AMZN (Amazon)

Despite the market volatility of the last four months, the tech sector continues to significantly outperform the rest of the market, returning 11.3% year-to-date. This is a sector that we have a considerable overweight in the portfolio due to the significant risk of it disrupting so many varied industries, as it already has so far. No firm represents the potential of the tech sector better than Amazon.

However, most of the world continues to view Amazon as merely an on-line retailer. For example, if an investor wanted to get exposure to Amazon through an index, she would have to invest in some type of consumer discretionary spending index. In the case of Vanguard, this would be the ETF with the ticker symbol VCR. The main sectors comprising this ETF are internet & direct marketing retail (22%), specialty retail (22%), and hotels, restaurant & leisure (20%). While Amazon is the top holding in this ETF, the remainder of the top-5 holdings are Home Depot, McDonald’s, Priceline, and Nike - companies not at all known for leading edge technology.

So, what is Amazon, if not a retailer? Amazon streams movies and TV shows. Amazon makes movies and TV shows. Amazon has a music streaming service. Amazon is the largest enterprise data storage and data services (artificial intelligence, machine learning, etc.) firm in the world (bigger than the next two - Google and Microsoft - combined). Amazon owns/leases a fleet of ships. Amazon owns a fleet of cargo planes (Amazon has a package sorting and air freight hub in Kentucky that’s equivalent to the well-known Fedex hub in Memphis and UPS hub in Louisville). Amazon builds tablets and develops application software and operating systems. And the list goes on.

The key to understanding the link between these disparate areas that Amazon is in currently (and the list is growing every year) is Amazon Web Services (AWS). AWS is Amazon’s data storage/services (DSS) business, and it is the engine that underlies its B2B and B2C services. It also sells its services to customers outside Amazon (including most of Amazon’s competitors) - AWS is by far Amazon’s fastest growing and most profitable business.

To really understand Amazon, one needs to flip the conventional view of Amazon on its head. Amazon isn’t a retailer. It’s a DSS business that happens to sell its services to both Amazon’s in-house retailer as well as retailers outside of Amazon. Amazon isn’t a video streaming service. It’s a DSS business that happens to sell its services to Amazon’s in-house video streaming business as well as video streaming companies outside of Amazon. Amazon isn’t an air freight business. It’s a DSS business that happens to sell its services to Amazon’s air freight business as well as air freight businesses outside Amazon. You start to see the pattern here. Amazon’s DSS business allows Amazon to enter virtually every industry that exists today, and it allows Amazon to enter these industries with a huge competitive advantage over the incumbent firms: Amazon can afford to earn zero profits in any industry it competes in because AWS will make the profits by selling its DSS to the incumbents of that industry. The incumbents are forced to use the services of AWS to remain competitive with the disruptive technologies that Amazon brings to bear on that industry (of course, the disruptive technology is entirely driven by AWS).

The classic example of this process is retailing. Amazon went into the retailing business utilizing new technologies ranging from an online platform to customer tracking/advertising to distribution/shipping. At the core of these technologies was DSS provided by AWS. With the use of DSS, Amazon utterly and permanently disrupted brick-and-mortar retailing. But today, Amazon makes very little from the retailing business. Almost all the money from retailing is made by AWS from selling DSS to other retailers; and these retailers are forced to use AWS because that is the only way to even the competitive playing field with Amazon. Large and specialty retailers ranging from Nordstrom to Brooks Brothers are now using AWS and the suppliers to retailers, ranging from Unilever to Under Armour are also using AWS. So, Amazon is monetizing the competitive edge it has developed in the retail industry by selling DSS to its retail competition.

This is the playbook that Amazon is utilizing and will continue to utilize in industries well beyond retail. In fact, there are few industries in which this playbook won’t be effective. Last year Amazon hired more workers than the entire workforce of Facebook. What are all these people doing? They are beginning to execute this same playbook in a whole host of diverse industries. It will be interesting to see how much of the global economy Amazon can disrupt with this approach, but it’s not hard to see that Amazon (through AWS) has a real chance to provide the infrastructure for virtually everything that all businesses and individuals do.

It must be recognized that Amazon could have a substantial disruptive impact on much of a portfolio. This disruption of course will result in poor returns. The only way to hedge the risk of this disruption is to own shares in the firm causing the disruption: Amazon. However, as we pointed out above, Wall Street doesn’t yet understand what Amazon truly is - they still think of Amazon as a retailer and have them lumped in with other retailers in forming ETFs. Therefore, the typical portfolio construction approach of buying ETFs will end up with a substantial overexposure to retail in order to get Amazon exposure.