Not many people like to admit their mistakes in life. This is especially true when it comes to admitting to a bad stock pick. Part of this is due to something called confirmation bias, where we will seek out positive information that confirms our own personal beliefs but ignore information that may contradict it. This also leads us to keep losing stocks far too long (loss aversion bias), because we tend to fight against new information that goes against our current views. In reality, you can probably learn the most from reflecting back on trades that have gone wrong (when things go right, you become complacent and do less self-reflection). This is the story of my own self reflection of my bullish bet on Apple (AAPL) that went wrong, and the lessons I learned throughout the process.
Low P/E Multiples an Early Warning Sign
Sometimes low P/E multiples can indicate something is cheap, that there's potential value there. Other times, it can be an early indication that something is potentially wrong. Markets are forward looking, and when stocks start trading down resulting in what looks like a low P/E multiple, it can be because some investors are selling and already anticipating that earnings will decline going forward. For example, if a stock trades at $10.00 now and earnings are $1.00 implying a 10x P/E multiple, but earnings actually decline to $0.50 next year, then the P/E multiple is all of a sudden 20x P/E (not so cheap anymore). This is very true for cyclical industries that go through peaks and troughs, where P/E multiples will trade low prior to an anticipated trough period. For example, if you look at the graph below on Seagate (STX), you will see that P/E multiples are very low when earnings are at its peak (current high earnings is not sustainable), because investors are already anticipating the coming decline or trough in earnings.
I wrote about the cyclical industry concern as it relates to low P/E multiples in another article here, and I probably should have factored that in a bit more when it came to Apple's stock, except I continued to view the Apple growth story as a secular, long-term theme.
Wall Street Projections Slow to Re-Adjust
Wall Street analysts are sometimes wrong on their projections, or are late to revise down their projections. When forward projections are slow to reset or re-adjust, it will create the illusion that current forward P/E multiples look cheap (because forward earnings are still too high). In Apple's case, you can see below that back in October 2012, Apple's 2013E EPS was $53.42, implying a 9.4x forward P/E (assuming a $500 stock price). However, as EPS projections began getting revised downward over the next few months, the P/E multiple no longer looks as cheap. Post Apple's earnings call, if we assume EPS gets revised again (let's say theoretically for now down to $44.00 EPS), then forward P/E is now 11.4x (assuming the same $500 stock price), compared to the much cheaper looking 9.4x in October.
Some people may argue that slow revisions by analysts are somehow related to some elaborate Wall Street pump and dump scheme. While there may have been a few cases like that before for smaller, illiquid stocks with little to no research coverage, I really do not think this applies to Apple's case. Apple is widely covered by 40 to 50 analysts (as well as media outlets) including top research analysts with their own personal reputation at stake (as well as internal Chinese firewalls within the firm) to promote their independent coverage.
What I do think helps explain why analysts are sometimes slow to revise down estimates, is that sell-side Wall Street analysts sometimes fall victim to group-think, where conforming their own projections to be in-line with average expectations, is oftentimes the safest route to take. Analysts do not benefit or get additional rewards (like buy-side mutual funds and hedge funds do) if they take the risk of going against the norm (they may get reputational benefits, but probably not enough to offset the risk of possibly losing their clients or their jobs if they're wrong). Also, they will not get penalized or criticized too much (little downside risk), when the entire industry is wrong and the entire industry over-projected earnings. Wall Street analysts are rational human beings just like anybody else; they will weigh their risk/reward ratio and will most likely take the path of least risk (if the reward does not justify the additional risk). In this case, the path of least risk is to remain with the herd or within the consensus range, and as Animal Planet taught us, herds tend to move slower than an individual (this is not to suggest analysts are herds, I use to work in investment banking on the advisory side, so I guess I too would be part of that herd).
Size Can be your Enemy, a Difficult Comp
iPhone comprises 55% of Apple's total sales and 67% of Apple's gross profits. Yes tablet still has growth potential, but the iPhone is still their bread and butter revenue and profit driver. Apple sold 125 million iPhone units in 2012, which represents a 73% increase over 2011 units sold of 72.3 million. To continue to show strong year-over-year unit sales growth off of the previous year's high base of 125 million, is very difficult (but not impossible) to do.
To continue to grow is difficult given that Apple currently has +50% of the U.S. smartphone market. I don't think Apple will begin to lose significant market share all of a sudden, but it is extremely difficult to continue to gain market share.
