A big difference exists between being wrong… and understanding why you’re wrong.
Consider the case of “Larry Smith”… That’s a fake name for a real person with whom I’ve crossed swords over the years on a well-known, investment-focused website.
It all started back in December 2011… Larry stated his case for short-selling Amazon (AMZN) in an article on that website. In other words, he wanted to bet against the stock.
Shares traded for around $197 at the time. And as we now know, Amazon has gone almost straight up over the past 10 years and counting… It’s at roughly $3,300 per share today.
With the stock at about $363 per share in October 2013, Larry finally conceded… He wrote, “I was wrong.”
Hold the applause, though… He didn’t mean it.
You see, Larry never understood why he was wrong… That’s because his process had a fatal flaw.
But it wasn’t an obvious one. It’s something that we must look hard to find…
Larry got off to a reasonable start with his case against Amazon…
He complained about the company’s high price-to-earnings (P/E) ratio, which had soared to 161. (For perspective, that was 10 times higher than the benchmark S&P 500 Index’s P/E ratio of around 16 back then.)
But as he correctly noted, that’s not enough to justify a short sale… He even acknowledged that excellent growth could excuse Amazon’s high P/E ratio.
From there, Larry moved on to Amazon’s growth expectations… He badly underestimated how much the company’s results would improve – particularly its margins.
However, I can’t condemn Larry for being wrong on that point. We’ve all misjudged the future at least once in our investing careers… No one gets every trade completely right.
That leads us to the fatal flaw…
Larry’s bet against Amazon went wrong because he had too much faith in himself.
Now, I’m not talking about self-confidence… That’s an admirable trait for investors. I’m referring to extreme self-confidence – otherwise known as “hubris.”
While acknowledging his misstep in October 2013, Larry oozed hubris. He wrote, “I simply knew too much, where ignorance would have been bliss.”
It got worse…
“Perhaps this is simply what [former Fed Chair Ben] Bernanke wants from the markets… To drive compliance into people’s skulls, or have them lose heavily no matter what happens. Thou Shalt Not Sell Short, no matter what.”
To this day, more than eight years later, I still don’t understand how Bernanke and monetary policy made Larry miss the Amazon story…
In the early 2010s, Amazon was pouring a ton of money into its technological infrastructure.
Company executives reasoned that sales growth would eventually more than justify the spending… They expected margins to expand dramatically over the long run. And in turn, the company’s meager results at the time would ultimately transition into big profits.
Most of the sophisticated investors who studied the situation – the so-called “smart money” – believed Amazon’s story was credible… They accepted that it would take time to unfold.
In late 2013, when Larry finally gave up on his bet, Amazon’s numbers were still weak. But by then, visibility into the future had improved.
And remember, great investors look ahead… The stock didn’t rise roughly 85% from December 2011 to October 2013 because Bernanke wanted to punish short-sellers. It was simply adjusting to more favorable expectations.
As we now know, Amazon investors who understood and accepted the story were right…
The company’s operating margin rose from 1.79% in 2011 to its recent 6.18% over the trailing 12 months. Its sales per share jumped from $106.13 to $909.11. Its earnings per share soared from $1.37 to $51.10. And over the past decade, the stock is up more than 1,500%.
Larry’s bet against Amazon went wrong because he didn’t respect the difficulty of his task – predicting the company’s future fundamentals. He suffered from hubris… He should’ve opened his mind and realized others might’ve been seeing things he didn’t.
Now, I’m not sharing this story today to make Larry look bad. We can all learn an important lesson here…
Many investors do what Larry did. And they suffer similar consequences.
My purpose now is to help you look forward…
We can proceed in a much better way. In tomorrow’s essay, we’ll dive into how you can use our proprietary “Power Gauge” system to help you avoid the same mistake as Larry.