Amazon On Top Again

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

Summary

With Amazon a top 10 Portfolio Armor name again, I present a couple of ways longs can limit their risk in the event my site is wrong this time.

In addition, I share an explanation from an early Amazon employee about how the company tackled customers' aversions to shipping fees and why its solution remains a moat today.

I also recap my site's track record on its Amazon calls and update the performance of its top names in general.

David De Gea Save

Manchester United goalkeeper David de Gea makes save. (Credit: Manchester Evening News). Amazon bought the rights to stream 20 Premier League games on Amazon Prime.

Amazon On Top Again

With Amazon (NASDAQ:AMZN) a top 10 Portfolio Armor name again, as it has been frequently for years, I show a couple of ways longs can limit their risk in the event my system is wrong about the stock this time. First though, since as recently as last year, we've had Seeking Alpha contributors questioning Amazon's dominance, I want to share an insightful post by an early Amazon employee about how the company became so dominant. After that, I'll recap of my site's track record on Amazon and update its top names performance in general, and then we'll get to the current hedges.

Amazon's Invisible Asymptote

I know from the comments on previous Amazon articles I've written that there are some Seeking Alpha readers who aren't Amazon customers. For you especially, Eugene Wei's "Invisible Asymptotes" post may be worth a read, as he explains how the company surmounted our natural aversions to buying physical products online (Wei started out as a strategic planning analyst at Amazon). First, a quick explanation of his use of "asymptote".

Asymptote

(Credit: Math Is Fun)

Wei defines an asymptote in a business sense as:

a ceiling that our growth curve would bump its head against if we continued down our current path.

One reason customers were wary of buying online originally was their concern about returns; to alleviate that, Wei writes how Amazon instituted a liberal return policy, even before it had the software to track whether the returns had been purchased from the company in the first place.

For a window of time in the early days of Amazon, if you shipped us a box of books for returns, we couldn't easily tell if you'd purchase them at Amazon and so we'd credit you for them, no questions asked. One woman took advantage of this loophole and shipped us boxes and boxes of books. Given our limited software resources, Jeff said to just ignore the lady and build a way to solve for that later. It was really painful, though, so eventually customer service representatives all shared, amongst themselves, the woman's name so they could look out for it in return requests even before such systems were built.

But the real invisible asymptote Amazon ran into was shipping costs, Wei notes:

People don't just hate paying for shipping, they hate it to literally an irrational degree. We know this because our first attempt to address this was to show, in the shopping cart and checkout process, that even after paying shipping, customers were saving money over driving to their local bookstore to buy a book because, at the time, most Amazon customers did not have to pay sales tax. That wasn't even factoring in the cost of getting to the store, the depreciation costs on the car, and the value of their time.

An obvious point Wei makes is that shipping physical goods costs money, so the company couldn't just waive shipping costs for every item, though with a large enough order, it could be economical. So its next crack at eliminating this asymptote was to offer free shipping for orders over $25. But that impeded impulse orders:

The problem with this program, of course, was that it caused customers to reduce their order frequency, waiting until their orders qualified for the free shipping. In select cases, forcing customers to minimize consumption of your product-service is the right long-term strategy, but this wasn't one of those.

Readers who are Amazon Prime members know the ending to this story:

That brings us to Amazon Prime. [...]

To his credit, Jeff decided to forego testing and just go for it. It's not so uncommon in technology to focus on growth to the exclusion of all other things and then solve for monetization in the long run, but it's easier to do so for a social network than a retail business with real unit economics. The more you sell, the more you lose is not and has never been a sustainable business model (people confuse this for Amazon's business model all the time, and still do, which ¯\_(ツ)_/¯).

The rest, of course, is history. Or at least near-term history. It turns out that you can have people pre-pay for shipping through a program like Prime and they're incredibly happy to make the trade. And yes, on some orders, and for some customers, the financial trade may be a lossy one for the business, but on net, the dramatic shift in the demand curve is stunning and game-changing.

Wei also addresses how Prime is a moat for Amazon:

Prime is a type of scale moat for Amazon because it isn't easy for other retailers to match from a sheer economic and logistical standpoint. [...]

[V]ery few customers shop enough with retailers other than Amazon to make a pre-pay program like Prime worthwhile to them. Even if they did, it's very likely Amazon's economies of scale in shipping and deep knowledge of how to distribute their inventory optimally means their unit economics on delivery are likely superior.

The company has also sweetened the Prime deal by offering digital products as part of the package with free shipping, for example the Premiere League games mentioned above.

Although my site doesn't take the fundamentals of Amazon's business into account directly, the company's dominance is reflected in the stock and options prices which my site tracks. Over the years, it has had a good track record with Amazon and with its top names in general.

