If you have a long-term view, one company is as close to a guarantee for investing success as you can get…
Some say he was the greatest investor ever. In the public-fund business, I doubt there’s been anyone this good…
Between 1976 and 1991, Peter Lynch was a rock star in the mutual-fund world. For 13 years, he returned 29% a year to the 1% of Americans who were clients of his firm, Fidelity Investments, and put their money in his Magellan Fund… me among them.
The Magellan Fund was the first mutual fund I ever put money into. I was getting my MBA at the Kellogg School of Management and then working at Goldman Sachs when Lynch was at the top of his game.
I’ve read all his books and remain a longtime student of his investing philosophy. My favorite, One Up on Wall Street, is required reading if you want to work for me.
For example, I love how he describes the type of businesses you want to own over the next decade: “In business, competition is never as healthy as total domination.”
One of the best-known Lynch stories (and one of my favorites) is how he noticed his wife was always purchasing L’eggs pantyhose when she went to the grocery store. Hanes had recently released the product and was placing the distinctive egg-shaped package near the cooler case. The marketing touched metaphors of freshness and goodness inside, and even youthfulness of a perfect product.
He asked his wife’s friends, and they too were smitten. The “total domination” was clear. Lynch bought Hanes for the Magellan Fund and made something like 10 times his money.
Most people think Lynch stopped there… with the recognition that people were buying and using things. But that’s not completely true. Lynch talked about understanding companies you invest in.
“I found out the average woman goes to the supermarket or a drugstore once a week. And they go to a woman’s specialty store or department store once every six weeks,” Lynch explained in a 1997 interview with the PBS show Frontline. “And all the good hosiery, all the good pantyhose, is being sold in department stores. They were selling junk in the supermarkets. They were selling junk in the drugstores. So this company came up with a product… They had all the sizes, all the fits… They never advertised price. They just advertised ‘This fits. You’ll enjoy it.’”
As Lynch said in One Up on Wall Street, a little bit of research and some basic math is all you need to invest well…
If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored.
The last component was time. You want to invest for the long run: “Time is on your side when you own shares of superior companies,” he wrote.
Lately, I’ve been seeing an investment Lynch would love…
Its total domination is clear: Every day of the week (even Saturdays and Sundays), the postman stops his small Express Mail truck nearby my house. Out he gets, every day, his arms overloaded with cardboard boxes. The familiar upturned arrow is stamped on all the deliveries.
Today, Peter Lynch would definitely pay attention to Amazon (AMZN).
It doesn’t take much basic math to understand just how wonderful this business is. And if you’ve got a long-term view – by which I mean three to five years – this is as close to a guarantee for investing success that you can get.
Cornering the Market in ‘Crazy’ Ideas
Jeff Bezos, founder and CEO of Amazon, runs his business for the long term. He doesn’t seem to care the slightest bit about quarterly or even annual earnings. That’s an advantage.
If you’re familiar with the online-retail colossus, look around your neighborhood… Those brown boxes with a smile that you see on all your neighbors’ doorsteps are Amazon deliveries of books, household goods, clothes, electronics, and just about everything else.
For many folks, Amazon is their first stop for nearly anything they want to buy. And by many, we mean millions of people have swapped out most of their retail shopping for Amazon.
Even beyond basic Internet retailing… Amazon offers a plethora of Web-based services. It can store your photos or host your website on its cloud. It can deliver items to your door in two hours. You can stream Manchester by the Sea on Amazon Video. Oh, and Amazon Studios produced that Oscar-winning movie as well.
The U.S. economy and retail sales have just recently surpassed the highs set before the financial crisis. Sales at the major department stores and big-box stores have grown 20% over the last 10 years. But that doesn’t even register when compared with Amazon’s 1,100% growth.
Amazon has booked this growth and its pervasive spread through the U.S. economy by having a fundamentally different approach than any other company we know. It focuses on the long-term view…
Let us draw a parallel between business and investing.
