The traditional bull and bear arguments on Apple (AAPL) have become extremely familiar and perhaps tiresome to investors. Thus, I will not rehash them here. Instead, I will present two ideas that I have not yet seen discussed:
- Samsung phones did not have any effect on Apple's Q1 revenue or profit;
- Investor diversification guidelines pose the most serious long term limitation to Apple's market cap.
Hopefully, when combined with reader responses that correct any of my mistakes, this article will add new insights into everyone's understanding of Apple. Disclosure: I am very heavily invested in AAPL for the long term and do not expect to make any trades in AAPL for the next several weeks.
Let's start with Samsung phones not having had any effect on Apple's Q1 revenue or profit. How can this be? Haven't I heard how great the new Samsung phones are and what a large percentage of the market Samsung phones represent? Yes, though I am an exclusive iPhone user myself, I have heard of the greatness of Samsung phones, and I don't doubt that they are every bit as good as their fans say. However, it is highly unlikely that they impacted Apple financially in Q1. For Apple's latest quarter management claims to have been supply constrained on the iPhone 4S for the entire quarter and supply constrained on the iPhone 5 for most of the quarter. Another way of saying this is that Apple sold virtually every phone they could make; even if there were no Samsung phones available during the quarter Apple could not have sold more iPhones. Furthermore, Apple's pricing for iPhones has remained remarkably stable over the past few years, in other words they have not had to drop pricing significantly due to competition from other vendors. If their volumes and prices have not been affected then they have not suffered financially, at least not in Q1.
The astute reader will quickly punch holes in the above argument. It is faint praise indeed to say that your major competitor couldn't hurt you because your own manufacturing system was an even bigger obstacle. And the argument above also says nothing about future sales when manufacturing constraints will presumably be reduced or eliminated. At that time (perhaps we are there already) it certainly seems logical that growth and pricing could suffer due to the presence of legitimate competition. The reader might also argue that Samsung, as a major supplier, may have been the reason behind Apple's supply constraints. It could also be noted that while there was no effect on iPhone revenue, Apple's tablet revenue probably was impacted by Samsung and Android based tablets. This is because Apple was forced into making smaller lower margin tablets and perhaps selling fewer full size tablets than they would have otherwise. My major takeaway from this is that investor concerns about larger iPhone screen sizes and competition from Samsung and other Android phones is a little overdone and possibly distracting. Apple needs to worry first and foremost about scaling their manufacturing and they need to dump Samsung as a supplier as soon as possible. This is especially important if Apple plans to come out with new less expensive phones to address even larger developing markets like China Mobile (CHL).
Now let's turn our attention to perhaps the most important long term limit on how large Apple's market cap can get. Before you stop reading let me say that this has nothing to do with the often but mistakenly cited 'law of large numbers', which near as I can tell has nothing to do with stock prices. Nor does it have to do with limits to market share or margins. No, this is about investor self-imposed diversification and risk mitigation rules that place limits on how much stock of a given company you or I or any other investor should own.
Before I complicate this analysis with secondary details it might be illuminating to look at an overly simplified example. Start with just one assumption: that every investor has a strict inviolable diversification rule to not allow any one company to represent more than 5% of their equity portfolio. This puts an absolute mathematical limit on the market cap of any company; no single company can be more than 5% of the combined market cap of all equities. And that could only happen if every investor buys up to their maximum 5% limit. Normally, this would be a crazy high ceiling not even worth thinking about. But in the case of Apple's $430B market cap it already represents about 3.2% of the S&P 500 or about 2.4% of all US equities combined. Moreover, if Apple reaches $700 again it would represent slightly more than 5% of the S&P 500 market cap, assuming the rest of the market stayed about the same.
Since we know that many investors purchase little or no Apple shares at all, for example, Warren Buffett or the funds indexed to the Dow Jones Industrials, the remaining investors must increase their concentration of AAPL well above the percentage represented by Apple's market cap. Given the diversification requirements of most investors it may be difficult for Apple's market cap to grow at a rate much faster than the overall market.
