Case Study In Second Level Thinking: Amazon

Several issues ago, I wrote about second level thinking, which involves looking at potential investments with a more critical and often contrarian context. I thought I would put that into practice with a dive into a stock that often takes up a lot of oxygen whenever and wherever I’m talking about investing: Amazon.

Amazon has been one of the “It” stocks for the last decade. It has had an epic run. Even if we don’t own shares, we often own it indirectly through Exchange Traded Funds (ETFs). Just in the U.S. alone 605 ETFs have Amazon in their baskets. In 2008, it was only 9.

Let me be very clear here at the outset. Amazon is a wonderful business. It demonstrates a key competency of successful, long-run viable businesses which is reinvesting back into its products and services and challenging itself to do better. It just does it in a hard-core style by choosing to reinvest all its profits and is willing to try anything and not rest on its laurels. That competency usually peters out for most, if not all companies, but after 24 years, Amazon continues to bring this element to its culture.

If we were to look at Amazon from a 1st level thinking perspective, the conventional thinking behind buying Amazon is that they are disrupting retail. Any space Amazon enters, be it grocery, streaming, pharmaceutical drugs or diapers, is met with fear and doom by the existing players. First level thinking would tell us that in the future we will shop at Amazon only.

I would consider Amazon to be a Fear of Missing Out (FOMO) stock. Many have missed the moves up and feel compelled to jump aboard so they won’t miss out. For those considering it, here are some second level thinking perspectives worth considering.

For all the banter about Amazon disrupting retail and various industries, when you drill down into the areas Amazon is involved, the one space they have truly dominated and taken over is the space they were founded upon: books. They are hands down the largest books retailer in the world and many large and small legacy bookstores have gone out of business because of them. Amazon has truly revolutionized how we buy and read books. When you go beyond books, it’s hard to find any of their other business lines dominating their space in this fashion. The logical progression for this would be book publishing but they really haven’t made any traction. In fact, you could say they have used their power to engage in some dubious publishing practices.

After buying Whole Foods, many called for the demise of grocery retailers. The reality is Amazon’s market share has gone from 0.2% to 1.4%. Hardly moving the needle. Walmart, Costco, and Loblaw have responded with expanded delivery services and are meeting Amazon head-on.

After buying Pill Pack to gain entry into the drug retail space, pharmacies like CVS and Walgreens came under pressure. The reality is Pill Pack does $100 million in sales, while companies like Walgreens does over $118 BILLION in sales and offer similar delivery options to Amazon.

Amazon has been building up its entertainment streaming catalog and producing more content, some of it quite good, and has some Emmy Awards to show for it. To their credit, they saw the potential of eSports and were the first to stream video game tournaments, which has created mass audiences and drawn in mainstream networks like ESPN to broadcast tournaments like the Overwatch League. Conversely their entrance into live sports has been sketchy with fumbles in delivery of the U.S. Open tennis tournament. Do you see Netflix, or Disney shaking because of this?

Does anyone remember when Amazon dabbled into building a social network to rival Facebook? It bought a portal called PlanetAll in 1996 to link its book customers. It didn’t fare well.

Then there was the acquisition of Diapers.com that had everyone in the children’s retail world hyperventilating. As a father, who’s been changing diapers the last few years, I can firmly attest that Pampers, Huggies and Kirkland diapers are still thriving quite nicely.

The genesis of the Amazon as a disruptor was in the electronics space as people went to a Best Buy to touch the TVs and computers and go home and order it on Amazon. So many experts painted the end of electronics retailers. They’re still around and more than holding their own (Note Future Shop which was bought out from Best Buy went under, not because of Amazon but because of duplication in their real estate footprint).

Despite selling 50 million of the Alexa smart assistant Echo products, only 2% of owners have used it to make a purchase this year and of those who did buy something, 90 percent didn’t try it again. Also, remember the Fire phones? They got shelved pretty fast.

Amazon has also tapped into the search engine model and has impressively generated about $2 billion in sales. Somehow I don’t think Google or Facebook which generate $24 billion in revenue per quarter is losing sleep right now.

If we get into numbers, Amazon has locked in about 49% of online retail sales, which thinking from a first level perspective is incredible. When we add some context and look at it from a second level thinking perspective, Amazon represents approximately 5% of total retail spending. Retail is not just Amazon.

I realize that none of these points will sway any of the Amazonians who have loyally ridden the stock to where it is. It has had the winds behind them thanks to Wall Street and now retail investors are joining the ride.

The reality is Amazon contrary to first level thinking has not achieved the same level of market power and dominance in any of their other retail ventures. They’re doing OK.

Somewhere along the way, an expectation has been embedded that just because Amazon enters a space, they will, by default, own it. The reality is entering a retail space does not entitle Amazon to 100% of that industry’s profits. It still has to compete. What has happened is when they do enter a space, the competition far from lies down. They, in fact, double down. I wouldn’t say that Amazon has disrupted retail, but invigorated retail from being complacent to being more proactive. In the long run that’s good for everybody.

From a second level thinking perspective, when you look at all these elements and then bring it back to its stock and how it has behaved and how it has been perceived by investors, it’s really hard to justify the valuations. It is being priced as a monopolistic business. As the above iterations show, it is far from one.

Again, Amazon is a wonderful business and it does offer value for its customers. The Prime program has allowed it to build a critical mass of sticky potentially loyal users. The reality is as investors we must always take a step back and look at investments with context. Amazon as a disruptor may be a sexy first level thinking concept that you can tweet out, however when you put it in context and look at it from a second level thinking viewpoint, a better perspective can be gained.

Aman Raina is an Investment Coach and Founder of Sage Investors. Aman can be reached through his website (www.sageinvestors.ca), Twitter (@sageinvestors) and Facebook (www.facebook.com/sageinvestors)