Portfolio Armor's Track Record On Amazon

Each week since June 8th, I've been presenting Portfolio Armor's top 10 names in terms of its estimate of their potential returns over the next six months to my Bulletproof Investing subscribers.

So far, Amazon has made the weekly top 10 list 18 different times this year. But it's been a top Portfolio Armor name for years before I began offering my Marketplace service. I gave an example of that in an April article on Assured Guaranty (NYSE:AGO), which David Einhorn announced he had shorted at the Ira Sohn conference:

One example that comes to mind is an article of mine from a couple of years ago ("Einhorn Shorted Amazon - You Shouldn't"), in which I noted that Amazon was Portfolio Armor's top name at the time, and suggested readers consider buying it, provided they hedged in accordance with their risk tolerance. You can probably guess how Amazon has done since I wrote that article, but if not, here's the chart from YCharts.

Chart via YCharts

There was a dip shortly after I wrote that article, as you can see in the chart above. I wrote a follow-up article then encouraging investors to stay the course.

I offered a few more examples of times my site was successfully bullish on Amazon over the years in an article last year ("Forget About Value Investing"). The success with its bullish calls on Amazon hasn't been anomalous. As I pointed out in my most recent performance update, Portfolio Armor's top ten names tend to outperform the market:

The table below shows the performance all of the 27 weekly top names cohorts for which we have complete 6-month performance data so far; each of the starting dates is hyperlinked to a page with an interactive chart of that cohort.

Starting Date Portfolio Armor 6-Month Performance SPY 6-Month Performance
June 8, 2017 14.49% 9.99%
June 15, 2017 19.85% 10.97%
June 22, 2017 24.46% 11.27%
June 29, 2017 18.24% 11.68%
July 6, 2017 21.03% 14.81%
July 13, 2017 28.25% 14.85%
July 20, 2017 25.04% 14.62%
July 27, 2017 33.52% 17.10%
August 3, 2017 20.72% 12.66%
August 10, 2017 13.05% 8.36%
August 17, 2017 10.71% 13.48%
August 24, 2017 15.23% 13.72%
August 31, 2017 8.42% 10.87%
September 7, 2017 12.75% 11.61%
September 14, 2017 29.19% 11.19%
September 21, 2017 22.56% 9.42%
September 28, 2017 14.30% 4.73%
October 5, 2017 11.53% 5.26%
October 12, 2017 15.46% 5.38%
October 19, 2017 20.73% 6.08%
October 26, 2017 18.10% 5.13%
November 2, 2017 12.64% 3.11%
November 9, 2017 5.41% 5.34%
November 16, 2017 6.11% 6.22%
November 23, 2017 5.18% 6.19%
November 30, 2017 -0.19% 3.80%
December 7, 2017 11.51% 5.99%
Average 16.23% 9.40%

So Portfolio Armor's top ten names averaged 16.23% over the average of these 27 6-month periods, versus SPY's average of 9.40%, an average outperformance of 6.83% over 6 months.

That said, my site still gets its calls wrong sometime. If you click on those starting dates above, you'll see examples of that (particularly in the November cohorts - that was a rough patch). So let's look at a couple of ways to limit your risk if you're long Amazon now.

Adding Downside Protection To Amazon

Let's assume you're long 100 shares of AMZN and are unwilling to risk a decline greater than 20% over the next several months. Here are two ways of hedging it (screen captures below are via the next version of the Portfolio Armor iPhone app).

Uncapped Upside, Positive Cost

As of Friday's close, these were the optimal puts to hedge 100 shares of AMZN against a >20% decline by mid-January.

Image via PA.

As you can see above, the cost here was $3,260, or 1.94%, calculated conservatively, using the ask price of the puts.

Capped Upside, Negative Cost

If you were willing to cap your upside at 18%, this was the optimal collar to hedge against the same >20% decline over the same time frame.

Image via PA.

There are two things different about this hedge. The first is that, after an iterative process taking into account its net cost, the hedging algorithm was able to find a slightly less expensive put strike - one that lowered the cost of the put leg to $2,650, or 1.57% of position value (calculated conservatively, using the ask price of the puts). The second is that cost was more than offset by the income of $4,200, or 2.49% of position value, generated from selling the call leg (calculated conservatively, at the bid).

So the net cost was negative, meaning you would have collected a net credit of $1,550 when opening this hedge, assuming you placed both trades at the worst ends of their respective spreads.

Wrapping Up

Jeff Bezos is arguably the greatest entrepreneur of his generation, and Amazon is such a dominant company that, as I've argued, the only foreseeable threat to it in the near future is the prospect of antitrust action against it. That said, its shares could still tumble over the next several months as part of a broader market correction. If you're concerned about that, a hedge like one of the two shown above may be worth considering.

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.