As I considered the recent $31 gain in the price of Amazon (NASDAQ:AMZN) stock, which sent shares spiraling upward almost 16% to $226, I got to thinking, "What would Benjamin Graham think about this?" So I went to my bookshelf, dusted off the copies of The Intelligent Investor and Security Analysis, and set out to find a couple of Benjamin Graham quotes that would be particularly applicable to Amazon's share price. I think I found three good ones, and they are all taken from "The New Speculation in Common Stocks" chapter in The Intelligent Investor (around page 563 onward) or Chapter 39 of Security Analysis titled "Price-Earnings Ratios for Common Stocks."
Graham begins his commentary on speculative investments by remarking:
Let me start with a summary of my thesis. It comes from the attitude and viewpoint of the stock-buying public and their advisers-chiefly us security analysts. This attitude may be described in a phrase: primary emphasis upon future expectations. The three M's which supplied so much fuel to the speculative fire a generation ago [are] Mystery, Manipulation, and (thin) Margins…
As soon as I saw the line about "thin margins", I couldn't help but immediately think about Amazon. Therese Poletti of Marketwatch offered this observation about Amazon's recent quarterly report: "Szkutak said that Amazon has 'very strong growth in the Kindle', but the company does not disclose unit sales…many analysts believe Amazon sells the company's Kindle devices at a loss…Amazon sells the devices at low margins in the hope of driving profitable sales of digital media products. In other words, the razor-blade model." The "speculative fire" that Graham mentions is partly due to the belief that super growth companies will be able to improve their margins some day in the future, which may or may not actually end up happening.
Obviously it is impossible to accurately calculate the intangible component of a splendid company. It may be well to recognize a vital difference that has developed in the valuation of these intangible factors, when we compare earlier times with today. A generation or more ago it was the standard rule, recognized both in average stock prices and in formal or legal valuations, that intangibles were to be appraised on a more conservative basis than tangibles….Now there is a logical reason for this reversal in valuation…due to the assumed superior expectations of increased profit in the future…About twenty times average earnings is about as high a price as can be paid in the investment purchase of a common stock. People who habitually purchase common stocks at more than about twenty times their average earnings are likely to lose considerable money in the long run.
I found Graham's remark on the calculation of "intangibles" to be quite fascinating. Because "intangibles" were unproven, they used to be calculated more conservatively because the "unknown" was considered unreliable. Now, we assume that all these intangibles will in fact materialize to produce whopping earnings increases for the company. Because Amazon makes heavy investments in the Kindle, it will all pan out in the form of rapidly increasing e-content sales. Cloudsearch and AWS Marketplace will drive revenue for Amazon Web Services as it will dominate the cloud platform worldwide.The expectations for Amazon's future rely on much going right--Amazon's heavy investments will generate monster profits somewhere down the line. And if Graham thinks it is foolish to pay over 20x earnings for a stock, I can only imagine his reaction to someone paying over 100x earnings for a stock. I mean, how do you give an honest evaluation of something at that level? I can understand the difference between a P/E of 15 and 20, or 20 and 30, but who can honestly tell you whether a stock is worth 120x earnings or 150x earnings? Once you enter that stratosphere, you really are buying growth at any price. And that's what turns me off about Amazon as an investment. The margin of error is simply not present at current market prices-putting money into Amazon right now is like betting on a pitcher to pitch nine innings of one-run ball. Sure, it can happen, but shouldn't we try to go through our investing lives trying to find the opportunities where we bet on the pitcher giving up six runs or less?
But more important than the foregoing is the general relationship between mathematics and the new approach to stock values. Given the three ingredients of (A) optimistic assumptions as to the rate of earnings growth, (B) a sufficiently long projection of this growth into the future, and (C) the miraculous workings of compound interest-lo! the security analyst is supplied with a new kind of philosopher's stone which can produce or justify any desired valuation for a really 'good stock.'"
Very high earnings growth for a long time. Isn't this exactly what investors are assuming if they buy Amazon today at $226 per share? If we're looking for high growth investments, I think we should consider Amazon in relation to the opportunity cost of what else is out there. Apple (NASDAQ:AAPL) is now trading below 15x trailing twelve months earnings. These margins of safeties are worlds apart-Apple could slow its growth to 15% annually when its trading at 15x earnings, and investors will still do all right. Imagine what happens to a stock that is trading at well over 100x earnings if that happens. A similar story exists for a margin of safety comparison between Google (NASDAQ:GOOG) and Amazon. The search engine giant is trading at less than 19x earnings. Margin of safety, margin of safety, margin of safety. Warren Buffett once remarked that there are no "called strikes" in investing. Sure, the lofty projections for Amazon might work out and make investors a lot of money, but why get in the habit of making bets on everything going right when we don't have to?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.