Amazon's growth since 2017 & the modern investment landscape...
We've covered the curse of the magazine cover before.
It struck again in 2017 👇
The article posed a simple question: 'Are investors too optimistic about Amazon?'
With the benefit of hindsight we know that they definitely weren't...
The stock would go on to appreciate 37.8 percent annually in the next four years versus a total shareholder return of 15.8 percent for the S&P 500 Index. That growth translated into an increase in market capitalization of more than $1 trillion.
Amazon will be at a $515 billion-plus sales run rate by the second quarter of 2022 and will have a 6-year sales growth rate ended 2022 of 27.6 percent, if the consensus estimates are accurate.
The above is taken from this excellent work by Michael Mauboussin & Dan Callahan at Morgan Stanley.
We'll come back to the paper in a second.
First, let's take a look at why The Economist got it wrong.
Simplifying the analysts' argument, the bigger a company is, the harder it is to keep growing at the same rate (and no company with sales of more than $100bn had ever done it before)...
If Amazon were to pull it off, it would be the most aggressive expansion of a giant company in the history of modern business.
Sounds like solid logic. History can often be a good reference for the future.
But there was some important context missing...
The role of 'intangibles'
Back to the MM/DC paper and defining intangible assets:
Intangible assets have two characteristics that are important for considering corporate growth rates.
The first is that they can enjoy strong economies of scale because they are commonly cheap to reproduce and share.
The second is obsolescence and the related concept of sunkenness.
The value of intangible assets can drop precipitously when a new and better version comes along and makes the old version obsolete. And because the old version has very limited value, the investment cost is sunk
Economies of scale are a measure of cost per unit as a function of output.
Think of software as an example.
The original code may be very expensive to produce but the cost per unit sold drops rapidly because it is inexpensive to share.
So what does this mean?
Intangible assets are more scalable than tangible assets.
That means successful companies that rely on intangible assets can grow faster than companies built on tangible assets.
As the overall mix of investments shifts from tangible to intangible, we should expect to see faster growth rates for the winners than we have seen in the base rate data
Intangible-based businesses can grow faster than base rate (historical) data shows
i.e. History is no friend to analysis if context is ignored.
Comparing the growth rates of historical 'tangible asset' companies with the growth rates of modern 'intangible asset' companies will lead to some poor conclusions.
One way to think of it is that there were capacity limits on individual companies 'in the old days', because they could only make a finite amount of products in their factories.
Amazon has no such constraints, and (theoretically) is only limited by the capacity of global production.
The entire manufacturing world is Amazon's factory, and they provide the customer base, the data, the algorithms, the brand loyalty (Prime) and so much more.
2. Growth rates lead to fat(ter) tails
The right tail (positive outcomes) of the distribution of growth rates is extending outward from the average. Amazon’s results provide anecdotal evidence for this.
But everyone can't win so...
We should observe greater variance in the distribution of growth rates for intangible-based businesses. That means that the left tail (negative outcomes) of the distribution of growth rates is also spreading further from the average.
BlackBerry’s 26.7 percent average annual revenue decline in the past decade through February 2021 is a case in point.
This provides investors with good and bad news.
The good news is there will be some businesses that grow in excess of what history would suggest, creating opportunity.
The bad news is some businesses will lose their positions of prominence and decline more rapidly than their predecessors did.
Base rates remain extremely informative, but we must have the mental flexibility to acknowledge how the population of companies has changed over time.
There are two main lessons for investors.
First, it is important to be mindful of the potential shift in the base rate as the result of the rise of intangibles.
Second, skilful investors may be able to identify the companies that will grow faster than expected, hence providing the potential for attractive returns.
Loosely speaking, the intangible/tangible comparison illustrates the difference between growth & value companies.
Investors chase returns on capital.
Value companies are typically defined by tangible assets (and limited by capacity constraints.)
Growth companies are typically the opposite.
Tesla is a superb example.
If they were 'just' a car company, their valuation would be in-line with other automakers.
But investors see Tesla as a tech/growth company.
That's how the higher valuations are justified.
The day Tesla tries to move into large-scale manufacturing is the day that story dies.
If you want the extreme bull case, ARK's paper from March is a good place to start... 👇
Wrapping up, the full paper is a very worthwhile read.
It's only 10 or so pages, and there's a lot more detail, including a study on the sales growth of the top 1,000 U.S. companies.
Healthcare and Technology represented over 60% of the top 20, 50, and 100 growers despite being only 29 percent of the universe
No surprise that the industries with the highest intangible asset intensity led the way.
That trend is unlikely to change.