Instead of boring everyone with more discussion about the fiscal cliff, I thought I would take an opportunity to provide some insight into how investment professionals actually find investment opportunities and the difference between investing and speculating. Apple provides us with that wonderful opportunity.
Apple is one of, if not the most, successful companies in the world. Over the last five years they have grown earnings at a rate of 62.2 percent per year, and that is during the “Great Recession.” Imagine what they could have done in a good economy. They have the hottest smart phone on the market, the number one tablet computer and on and on.
There is a cliché on Wall Street that says great companies make lousy stocks. The reason for that is because most great companies have all their greatness priced into their stock. Usually great companies sell at large premiums to the market in terms of their price-to-earnings ratio. For example in 2004 when it was clear that eBay would be a successful survivor of the tech bubble, they sold at a price that was in excess of 100 times their current earnings. eBay has done well as a company, much as expected, and their stock is currently selling at around $50 per share, a full $7 per share less than their 2004 peak. Great company, lousy stock.
Many people assume the same is true for Apple, but they simply are not looking at the reality. Apple is currently selling for 12 times its earnings. To put that in perspective, the S&P 500 sells at almost 17 times its earnings. In other words the price for an average company today is 17 times earnings, but one of the greatest companies on the planet sells for considerably less? How could that be?
Part of the answer is in investor psychology. While Apple’s stock is cheap by just about any measure, it looks expensive because Apple has not split their stock. Apple hit its peak of a little over $700 per share earlier this year and a lot of smaller investors get nervous about that large of a price tag, after all what stock is worth $700? This is a classic case of perception trumping reality. The share price is a mere accounting function, determined by how many shares the company wishes to have outstanding. Apple could have split the shares 10 for 1 and every shareholder who held one share at $700 would now hold ten at $70. The reality is the same – the same percentage ownership of the company, the same total value. However, had Apple split its stock and the price tag appeared to be $70 vs. $700 I would wager that the stock would have jumped significantly. After all a company like Apple should be trading at a large premium to the market, not its current discount.
As it was the stock peaked at $705 and has been in a downturn ever since. This started most likely because of simple profit-taking; Apple’s stock sold for as low as $380 per share just a year ago, so some investors were sitting on hefty gains. No doubt this activity was exaggerated by the threat of higher taxes on investment gains next year. Then the “technical analyst” started talking about how awful Apple’s chart looks and the fall continued. For those who are not familiar, technical analysis sounds very sophisticated but it is nothing but the tracking of prices to attempt to find patterns which indicate the future direction of prices. Academics hold technical analysis in approximately the same level of regard with which they hold witch doctory. It has a dubious record as there are no actual investors who credit long records of success to its practice, but it does one thing well: it turns investors into speculators, making otherwise rational people buy and sell stocks like riverboat gamblers. That is good for business, which is why almost all technical analysts work for Wall Street firms. There is no such thing as a buy-side technical analyst.
The technical witch doctors are assisted in scaring people by Apple’s stock price. The drop from a $700 price to a $500 price is much more compelling on CNBC than a stock that dropped from $70 to $50. Of course in reality those are the same thing and the stock that dropped from that level can get back there just as quickly, but the perception of investor fear is far greater with higher numbers.
In the meantime, as Apple’s stock price drops the company itself is doing fantastically. Just this past weekend they announced selling two million iPhone 5s in China on the day of its launch; the most optimistic analyst we saw thought they would sell four million in the first quarter and they did half that the first day. They still have lines around the world for their products and they have a brand loyalty that is second to none.
Speculating is guessing which way a stock’s price will go next week and I would guess that technical analysis is as good at doing that as any other similar method – the magic 8 ball, darts, dice, etc. Investing, on the other hand, is about buying things of value at a good price and waiting patiently for the value to be recognized. Benjamin Graham defined investing as follows, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.” That safety of principal was found in what he called the margin of safety, which is the difference between an investment’s actual value and the price. We calculate Apple’s actual value at more than $1,000 per share, assuming 18 percent growth over the next few years, down from the 62percent growth they have had over the last five years. Don’t just take our word for it; many sell-side analysts have price targets ranging from $800 to $900 per share. That is a huge margin of safety.
Of course we could be wrong; there is always risk in investing. Apple may suffer a complete collapse like other companies of the past, but if that possibility – however remote – did not exist, then the opportunity would not exist. The thing about margin of safety is that it is at its highest precisely when the perception is the opposite, otherwise the price would not be so low and the margin would not exist.
Owning Apple directly is not appropriate for everyone. We do own it in many clients’ portfolios and it is a large holding of several mutual funds, so most of our retirement clients have indirect ownership. That is not the point here. The point is to start to learn what an investment opportunity looks like when it happens. Apple is it.
Chuck Osborne, CFA
Managing Director
