Amazon: Priced For Perfection?

| About: Amazon.com, Inc. (AMZN)

Summary

Pop Investment Research Group warned recently that Amazon was "priced for perfection" and not as financially solid as most investors believe.

Our site remains bullish on Amazon, though it's not currently one of its top names. We explain why it may still make sense for Amazon investors to hedge.

We also present two hedges for the stock over the next several months, one of which may be of interest to investors wary of hedging costs.

Photo of Jeff Bezos at Trump Tower via Bing.

Amazon: Priced For Perfection?

That was Pop Investment Research Group's conclusion about Amazon (NASDAQ:AMZN) shares in their recent Seeking Alpha article (A Warning For Amazon Longs). After walking us through their financial analysis, Pop concluded:

It is crucial to stress that investors and analysts need to distinguish between "Amazon as a business' and 'Amazon as a stock." It is no secret that the movement of a stock not always reflects financial strength of the associated business. In Amazon's case, although the stock has shown tremendous growth, the company's fundamentals aren't as solid as many might think. By no means is Amazon a cash cow and as discussed above, the company is not a solid value generator either. As far as the intrinsic value of the stock is concerned, Amazon looks overvalued and the shares are priced for perfection. Even with rather optimistic assumptions, Amazon's fair value is lower than the current share price. For these reasons I am staying away.

Some commenters were skeptical of Pop's bearishness on Amazon ahead of its earnings release, with reader "MAGForce" offering a novel comparison:

Screen capture via Seeking Alpha.

Donald Trump and Jeff Bezos have certainly defied their doubters repeatedly, and we haven't been among those doubters in either case. Although no longer one of Portfolio Armor's top names, as it was in August of 2015, in January of last year (Einhorn Shorted Amazon - You Shouldn't), and for much of the time in between, our site is still bullish on the stock, estimating a potential return of 12% for it over the next six months (for an explanation of how the site calculates potential returns, see the section titled "Calculating A Potential Return For Amazon" here).

So why consider hedging it? Think back to the beginning of last year. George Soros, who knows a thing or two about markets, was warning that 2016 could be another 2008. A week and a half into February, it looked like he might be right.

Screen capture via YCharts.

Investors who were hedged in February knew that their downside risk was strictly limited. That peace of mind can help an investor stay long during a correction, if he feels it's going to be temporary, and it can cushion his downside if he decides to exit. Either way, he has breathing room to make an informed decision without panicking. Let's look at a couple ways of hedging Amazon now.

Downside Protection For Amazon

If you'd like a refresher on hedging terms first, please see the section titled, "Refresher On Hedging Terms", in this previous article of ours, Locking In Gold Gains.

Hedging AMZN With Optimal Puts

We'll use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge AMZN, but you can find them yourself instead by using the process we outlined in this article if you're willing to do the math. Either way, you'll need to decide the maximum decline you are willing to risk (this field is labeled "Threshold" on the app). This will vary depending on your risk tolerance. For the purpose of the examples below, we've used a threshold of 15%. If you are more risk averse, you could use a smaller threshold. And if you are less risk averse, you could use a larger one. All else equal, though, the higher the threshold, the cheaper it will be to hedge.

Here are the optimal puts as of Tuesday's close to hedge 200 shares of AMZN against a greater-than-15% drop by late July.

Screen capture via the Portfolio Armor iOS app.

As you can see at the bottom of the screen capture above, the cost of this protection was $4,560 or 2.77% of position value. A few points about this hedge:

  1. To be conservative, the cost was based on the ask price of the puts. In practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 15% threshold includes this cost, i.e., in the worst-case scenario, your AMZN position would be down 12.23%, not including the hedging cost.
  3. The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the underlying security declines in the near term, when the puts may still have significant time value.

Hedging AMZN With An Optimal Collar

Just as when scanning for optimal puts, you decide the maximum drawdown you're willing to risk (your "threshold"). But when scanning for an optimal collar, you also need to determine your "cap," which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. You don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

As we mentioned above, Portfolio Armor estimated a potential return of 12% over the next six months for Amazon. We started with that, but when we were able to raise the cap to 14% without raising the hedging cost, we used 14%.

This was the optimal collar, as of Tuesday's close, to hedge 200 shares of AMZN against a >15% drop by late July while not capping an investor's upside at less than 14% by then.

Screen capture via the Portfolio Armor iOS app.

As you can see in the first part of the collar above, the cost of the put leg was $3,420, or 2.08% of position value. But as you can see in the second part of the collar below, the income generated from the call leg was a bit more, $3,980, or 2.42% of position value.

Screen capture via the Portfolio Armor iOS app.

So the net cost of this collar was negative, meaning an investor would collect an amount equal to $560, or 0.34% of position value when opening this hedge. A couple of points about this collar:

  • Similar to the situation with the optimal puts, to be conservative, 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 collected more than $560 when opening this hedge.
  • This hedge may provide more protection than promised if Amazon declines in the near future due to time value. However, if it spikes in the near future, time value can have the opposite effect, making it costly to exit the position early.

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.

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