In investing, you can instantly claim an advantage over everyone else in the market by adopting (and more difficult… sticking with) a long-term view.
Thousands of fund managers and millions of individual investors are trying to find good investments for this quarter or boost their returns for this year. If you can widen your view to five years, you’re playing a different game and the competition disappears.
That’s an important lesson for investors. And Jeff Bezos takes the exact same approach with Amazon.
“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people,” Bezos said in a 2011 interview with Wired magazine. “But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that.”
Bezos built Amazon by going against expectations and testing new ideas. Amazon started in 1994 as a bookseller. I remember when it branched out to sell other items around 1998, and it seemed like a strange choice. Amazon’s brand was books. In those days, people went to different websites to buy different things.
Aside from selling “everything,” Amazon has undertaken big projects that turned into great businesses. Those projects took a lot of time and capital… and seemed a little crazy at the time.
Consider the Kindle e-book reader, which Amazon first released in 2007… The thought of a bookstore making hardware was a huge leap in thinking and a big risk. First of all, Amazon sold things, it didn’t build them. Second, Amazon sold books. E-books would be a direct competitor to its core business. Most companies don’t have the guts in invest in the technology that will undermine its very business.
These days, e-book sales total billions of dollars. Amazon claims about 70% of the e-book reader market with its Kindle device. I love a print book as much as anyone, but it’s hard to argue against the future of e-books. And it’s clear that Amazon will own it.
Amazon doesn’t report detailed sales for different units, but a few years ago Morgan Stanley estimated that the Kindle “ecosystem” (all the devices and the sales) accounted for 11% of Amazon’s massive revenue.
That’s a successful gamble on hardware.
Next up is Amazon’s Echo. Lots of companies are betting that the “smart home” will be the future of technology. Amazon jumped into hardware again with the Echo “smart speaker” – a cylindrical device for your home that listens to voice commands and responds by playing music, adjusting the controls around your home, and ordering things from Amazon.
It’s an unqualified hit. The device sold 5.2 million units in 2016, and Amazon’s branching out into new products in that vein like the smaller-sized Echo Dot.
These are huge successes, but they don’t match the ingenuity of Amazon’s two biggest successes…
Two Game-Changing Businesses… With More to Come
To handle the flood of sales during peak times, Amazon built a huge computing infrastructure. But for much of the time that power sat idle. A few engineers developed software to allow outsiders to rent out this power for their own purposes starting in 2006.
Before long, Amazon poured billions into this cloud-computing business called Amazon Web Services (AWS). We can say this without exaggerating: AWS has changed the way the Internet works.
Prior to AWS, a business that needed an IT setup to host websites or databases could spend tens or hundreds of thousands of dollars and work for weeks to get their own servers up and running. With AWS, deploying the same capabilities takes hundreds of dollars and less than a day.
That’s why major companies like Netflix, Comcast, and 3M use AWS to host services.
From Amazon’s perspective, AWS practically prints money. For years, Amazon hid the AWS results within its broader revenue numbers. But in 2015, it started reporting the service’s revenue numbers.
Now, AWS accounts for $12 billion in revenue (or 9%) of Amazon’s total sales. More impressive, it totals $3.1 billion in operating profit, or 74% of Amazon’s total.
Now, Google and Microsoft and others are trying to hop in on the cloud-computing game, but Amazon owns 40% of the market and its revenue grew 55% last year.
This is the way technology will work for decades… and Amazon owns it.
Amazon may have an even bigger success with Amazon Prime. Again, it’s the focus on the long term that allowed Amazon to make billions from a daring move.
Amazon Prime is a loyalty program that gives customers free two-day shipping and other perks for a $99 annual fee. Here’s the problem… It only takes about 10 orders a year for the shipping program to cost more to Amazon than the Prime fee. Doesn’t seem like a great business…
“We made this decision even though every single financial analysis said we were completely crazy to give two-day shipping for free,” former Amazon Vice President Diego Piacentini told author Brad Stone for his book on Amazon, The Everything Store.
