Amazon Remains Tier 1

Fearful investors are underestimating the e-commerce titan's long-term growth potential.

Mar 31, 2014 at 7:15PM

One of the long-term investor's greatest advantages is the utilization of a concept known as time arbitrage. Investopedia defines time arbitrage as:

An opportunity created when a stock misses its mark and is sold based on a short-term outlook with little change in the long-term prospects of the company. This miss occurs when a company fails to meet earnings estimates by analysts or its guidance, resulting in a short-term stumble where the price of the stock decreases. Some investors use time arbitrage to increase their chances of outperforming the market.

Basically this means that as long-term investors, we can use Wall Street's short-term focus to our advantage. As the sell-first-and-ask-questions-later crowd is running for the exits, we can calmly step in and buy shares of great businesses at more attractive prices.

But here's the key: We must have confidence that the business's long-term competitive advantages are still intact. Otherwise, we may be stepping in front of a bus. For if the company's short-term struggles are signs of further danger ahead, buying ahead of that decline will lead to steep losses. However, if nearsighted traders are overestimating the impact of a temporary downturn in a company's business performance, buying into that weakness could give long-term-minded Fools a powerful profit opportunity.

The ability to tell the difference between a business that is in a state of decline and one that is only temporarily struggling and poised for a rebound is often a key factor in whether an investor can earn market-beating returns. At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I've used time arbitrage to help us achieve a time-weighted return of 74.63% since Tier 1 was launched on Sep. 1, 2011, compared to the S&P 500's 62.41% return during that time. And today, I believe I've found another time arbitrage opportunity in Amazon.com (NASDAQ:AMZN).

The sell-off
Amazon's stock is down about 18% from its 52 week high after the e-commerce titan reported fourth-quarter revenue and earnings that fell short of Wall Street's lofty expectations. Revenue rose 20% to $25.59 billion — which was at the high end of Amazon's own guidance — but below the $26.1 billion Wall Street had projected. Operating margin improved slightly from 1.9% to 2% and net income and earnings per share more than doubled to $239 million and $0.51, respectively. However, the EPS number was significantly below the $0.66 analysts had been expecting.

Going into the quarter, many investors began to anticipate just how amazing Amazon's fourth-quarter earnings would be, likely spurred on in part by comments by Starbucks (NASDAQ: SBUX) CEO Howard Schultz, who spoke about a pronounced shift in consumer shopping behavior, saying "Holiday 2013 was the first in which many traditional bricks-and-mortar retailers experienced in-store foot traffic give way to online shopping in a major way." As a result, the stock, which had already run up sharply over the several months leading up to Amazon's quarterly report, jumped another 5% right before Amazon was set to report. 

I have to admit that I, too, was waiting by my computer with bated breath in anticipation of what I thought would be a "shock and awe" type earnings report. When that didn't happen, and Amazon's revenue and earnings actually came in below Wall Street's estimates, it was a major letdown for many investors. Many of them reacted by selling their shares, leading to a subsequent steep decline in Amazon's stock price. That's the danger of sky-high expectations.

The opportunity
That said, the Internet shopping megatrend is still very much under way, and with only about 6% of retail sales conducted online, I fully expect it to power Amazon's sales — and profits — well beyond the next decade. In fact, I can't think of any company better positioned to profit from this trend, thanks to its dominant competitive advantages that continue to grow stronger. So while Amazon's stock price may continue to experience some volatility in the coming weeks and months, I still think the long-term outlook is extremely bright for this Tier 1 enterprise. And with a recent increase in its Prime membership fees, I believe we'll soon begin to see Amazon's profits once again exceed investors' expectations.

The strategy
I want to increase Tier 1's ability to profit alongside Amazon, before Wall Street realizes its mistake. But I want to do so in a more conservative manner than simply buying shares to account for the possibility of further downside in the months ahead. To do so, I will be selling "mini" puts on Amazon. With this option strategy, I will be paid a premium to enter a contract to buy 10 shares of Amazon at a specified time and price. Specifically, I will be selling the Amazon January 2015 $330 puts, currently trading at about $33 per share. If Amazon is trading at or above $330 on the Jan. 17, 2015, expiration date, the puts will expire worthless. And the $330 I receive in premium ($33 per share times 10 shares) will amount to a 10% gain on the $3,300 at risk ($330 per share times 10 shares).

If Amazon is trading below $330, I will be obligated to purchase shares at an adjusted price of $297 ($330 strike price minus the $33 per share in premium), or about 11% lower than today's $335 price. I think it's also important to note that I would be buying Amazon in January 2015, after the company will have had time to grow its earnings and cash flow. So, in effect, I would be buying shares of an outstanding business at a better valuation than is possible by simply buying shares today. And, importantly, I'd be very happy to purchase Amazon shares at that adjusted $297 price.

Finally, between the time I sell the puts and the expiration date, I will have the option of buying back my puts or rolling them to other strike prices and/or expiration dates. And so, with this put writing strategy, there will be many ways to earn a profit.

The Foolish bottom line 
Wall Street has begun to question whether Amazon can continue to grow as it has in the past. Many investors have headed for the exits, pushing down Amazon's share price in the process. But, by applying the concept of time arbitrage, we can take advantage of temporary market fear to profit alongside this elite, Tier 1 enterprise. And so, at least 24 hours after this article is published -- standard operating procedure for The Motley Fool's Real-Money Stock Picks program that's designed to give Fools the opportunity to buy ahead of us should they so choose -- I will be writing Jan. 17, 2015, $330 puts on Amazon in the Tier 1 Portfolio.

Next steps
To learn more about Amazon as well as another retailer with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

Joe Tenebruso manages a Real-Money Portfolio for The Motley Fool and is an analyst on The Fool's Stock Advisor and Supernova premium service teams. You can connect with him on Twitter @Tier1Investor. Joe has no position in any stocks mentioned.

The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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