It is not impossible to continue to grow however, but Apple will need to find that growth in international markets. On a global basis, Apple has just 18% of the global smartphone market by units. Future significant growth for the iPhone has to primarily come from overseas, with China arguably their most important market to focus on going forward (Apple began separating out China revenues starting this quarter).
High Margins Create High Challenges
This seems counter-intuitive given high margins are usually a good thing. This has to deal more with the challenge of maintaining high margins and continuing to grow such large profits. In 2012, Apple had gross profit margins of 44% and net profit margins of 27%. Those are phenomenal margins that any company would be envy of, especially for a primarily hardware company like Apple (Software companies like Microsoft (MSFT) and Google (GOOG) historically have +70% gross profit margins and 30-40% net profit margins, but as they both move more into hardware, those margins will come down). The challenge of such impressive margins, is how do you continue to maintain them going forward (or can you grow sales enough to offset the declining margins so that net income still increases). Let's go back to the previous example of say a stock is trading at $100, and their annual sales is $40 and net income is $10, which implies a 25% net income margin. Again, this stock currently is valued at 10x P/E. If net income margins contract from 25% to 20%, then the P/E multiple goes from just 10x to 12.5x, again not that cheap anymore.
Remember though, companies typically receive some sort of incremental sales benefit related to the cost of compressing their margins with lower priced products (i.e.: Apple offered iPad mini, which has lower margins than most iPad 3 versions, to continue to grow tablet sales and defend their tablet market share). If incremental sales are high enough to offset declining margins, then the absolute net profit can still increase. For example, in our theoretical $100 stock, if sales grow 30%, but net income margin falls from 25% to 20% (a decline of 20%), then net absolute income can still grow from $10.00 to $10.40. This is not easy to do though, but this is what Apple will need to do if they are to continue growing their absolute net income profits.
Factoring in Greed and Fear
Emotionally, we all occasionally fall victim to greed and fear, and at the end of the day, stock prices are determined by basic supply and demand. Besides all of the quantitative and fundamental valuation analyses you can perform, you need to also consider the qualitative factors of greed and fear (which also drives boom and bust cycles in the stock markets) that can affect stock prices. What I have learned is that I need to apply a 15 to 20% greed (premium) or fear (discount) to stocks in certain situations. There's no real empirical data supporting this range, it's just my own personal gut feel (you can apply your own premium or discount). There are reasons investors sometime look at technical charts and momentum, because human psychology and our emotional side can affect our trading behavior. Unfortunately right now, Apple has a fear discount applied to it right now, and it may take awhile for it to go away.
Putting it All Together, What to do Now?
So where does all of this leave me? Well I still own Apple' stock. On average, I'm down around 20%, based on yesterday's close of $450.50) and my weighted average price of around $558 (bought in twice, once around $600s, once around $500s). In the past few days, I've completely revised my own personal model and projections, based on all of the above concerns mentioned. I now get to my own revised 2013E EPS of $42.76 (compared to current analysts' estimates of $47.97, which will come down as revised estimates get factored in). I apply a 10x P/E, because until Apple gets their mojo back, I can't give them anything higher (I'm not that negative on them to give them anything lower). I arrive at a new target price of $547 (versus my previous expectations of $650+). Unfortunately, the fear discount is real, so applying the mid-point of the 15-20% discount gets you to $452. If the fear gets even more amplified, maybe it gets closer to $420s.
If interested, here are the quarterly units sold and ASP I'm using to derive my full-year projections. By the way, thanks to Bill Maurer, who helped point out some inaccuracies in some of the historical ASP data in my past article. I have since updated my model for the correct numbers.
In summary, unless Apple announces some kind of game changer (i.e.: new product category like iTV, new larger screen iPhone or iPhone mini, or new major international carrier contract like a China Mobile (CHL)), the best I can hope for now on my Apple trade is to sell around $548, or slightly below my average price of $558 (or maybe I sell/settle for a 10% loss around $500s, I just don't know yet). And in the meantime, I have to stomach the short-term pain of having a 20% unrealized loss stock in my portfolio. By the way, this is also an example of the benefits of diversification. Apple is about 15% of my stock portfolio (a bit higher than the 10% I usually target for a stock). The 20% decline in Apple amounts to just a 3% decline in my overall portfolio, which is much more manageable and allows me to not sell immediately out of panic or fear).
Finally, note that by me still holding on to Apple, perhaps I'm falling into my own loss aversion bias of holding on to a losing bet. Only time will tell. Good luck everyone.
Disclosure: I am long AAPL.