On the surface, Prime is just that… a money loser. Amazon has around 65 million Prime members. That’s half of all U.S. households.
And, as predicted, the shipping consistently costs more than the $99 fee. That means hundreds of millions in “losses.”
Still, Amazon chased this project and aggressively marketed it to build up the number of customers on board. It had its eye on the long term and it paid off. The average Prime customer spends double what the typical Amazon customer does: $1,200 a year versus $600 a year, according to the firm Consumer Intelligence Research Partners.
As if Amazon wasn’t dominant enough already, hooking people up with free shipping makes buyers Amazon addicts. Many Prime members check Amazon first for nearly everything they buy.
Prime also includes Amazon’s streaming-video service. It’s a Netflix competitor, but it has three times as many movies and has started producing award-winning original material.
Herein lies the real genius to Amazon’s plan. “We get to monetize [our subscription video] in a very unusual way,” Bezos said in a speech last year. “When we win a Golden Globe, it helps us sell more shoes.”
Netflix and Wal-Mart can’t do that and never will…
The only way for Amazon to have built Prime (or Amazon Video or AWS or the Kindle ecosystem) is to take a long-term view. These products took millions to build and had no clear path to earning that money back at their start.
They weren’t unreasonable ideas. Many startups today burn through cash with the intention of figuring out a business model later. Amazon doesn’t do that. These products all have paying customers from the start. It’s just that the ideas often don’t branch out naturally from Amazon’s offerings or make profits on Day One.
Of course, not every bright idea grows up to be a big hit. The company has suffered missteps. For one, it lost hundreds of millions developing the Amazon Fire smartphone, which flopped. It’s also shuttered smaller projects, like its travel website and a payment system called Webpay.
Looking forward, Amazon is secretive about what it’s working on, but bits of information leak out here and there. The company has invested in drone delivery. It’s designed grocery stores that automatically ring up your purchases when you walk out of the store. It’s also been buying up shipping assets, like planes and ships, with the suspected intention of building its own global shipping network.
What’s next? We don’t know exactly. But the only way to hit on the next big thing is to invest… And it seems like Amazon is one of the few companies even trying…
Where All of Amazon’s Money Goes…
Amazon sells, and Amazon spends. For 2016, the company took in $135 billion in sales but it’s got slim profit margins. On those sales, it only earned about $4.1 billion in operating profit (which doesn’t include taxes or interest). That’s a small 3% margin.
After paying for everything else, this web giant earned only $2.3 billion in income.
It’s this low level of earnings (and its high valuation – more on that later) that make some investors skeptical.
However, all the blockbuster projects we listed above explain where the money goes.
Amazon constantly reinvests the bulk of its money back into its own business and new products. It doesn’t rest. For a decade now, Amazon has had the best logistics systems and provided the fastest delivery. But they keep investing more and making it faster. They cut available delivery to two days, then to one, and now you can get some items in two hours.
They do this to please customers and make sure they are always ahead of any competition that may arise.
For 2016, Amazon spent $6.7 billion on the purchase of property and equipment and $16 billion on research and development (R&D).
These are investments that boost productivity and lead to opportunities in the future.
We want more businesses to be investing like this and we want to invest in them. Too many other companies have no profitable ideas and have seen trillions in cash pile up on their balance sheet. We like stocks like Apple (AAPL), Alphabet/Google (GOOGL), and Microsoft (MSFT), but they have a problem. They make gobs of profits, but they have no new businesses to invest in.
Google, for instance, does spend about $13.9 billion on R&D, but they’ve still got $86 billion in cash. It’s not anywhere near Amazon’s method of spending everything it can.
Somehow, Amazon doesn’t seem to have the same problem. It can always find a new place to put cash to work.
Amazon can turn profitable – highly profitable – any time that it wants to. It can simply dial back the spending on some projects and the money will pile up.
It’s done this before. In the fourth quarter of 2014, analysts expected earnings of $0.18 per share. Amazon doubled that by earning $0.45 per share. In the first quarter of 2016, analysts expected $0.57, and Amazon earned $1.07.
