Amazon Beats Apple On This 'Buffett-esque' Metric, But It Still Faces Headwinds

| About:, Inc. (AMZN)
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Fair Businesses Versus Wonderful Businesses

Most followers of Warren Buffett likely know that the Berkshire Hathaway, Inc. (NYSE:BRK.B) chief's friend (and Berkshire vice-chairman) Charlie Munger changed the way Buffett invested in stocks. For those who didn't know, Buffett included a reminder on p.13 of Berkshire's most recent shareholder letter:

More than 50 years ago, Charlie [Munger] told me that it was far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price. Despite the compelling logic of his position, I have sometimes reverted to my old habit of bargain-hunting, with results ranging from tolerable to terrible. Fortunately, my mistakes have usually occurred when I made smaller purchases. Our large acquisitions have generally worked out well and, in a few cases, more than well.

Quantifying Quality

In recent Business Insider article ("A Wonderful Lesson From Warren Buffett That Explains One Of The Biggest Mysteries About Amazon"), Joe Weisenthal noted Buffett's reminder about his transition from pure bargain hunter to buyer of high-quality (or "wonderful", to use Buffett's term) companies and relayed a way of quantifying quality developed by University of Rochester finance professor Robert Novy-Marx in a recent research paper ("The Quality Dimension Of Value Investing") and popularized by Jason Zweig in a recent Wall Street Journal column ("Have Investors Finally Cracked The Stock-Picking Code?"). Novy-Marx found that the simple metric of gross profits to assets served as a proxy for quality.

Weisenthal shared Jason Zweig's demonstration that (NASDAQ:AMZN) is a high-quality business. I thought it would be interesting to calculate the same metric for Apple, Inc. (NASDAQ:AAPL), and compare the two, so we'll do that below. First, though, let's look at the Novy-Marx quality ratio for Amazon.

Calculating Amazon's Quality

Zweig gets slightly different numbers for Amazon's total assets and gross income than the ones Yahoo Finance shows, so, for consistency, instead of using Zweig's numbers, I am going to use Yahoo Finance's numbers here for Amazon as well as for Apple. Using income statement data from Yahoo Finance, Amazon generated a gross profit of $15,122,000,000 over the last four quarters. According to balance sheet data from Yahoo Finance, Amazon had total assets of $32,555,000,000 in its most recent quarter. So its gross profits to assets ratio was 0.46.

Calculating Apple's Quality

Using income statement data from Yahoo Finance, Apple generated a gross profit of $69,019,000,000 over the last four quarters. According to balance sheet data from Yahoo Finance, Apple had total assets of $196,088,000,000 in its most recent quarter. So its gross profits to assets ratio was 0.35.

The Impact Of Apple's Cash On Its Quality Ratio

Apple's large cash horde swells its total assets, which in turn, lowers its gross profits to total assets ratio, giving Apple a lower quality signal than Amazon, according to Novy-Marx's quality metric.

Quality Versus Price

Weisenthal doesn't mention it in his post, but in his research paper, Novy-Marx advocated a system similar to that of Joel Greenblatt, in that it combines the ranking of two metrics: one for quality, gross profits to assets (in place of Greenblatt's return on invested capital), and one for price, book value to market value (in place of Greenblatt's earnings yield). So, like Greenblatt, Novy-Marx has developed a method that aims to find stocks that are high-quality ("good") as well as cheap Although Amazon outscores Apple on Novy-Marx's quality metric, it falls short of Apple on Novy-Marx's price metric. Using Yahoo Finance data, Amazon has a book-to-market ratio of 0.07, versus Apple's book-to-market ratio of 0.29. On this metric, since cash is a component of book value, and book value is in the numerator, Apple's cash horde helps it outscore Amazon.

Risks Remain For Amazon Shareholders

Despite Amazon's high quality ranking, it is an expensive stock as its book-to-market ratio (as well as other valuation metrics) shows. As Seeking Alpha contributor Matthew Dow pointed out a few months back ("Amazon - History Tells Us That Shorts Will Be Rewarded"), Amazon's high valuation is dependent on it consistently producing high, >30% revenue growth. Dow laid out four specific reasons why he believed it would be difficult for Amazon to keep generating such high growth:

  • E-commerce starting to grow at a slower pace
  • Strong competition in the cloud computing space
  • Infrastructure expansion could raise fixed costs
  • Traditional retailers improving their e-commerce efforts.

Since Dow laid out his bearish case, additional risks have appeared for Amazon:

  • Earlier this month, Reuters and Tech Crunch reported (via The Register) that Google, Inc. (NASDAQ:GOOG) was readying a "'Same Day Delivery' Amazon Prime Killer".
  • Last week, an analyst at JPMorgan Chase & Co. (NYSE:JPM) downgraded Amazon, citing decelerating growth.
  • On Tuesday, Tech Crunch reported that eBay, Inc. (NASDAQ:EBAY) was going to offer free listings and a simplified fee structure to compete with Amazon's e-commerce market place.

Ameliorating Amazon's Risks With Downside Protection

Given the headwinds Amazon is facing, shareholders may want to consider adding some downside protection here. Below are two ways for an Amazon shareholder to hedge 100 shares against a greater-than-20% drop between now and October.

1) The first way uses optimal puts*; this way allows uncapped upside, but is more expensive. This was the optimal put, as of Wednesday's close, for an investor looking to hedge 100 shares of AMZN against a greater-than-20% drop between now and October 18th:

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 3.46%.

2) An AMZN investor interested in hedging against the same, greater-than-20% decline between now and October 18th, but also willing to cap his potential upside 20% over that time frame, could have used the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was 0.54%.

Note that, to be conservative, the cost of both hedges was calculated conservative, using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar; in practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).

Possibly More Protection Than Promised

In some cases, hedges such as the ones above can provide more protection than promised. For a recent example of that, see this Instablog post about hedging shares of the drug company Affymax, Inc. (NASDAQ:AFFY).

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.

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.