Although Apple has lost about 40% of its market cap over the last 3 months, strict value investors (that put a great emphasis on downside protection) should think twice before investing in the company as the current valuation continues to offer little downside protection.
As they say: "Downside protection is the most important characteristic in any investment" and "Make sure the downside is protected and then the upside will take care of itself."
Investing in Apple (without any other sort of hedges) is simply not an investment where the downside is protected.
I generally do not write articles on large cap companies but I recently read Jae Jun's Seeking Alpha article regarding Apple (AAPL) which I felt compelled to write a rebuttal about. I am a frequent reader of Jun and enjoy much of his data-driven analysis, but I believe in his latest analysis of Apple, he has underestimated the downside risk of investing in the company.
Jun mentions in his article:
"Downside protection: The balance sheet protects the business from going bankrupt. If I can find a net-net with a dying business with AAPL's balance sheet metrics, I would be all over it. So why wouldn't I buy AAPL?"
Is bankruptcy risk really all that one is concerned about when making an investment and is Apple really a net-net?
The company's current book value of equity is $127 billion while its market cap is $418 billion and enterprise value is $392 billion. As we all know, book value is an accounting metric (which often overstates actual liquidation value) and does not say much about the company's actual value; it does, however, give some ballpark estimation of a base value for the company. The difference between market cap and enterprise value to book value can be a quick, rough estimation of what sort of premium the market is giving to the company. In this case, it is giving a premium of about $275 billion or 2-3x base value!
Another way to think about this is to look at how long it will take to earn that premium. Using the average EPS of 2011 and 2012, we get to about $35 a share. The book value per share is $135 while the share price is $450. That means as a rough estimate there is about $315 built in as a premium. At a run-rate of $35 a year that will take the company 9 years to earn that premium. If the EPS turns out to be in the $25 area going forward, it will take the company about 13 years to earn that premium.
Even if Apple continues to generate positive EPS and free cash flow into the future, this premium could come down significantly if these metrics decrease even marginally. In a net-net situation, the company is generally trading at a liquidation value meaning that the price doesn't have much room to go down before someone would acquire the whole thing and sell it off for pieces. Apple is not a net-net and investing in it exposes oneself to significant downside exposure and the potential for a permanent loss of capital.
Jun goes on to state that Apple is priced for doom and that "current valuations predict AAPL has zero growth remaining."
Zero growth, however, is not doom; not even close.
Investors analyzing Apple as an investment need to take into account the potential for significant negative growth in future periods. Apple operates in a consumer business with fickle customers and rapid technology changes. To think that Apple will continue to sprint ahead without stumbling at some point would in my opinion be extremely unlikely. I know I'm not the first to make the comparison of Apple to Blackberry and Nokia, but it is definitely worth repeating.
Blackberry specifically was a market darling at one point, with astronomical growth and leading technologies like Apple but were unable to keep up with innovation and consumers' tastes.
Jun builds his analysis off an average of 2011 and 2012 earnings of $33.55. He assumes that this is a base price and that earnings will continue to grow off of that. Apple is not a company that is based on recurring revenues from a subscription business though. It is based on continuing to sell new products to consumers. There may be some built-in stickiness of customers due to synergies between devices, but for the most part, consumers could easily decide to purchase a smartphone from Nokia, Samsung, Blackberry or HTC as opposed to Apple next time they replace their phone.
Jun also forgets to take into account a discount for "big numbers." Apple's sales last quarter was nearly $55 billion. Annualized that is $220 billion! That is a gigantic number which will be difficult to grow. To increase sales by $1 billion, the company has to sell approximately 2 million additional iPhones at $500 a pop.
Value investors that focus on downside risk should not be blinded by the fact that Apple is now offering a 40% discount from its all-time highs. The potential that Apple continues to decline another 50% is a very real risk which cannot be ignored. I personally prefer much more downside protection in my investments which is why I am staying away.
This is not to say that Apple won't go up. If Apple comes out with new innovative products and is able to retain its current customers then sure, the stock would most likely appreciate. The problem is that this is just speculating. A good value investment should have a smaller risk of a permanent loss of capital.