Some suspect that Amazon chooses to do this on occasion just to prove to the market that it can make profits when it wants to… Though no company’s management would admit to playing such games.
Aside from all that, Amazon does earn positive free cash flow to the tune of $9.5 billion, holds $25 billion in cash, and has only a small amount of debt.
The risk in Amazon shares doesn’t come from its financials. It comes from valuation…
The Valuation of a Growing Company
Amazon trades at a triple-digit price-to-earnings ratio today. There’s no way to sugarcoat that. It’s a very high valuation.
But there’s many ways to look at it to see how it makes sense. Amazon could be much more profitable any time it chooses. That helps.
Second, this is not an investment mania. It’s a business with phenomenal prospects.
When shares get frothy, investors don’t fret over the future of the company. Rather, they buy at a price they know is undeserved simply because they believe they can sell for an even more undeserved price in the near future.
That’s not the case with Amazon. Investors pay a triple-digit price-to-earnings ratio because they legitimately believe it’s got such a bright future that it will justify the price.
Furthermore, we need to think about valuations and the “life cycle” of a stock. When a company is young and growing fast – think greater than 10% a year – it deserves a higher multiple.
As it matures, its growth slows and its multiple contracts, but the share price still rises as the fundamentals match the future expectation.
You can see this with technology companies. We can use price-to-sales and the rate of sales growth to watch companies turn from high-growth tech obsessions to mature, profitable companies while still handsomely rewarding shareholders.
The 2000 dot-com boom caused a big hump in these charts. But you can see below in the chart that an investor could have paid 10 times sales (usually a very expensive price) when Microsoft grew at 20% a year. Since then, revenue growth has slowed to about zero and shares trade for a smaller multiple. But shareholders were paid well.
The same goes for Oracle. Note in the chart how sales growth slowed from 30% to 0%. It’s still making money, but sales have leveled off from the days of 40% and 50% growth. As a result, its price-to-sales multiple dropped, but shares have tripled.
The important thing to note here: Amazon is still growing sales at 20% a year, while it trades for three times sales. In the context of other growing tech companies, that’s still fast growth and a relatively cheap price.
An Investment for the Long Run
Just like Bezos, you have to think long term as an Amazon shareholder. Its share price could be volatile in the short term given its valuation.
However, if you give it three to five years, you can pretty much guarantee a few developments…
First, Amazon will be bigger in the future than it is today. Unlike so many flash-in-the-pan tech companies, Amazon has major competitive advantages and an infrastructure that cannot be replicated.
We often hear about how digital sales are killing other retail stores… But lost in all that hype is the fact that online purchases still account for roughly 5%-10% of retail spending. Whether you think that online spending will account for 30%, 50%, or 90% of spending in the future, it’s clear that it will be multiple times larger than it is now. And the primary beneficiary will be Amazon.
Second, you can be sure that Amazon will have the ability to be massively profitable at any time. It may wait a long time to turn on the profit spigot, but it’s there waiting.
Third, Amazon will have more big hits. We don’t know just what they are yet, but it will have multiple products that succeed and transform the company, as AWS and Prime have already.
Don’t let valuation and short-term thinking keep you from investing in one of the best businesses in the world.
Dr. David Eifrig initially wrote about Amazon for his Retirement Millionaire subscribers… Since then, folks who invested in his recommendation are up by double-digit gains – double the S&P 500 index. And recently, he detailed an even more impressive opportunity… a “one-day cash event.”
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Dr. David Eifrig worked in arbitrage and trading groups with major Wall Street investment banks, including Goldman Sachs, Chase Manhattan, and Yamaichi in Japan. In 1995, Dr. Eifrig retired from Wall Street, went to UNC-Chapel Hill medical school, and became an ophthalmologist.
Today, he publishes a free daily letter on health and wealth that shows readers how to live a millionaire lifestyle at http://retirementmillionairedaily.com/.
