to determine whether Mr. Market may be onto something in a particular instance.

I do not want you to come away from this article with the notion that you should buy AMZN (I don't own it at present). But I do want you to come away with an understanding that while Mr. Market is not always right, he's not always wrong, and that when he's as definitive as he is in accepting AMZN's valuation, his views at least deserve respectful consideration.

Disclosure: I 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.