Active vs. Passive vs. Amazon et al.
The power of individual companies barely features in discussions of active versus passive investing.
It ought to. The increasing returns to scale that certain companies benefit from has built more than just great investment returns. Technology-enabled “platforms” are omnipresent in our lives, with implications for everyone from parents and policymakers to C-suite executives. As these firms compound in power without much apparent profit, one can’t help but see them in their own category.
Examining Amazon helps to better understand this phenomenon. Sentieo shows 770 mentions of Amazon in SEC filings from 439 different companies in just the last three months, more than the president of the United States. Alex Lykken, writing for PitchBook, notes that Amazon competes directly with companies ranging from Ticketmaster to Banana Republic to IBM.
Lina M. Khan observes that Amazon’s influence is not easy to calculate “if we measure competition primarily through price and output,” the traditional way regulators have evaluated monopoly. Her 24,000-word essay was published before the company bought Whole Foods, and before CVS initiated a $66-billion buyout of Aetna that has been seen as “defense against Amazon’s potential entry into the pharmacy space.”
What’s confounding is that bullish investors are the quickest to use “the M word.” Chamath Palihapitiya began his pitch at the 2016 Sohn Investment Conference with “We believe there is a multi-trillion dollar monopoly hiding in plain sight.”
A further wrinkle: The only chart in Khan’s essay has been widely cited by investors shorting Amazon:
Amazon’s Annual Revenue and Net Income
David Einhorn, for example, initiated his short position in 2014, noting that “Now growth is slowing, but rather than unleashing higher profits, the slower growth is leading to even greater losses.”
It hasn’t mattered. This stubbornly low-profit company has outperformed the S&P 500 by double digits or better in six out of the last 10 years.
There’s nothing wrong with competing and winning, but a track record of victory implies casualties. These are not hard to find. Bespoke Investment Group publishes The Bespoke “Death by Amazon” Indices, and investment firm adventur.es recently published Gorilla Mode: What Amazon Means for the Rest of Us.
In 2016, Ben Thompson wrote “The Amazon Tax,” which offers a compelling exploration of the company’s growth. Amazon took an early decision to concentrate on building “primitives” — the most basic elements of services — that the company could use and also sell to outside developers. The approach with each primitive, per Thompson, is to “get out of the way, and take a nice skim off the top.”
There’s no question that this approach is one of the most important of the modern era. Amazon is a beautiful executor with an unbelievable economic engine and unusual investment opportunities. These investments pay off. As Justin Fox noted in Harvard Business Review, the company generates cash remarkably well.
So where are the profits? The company’s $4.1 billion in operating income during 2016 is a drop in the S&P 500’s trillion, according to Edward Yardeni and Debbie Johnson in their report, “Stock Market Briefing: NIPA vs. S&P 500 Profit.” (See Figure 16).
It’s worth wondering why. When McKinsey & Company released an analysis of the global profit pool in 2015, they highlighted a trend that would seem to play directly in Amazon’s favor:
“Sectors such as finance, information technology, media, and pharmaceuticals — which have the highest margins — are developing a winner-take-all dynamic, with a wide gap between the most profitable companies and everyone else.”
That same report included a remarkable finding: The top 10% of firms account for 80% of all profits. This leaves us with two seemingly conflicting truths: Winners win bigger than ever, but one of the world’s biggest winners is not making much in the way of profits.
How’s that for a brain twister?
Making sense of the company’s soaring stock price and still-forthcoming profits is becoming a cottage industry. Aswath Damodaran writes in “Loss Leader or Value Creator? Deconstructing Amazon Prime“:
“I have long described Amazon as a Field of Dreams company, one that goes for higher revenues first and then thinks about ways of converting those revenues into profits; if you build it, they will come. In coining this description, I am not being derisive but arguing that the market’s willingness to be patient with the company is largely a result of the consistency with [which] Jeff Bezos has told the same story for the company, since 1997, and acted in accordance with it.”
Amazon is an example of a long time frame functioning as a latent currency for investors. It’s the “dark matter” that helps rapid growth and unrelated profits make sense. The central presence of the company’s founder helps us to have faith that a vision — not just millions of packages — will be delivered.
But now imagine Amazon is just a singularly successful operator in an entirely new market context. Remember: If the “world is flat,” it’s flat for everyone. Amazon may just be the focus because we pay extra attention to companies that come early in the alphabet.
Joseph Stiglitz won the Nobel Prize in economics for advancing models that accounted for asymmetries in information. In “America Has a Monopoly Problem — and It’s Huge,” he recommends considering a breadth of issues that can come from increasing concentration in market power.
No Easy Answers
It might be that the lens of competition and antitrust simply provides a window into a set of challenges that are best addressed elsewhere. Carl Shapiro traces the problem elegantly in a forthcoming paper for the International Journal of Industrial Organization. His discussion with Walter Frick of the Harvard Business Review ends with the opinion: “when people express general concerns about the power of the large tech firms and look to regulation to check that power, I’m more skeptical.”
There seems to be a consensus that the analytical norms of antitrust regulation that focus mostly on short-term price effects should be revisited, but there is no evidence that such work can invert the anticompetitive nature of these newer firms.
Damodaran revisited his thoughts on Amazon and other large tech companies in a lecture at the CFA Institute Conference: Equity Research and Valuation 2017. When the subject of monopoly came up, he said, “These models have an in-built structure where they are going to tip into winner-take-all areas. The cost of adding a new user gets smaller and smaller the bigger you get. [This starts] creating a competitive advantage that gets harder and harder to bridge.”
It’s not unusual for a few stocks to drive broader market performance in a given year, but we would be foolish to ignore that it has been the same several stocks quite frequently in recent years. Facebook, Apple, Amazon, Netflix, and Google are responsible for roughly 20% of the S&P 500’s performance this year, and generated more than the entire return of the index in 2015. Is it healthy that including or excluding monopoly firms explains so much performance?
It’s true regardless.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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