There are at least two objections to the analysis above:
- Apple has a global brand and attracts foreign investors, so its market cap should really be compared to the total capitalization of global equities not just US equities. The total global equity market is roughly three times larger than the US market alone, so Apple represents only 1% of the market cap of global equities. I think this is a fair objection though I expect that foreign investors are dramatically underrepresented as Apple shareholders -- certainly far less than the two-thirds that might be hoped for from the ratios above.
- On a global basis equities are only about half the size of the bond market. Shouldn't this be taken into account since investors diversify portfolios with bonds as well? Here I believe that the normal diversification of portfolios between bonds and equities is a bit of a red herring, since whatever amount investors do allocate to equities they will still further diversify among various companies. And, it is unlikely that the equity portion of their portfolio will have much more than 5% (on average) devoted to a single company. If we get a net flow of funds from bonds to equities it should lift the entire equity market and this would allow Apple to grow but presumably at the rate of the overall market.
How have investors actually behaved with respect to the concentration of Apple in their portfolios? The table below shows the twenty largest shareholders that together represent about 28% of all Apple shares. While some shareholders such as Susquehanna Financial Group and Invesco Powershares Capital Management have an incredible 15% of their total assets concentrated into Apple stock, the overall unweighted average is much lower at about 4.68%. Given the volatility of Apple I doubt that most large investors will allow Apple to be much more than 5% of their total holdings going forward. Other large Apple investors tend to hold far lower percentages of their overall assets in Apple. For example, CalPERS holds 2.7 million Apple shares but that represents only about 0.5% of its overall assets. Much smaller institutions such as Gladius Capital Management may hold as much as 90% of their portfolio in AAPL shares. However, since they hold only a few tens of thousands of shares each, my assumption is these small overly concentrated funds represent a small fraction of AAPL's total shares.
Largest Institutional Shareholders
% of Total Shares Held
% Total Assets
Date of Report
Vanguard Group, Inc.
Fidelity Management and Research Company
State Street Corp
T. Rowe Price Associates, Inc.
Susquehanna Financial Group
Northern Trust Investments, N.A.
Invesco Powershares Capital Mgmt LLC
Wellington Management Company, LLP
Geode Capital Management, LLC
BlackRock Fund Advisors
J.P. Morgan Investment Management Inc.
Janus Capital Management LLC
TIAA-CREF Investment Management LLC
Jennison Associates LLC
Bank of New York Mellon Corp
Mellon Capital Management Corporation
Government Pension Fund of Norway - Global
American Century Inv Mgt, Inc.
4.68% (Unweighted average)
A company with a market cap as large as Apple's cannot afford to leave out any large group of investors. If it does so, diversification limits will make it very difficult to grow faster than the market as a whole. This is likely not a problem at the current market cap but certainly if the market cap reaches its previous high, growth at faster than the overall market will become increasingly difficult. I believe the following steps should be taken by the company as soon as possible:
- Increase the dividend to capture as many value and dividend investors as possible. I believe the dividend should be raised to about 4% from its current 2.3%. This may also attract part of the very large pool of funds sitting in the bond market, allowing Apple to benefit disproportionately from any net flow of funds from bonds to equities.
- Initiate a 10 for 1 stock split so that the stock can become part of the Dow and thus a required purchase by Dow based index funds. This will also attract individual investors who through ignorance associate the numerically high share price with over priced. It will also make it easier for small investors to buy round lots and trade options.
- Attract more foreign investors. I am not sure how to do this but it holds the greatest opportunity for bypassing the diversification imposed limits on market cap by nearly tripling the pool of investors.
In summary, Apple faces unique problems because its market cap represents an appreciable percentage of the total equities market. It must take steps to ensure the broadest possible investor base in order to improve its chances of outgrowing the market in the long run. In the short run, investors (and hopefully management) need to be far more concerned about scaling manufacturing and eliminating Samsung from the supply chain than about screen size.