Amazon and the Shleifer Effect

March 22, 2012 — Leave a comment

I’ve been thinking a lot about Amazon.com lately. The business is in an interesting place. 

Few would argue against it being the dominant web retailer (let’s call this Amazon’s Business One), a market which provides plenty of runway to grow by expanding into new product lines and new geographies. Few would argue that its competitive advantages in web retail are not pronounced and formidable. 

Yet a huge chunk of its revenue comes from media (Amazon’s Business Two). Indeed, books and music and video and games, these provided the foundation for Amazon as a fledgling business and still (for 2011 at least) account for nearly 40 percent of sales.  The manner in which each of these products is consumed (and sold) is in major flux, transitioning from tangible inventory to digital formats. Where does Amazon fit in the world of digital media? Can it manage the cannibalization of its strength in the domain of physical media and segue into digital?

And now a growing chunk of its expense structure is devoted to a relatively new business, Amazon Web  Services (AWS/Cloud Computing…Business Three), which seems to produce paltry revenue compared to the resources the company throws its way.  At least for today.  Amazon is convinced that cloud computing represents tremendous growth potential and that it’s a market whose economics lend themselves to one of the company’s strengths…namely, the capacity to drive high volume through low margins to earn nice cash returns. Amazon believes it can dominate this market.

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In 2011, Amazon’s revenue grew $13.8 billion over the previous year while operating expenses grew $14.4 billion. Management is plowing cash back into all three of the businesses.  As a result, net income dropped in half. 

For most of 2011 Amazon was riding a multi-year wave of do-no-wrong sentiment from investors. Since 2006, revenue grew from $10.7 billion to over $48 billion. The business was stringing together five consecutive years of EPS growth, an increase of more than 5x from 2006 through 2010.  Media coverage was effusive in its praise; the story was a good one. The stock price soared from $38 at the end of 2006 to a high of $246 last October as investors were rubbing their palms together in eager anticipation of a trend line pointing forever north-by-northeast. 

Now Amazon was not necessarily cultivating this investor mentality. By most accounts, CEO Jeff Bezos is inclined to take a stoic view of the stock price, abiding to his long-term goal of building an enduring franchise and leaning into investments today to achieve market dominance tomorrow.

But as the Shleifer Effect teaches us, investors have a tendency to get excited by what they perceive to be a trend, and five straight years of EPS growth taps into that tendency to generalize a trend far into the future.

Here is the progression of headlines from the previous five quarters:

 

The Shleifer Effect suggests that a few tenets of behavioral finance might be in play here. First is the representativeness heuristic.  Investors get so excited about the uninterrupted revenue and EPS growth between 2006 and 2010 that they infer a growth trend that will continue. They conclude that it’s worth paying a premium for Amazon shares, and over time the share price grows from $38 to $246.

The second is the conservatism heuristic. The idea of the trend is set in the mind of owners of the stock and the idea has been reinforced with impressive performance quarter over quarter. Now they run into the first signs of evidence to the contrary.  What do they do? Nothing. They are defensive in their views. They aren’t going to change their minds at the first sign of storm clouds. So, even as Amazon guides toward lower earnings quarter after quarter, they hold steady. They keep their wits about them and perhaps even buy more shares. The stock price actually hits all time highs despite reduced EPS and guidance suggesting lower earnings to come.

The third part of the Shleifer Effect now comes with overreaction. After two or three consecutive quarters of guidance toward lower EPS, shareholders begin changing their minds. They see net profit cut in half from 2010 to 2011 and they lose their resolve. They begin subscribing to a new representative heuristic, i.e. after several consecutive quarters of declining performance, the new trend must have a down slope. Sell! The stock price ultimately falls to a multi-year low.  

When observers begin to believe a new down-slope trend has set in, the long knives come out. A company and its executives can quickly fall from media grace. One day all stories are written to extol their virtues, the strength of their business, the genius of their vision, the wisdom of their philosophy. And the next day, a barrage of criticism roles out…

In February, Barron’s says It’s Time to Rein In Bezos

The blogs call Amazon a “secular short,” calling out initiatives to grow market share (like Amazon Prime) and doubting the strategy of making investments in the expense structure in anticipation of growth.  

Others note the exodus of guru investors like George Soros and Julian Robertson. 

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So, back to my opening point: Amazon is in an interesting place. For five years it showed the world an ability to grow sales at a blistering pace without much damage to EPS. In 2011, that has changed. On the surface it would seem that Amazon believes it can accelerate investments now to solidify its place as market leader in web retailing, digital media, and cloud computing.  And it’s very willing to sacrifice quarter-to-quarter results by leaning hard into these investments. 

All investors, existing and prospective, should be on the edge of their seats to see how this plays out. 

On the one hand,  there is reason to believe Amazon is preparing to take its current owners on a bumpy ride by going all in with Amazon Prime (shipping subsidies and freeby services like streaming movies), Kindle devices, and building a bigger-better-cheaper AWS. EPS are very, very likely to suffer. Current owners must develop a steely resolve and recognize this will be turbulent. The Shleifer Effect is in play.

On the other hand, it’s not a stretch to interpret these investments as bets with pretty decent odds behind them. They have the hallmark of informed managers investing in their moat…recognizing their competitive advantages and spending heavily in their defense. Sure, that will lead to a short- or mid-term reduction in earnings, but it should create significantly more value over the long-term. 

Next, I want to explore whether it makes sense to forego those profits today for the possibility of even greater profits down the road.

Paul Dryden

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