Capturing Amazon With ETFs

NEW YORK (TheStreet) --This week Barron's looked at the valuation of Amazon (AMZN) and expectations for increased earnings in upcoming years in an effort to explore the risk of owning the stock versus the potential reward.

Amazon has always been very expensive on a price-to-earnings ratio with Barron's noting the current PE is 300. Based on estimates going out several years, the stock is trading at 30 times current predictions for 2016.

Many analysts believe Amazon is not a technology stock, and apparently the larger exchange-traded-fund providers agree. The Technology Select Sector SPDR ( XLK), iShares US Technology ETF ( IYW) and the Vanguard Information Technology ETF ( VGT) all exclude Amazon.

ETF investors looking to include Amazon could instead consider the First Trust DJ Internet Index Fund ( FDN) or the PowerShares NASDAQ Internet Portfolio ( PNQI) which have 7.7% and 8% respectively in the stock.

Not surprisingly, the funds have similar weightings in many of the same companies. Facebook ( FB) has a 6.7% weight in FDN and a 8.7% weight in PNQI. Google ( GOOG) has a 9.6% weight in FDN and 7.3% in PNQI.

Other stocks with large weightings in both funds include Priceline ( PCLN), eBay ( EBAY)and Yahoo ( YHOO).

Despite its name, the PowerShares NASDAQ Internet Portfolio can own stocks traded on the New York Stock Exchange, which means it will be possible for it to own Twitter if the microblogging site follows through with its intention to list on the NYSE.

Funds like XLK, IYW and VGT are core type funds for investors who build their portfolios at the sector level; any one of the three would serve well for broad technology exposure, but they have meaningfully lagged behind the Internet ETFs. Year to date, FDN is up 39% and PNQI is up 51%, compared with gains of 11%, 12% and 17% respectively for XLK, IYW and VGT.

The broad tech funds have exposure to Internet stocks, especially Google, Facebook and Yahoo, but they have larger positions in slower moving mega-cap stocks. Apple ( AAPL) is of course the largest holding in all three with a mid-teens weighting; it is down 9% so far this year.

At some point the Internet ETFs will lag behind the others, but a catalyst for the outperformance to continue in the near term is Twitter. The continued buildup of excitement combined with market-friendly pricing of the initial public offering would likely let the party roll on.

As for whether it makes sense to buy Amazon, Yahoo Finance reports that 11 analysts rate it a strong buy, 21 buys, 11 holds and no sell ratings, but according to Barron's reporting, it is trading at 111 time 2014's earnings. If 30 times 2016's earnings sounds reasonable, then what is the expectation for price appreciation between now and then?

In the last three years, the stock is up 107%. If an investor hopes for half of that in the following three years, then he is hoping it grows into a 45 PE ratio three years from now, which is very high by any traditional measure.

The reason for Amazon's low earnings has to do with the company's philosophy about investing in its future, and so the PE ratio has almost always been either sky high or negative. This is not new and hasn't prevented the stock from going up 376% in the last five years.

Market history tells us that sky-high valuations can't persist forever, but Amazon has been public for 16 years and is a service that many Americans can't live without. Instead of trying to guess when or if the stock will come spiraling down to earth, investors interested in owning Amazon should define an exit strategy before buying and then maintain the discipline to stick to it should it start to drop.

At the time of publication, the author held no positions in any of the ETFs or stocks mentioned, but many clients of Nussbaum's firm own IYW.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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