Stupid Investment of the Week — Amazon.com

To a man with a hammer, every problem looks like a nail.

Sometimes it looks that way even after he has pounded his thumb and wounded his pride.

Well, writing this column is like carrying a big hammer, and after watching Seattle-based Amazon.com take a huge leap recently on the strength of better-than-expected quarterly results, it’s hard not to bang away on the company as Stupid Investment of the Week, based mostly on its inflated valuation and the way the stock is traded.

It’s the second time Amazon is being awarded this distinction, which is odd on two fronts: First, when I picked the stock in November of 2006, expecting a fall based on the company being overpriced, I was wrong. Second, I said then — and will say again today — that this is a great company, not some bottom-dweller piling one mistake on top of another to draw my wrath again.

Stupid Investment of the Week showcases the traits and characteristics that make a security less than ideal for the average investor. It is written in the hope that spotlighting danger in one situation will help investors to root out trouble elsewhere. While obviously not a purchase recommendation, neither is this column intended as an automatic sell signal, as there are times when dumping a problem investment only makes the situation worse.

With Amazon, the problem could be capital gains, especially after the stock has gained more than 40 percent in a week.

On April 24, Amazon reported a quarterly profit of $111 million, more than double the same period of a year ago. Sales rose 32 percent from 2006. Most important, those earnings beat analysts estimates by about 60 percent.

The news fired up the bulls and seemed to scare the considerable number of short-sellers. CIBC World Markets analyst Paul Keung told clients in a note that Amazon is now “a core holding in an Internet or large-cap growth portfolio.”

That may be a bit of a stretch. Core holdings tend to be stable, and the stock’s pop showed Amazon to be anything but.

Rob Plaza, who follows the stock for Zacks Investment Research, said that the heightened volatility makes the stock wrong for most investors.

“This is a tough stock for the average investor to own,” says Plaza, who has had sell recommendations on Amazon since last summer. “It’s going to be hard to stomach this ride if you own Amazon in your individual retirement account or 401(k).”

Unlike most large-cap growth stocks, Amazon has morphed into a trader’s vehicle. Large-cap stocks for established companies tend to be a bit more stable and have fewer short-sellers than smaller, aggressive growth firms.

Amazon, with a market cap in the $20 billion range — has plenty of people betting against it, although many of those naysayers covered their short positions after the company’s good news, so that their losses did not get worse.

Having raised the bar by beating estimates, the stock will get whipsawed the next time it misses earnings. And in spite of rosy projections, that could be soon.

Until the current surge, Amazon shares tended to jump or dive by about 6 percent when the company exceeded expectations good or bad. The next miss off of the new, heightened expectations will reach double digits.

And despite the good news, there doesn’t seem to be a fundamental improvement in the business. Gross profit margins deteriorated again, marketing costs and inventories continued to grow more quickly than revenue. Cash flow from operations for the past 12 months was no higher than the previous year. Those are not signs of a company that has a whole lot of value for its current share price.

“If you disliked this stock at $32, you’ll really hate it at $60,” says Joseph Beaulieu, who follows the company for Morningstar. “There’s nothing wrong with the business — it’s a great company — but you need to know how much it is worth to you as an investor, and I don’t think most people can make the case that it’s worth a lot more than it is trading at now.”

Some of the positive news from quarterly earnings involved tax and currency situations, and while those things added more than $15 million to Amazon’s bottom line, it’s not the same as figuring out a way to minimize the damage done to operating costs by all of those free-shipping deals.

One key part of the earnings announcement was that Amazon showed that it could increase sales without a corresponding increase in operating expenses. That’s good, but the change involved planned cuts in spending. It’s safe to assume that AMZN’s competitors — including Google, Yahoo!, eBay and others — aren’t cutting back on their tech spending. That makes it hard to believe that Amazon can continue to hold the line on operating expenses while remaining competitive.

“Having been wrong on the stock in the past doesn’t mean I’d chase it now, especially at this price,” Plaza says. “It’s not about what you have missed out on, it’s about what is going to happen next. It is still trading at a valuation that doesn’t reflect its fundamentals, and valuations tend to come down — sometimes way down — when that happens.”

In the end, looking at Amazon’s problems, you recognize that it’s not the business or the brand name that is a problem, it’s the share price. But just because a good company has a good run of performance, it’s not necessarily a good time to buy.

“I don’t recall ever seeing such a sea change in the way a company was viewed as I saw on Tuesday with Amazon,” says Beaulieu. “It was as if everyone couldn’t wait to get off the phone to go put their buy orders in. … That makes them excited, but it doesn’t make Amazon a good stock to own all of a sudden, and definitely if the valuation levels are wrong.”

Chuck Jaffe is senior columnist for MarketWatch. He does not own or hold short positions in any securities covered by Stupid Investment of the Week. If you have a suggestion for Chuck Jaffe’s Stupid Investment of the Week or a comment about this week’s column, you can reach him at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.