Momentum stocks have taken a beating recently. The selling has been concentrated in biotech, technology/internet, and retail. Unfortunately, Amazon (AMZN) falls into two of those three categories, and as a result the stock has dropped from a high of $408 to a recent low of $313. Clearly, investors saw the first quarter of 2014 as an opportunity to take some of their biggest 2013 profits off the table.
We believe that the technicals and fundamentals on AMZN are very attractive at this point. In this article, we will make an argument that AMZN is undervalued fundamentally, which will strengthen underlying support at $315 per share. We believe that if traders are going to start accumulating the stock, this would be the price point to do so.
The Technicals
AMZN’s first quarter pullback dropped the stock to the same price level as its breakout gap last October. Bullish gaps (or windows) tend to be strong levels of support. On the chart below you can see how the recent draw down was interrupted in February when the stock hit the price level of the second breakout gap from last October. If the stock were to find support in the short term, this would be a likely level for that to happen.
We may be able to confirm that the bounce this week if we see another two days of higher highs and higher lows. This method of confirmation is called a swing-low (Gann Method) and can be an effective way to confirm support levels within a trend. Assuming the bounce is confirmed, we suggest placing stops below the bottom of October’s gaps at $305 per share and letting the trade run through $360 at least.
Gaps can also act as resistance once they have been filled, so we suggest that technical traders move their stop loss above break even if AMZN rallies to the top of the second October Gap (at $360 per share) and begins to consolidate. That behavior could be a precursor to another decline now that the stock has put in a lower-low. In the next chart you can see an example of what we mean and when traders might consider increasing their stop-loss to a break-even point.
The Fundamentals
From a fundamental perspective AMZN is tricky, and with the introduction of Prime and aggressive expansion spending, the future growth rate is even more difficult than normal to project. As we see it there are three basic issues with AMZN’s fundamentals.
- Revenue is growing but profit margins are shrinking from their already low levels.
- Value ratios are incredibly high already. The trailing P/E ratio is 548, which is much larger than many of its ‘peers’.
- The company is launching and investing in new products that have no comparable peers or industry group.
However, although it is speculative, it doesn’t seem unreasonable to us that AMZN’s price is based on what investors think AMZN’s profitability and growth rates will be when they mature. That could be 10 years from now, but it seems likely that all this topline growth will eventually settle into the bottom line as the market matures.
In a situation like this we defer to similar companies that are already mature. This is tough for AMZN because there are no firms that are completely similar. However, if we use the average valuation measure of return on equity (ROE) from several retail firms with long-term top and bottom line growth patterns – i.e., Costco (COST), Target (TGT), Wal-Mart (WMT) – and the market’s risk premium we can back into a hypothetical value for AMZN as if its profit margins were more mature.
While this layers several assumptions on top of each other, it does help to explain what investors expect from AMZN in the future. So, let’s break down what we believe about AMZN’s fundamental value based on a single-stage residual income model.
- AMZN will be able to trend towards a return on equity equal to the average of other successful retail firms.
- If #1 is a given then AMZN’s implied growth rate is closer to 5%, which is relatively moderate compared to their ‘peers’.
- Assuming #1 is achievable and growth is 5%, then the current justified price is closer to $400 per share.
To be clear, it’s a stretch to apply these assumptions to AMZN, but we feel that it a good check figure when we consider AMZN’s actual growth rates. What we want to do with an analysis like this is to confirm that the market isn’t doubling or tripling even an aggressive forecast like we have made.
Over-estimating even aggressive assumptions like this often happens with the so-called ‘momentum stocks’. We believe this is one of several reasons why investors dumped many of the new ‘dotcoms’ and biotechs over the last month. In those cases, even borrowed fundamentals wouldn’t come close to justifying their current stock prices.
In this case, we feel that our forecasted fundamentals support the technical argument for support at this level. We like the idea of buying in at current prices, moving a short-term stop loss to break-even when if the stock consolidates at the top of October’s second gap, and letting the trade run if prices can get beyond March’s highs. If traders are looking for growth in 2014, we think AMZN is the place to find it.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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