In recent weeks, while investors appeared to be piling out of Apple (AAPL), I have seen many articles with suggestions on how Tim Cook should run his company. While I consider myself a savvy investor from the standpoint of uncovering value using models, trends, and comparisons, by no means am I a skilled enough technology expert to be able to instruct the CEO of Apple, its sophisticated employees, its financial experts, and its impressive board on how to run Apple simply because the share price refuses to go up in the near-term.
And that is exactly the point. Apple's share price will not always be connected to the success of its business. The markets are not always efficient.
How do we find Apple's fair price?
While the majority of traders on here most likely follow fundamental or technical analysis principles, my beliefs fall into a third camp and that is using fundamental analysis with a combination of quantified risk management tools. While I will not object to either of the first two principles, I will offer my reservations to just using them alone.
Too often I find that it is not the fundamental value that is driving an asset price, but it is the market participants driving the fundamental value. What do I mean? The usual cycle is all too familiar. The few sophisticated investors identify a specific asset with upside value. As the share price leaps, the cycle moves to the next level in which less sophisticated investors form bullish opinions about the asset causing them to form confirmation biases towards the particular asset. The offered multiple investors are willing to pay for the asset continues to soar to higher levels and analysts then confirm through their own interpretations why these multiples are correct and why they should meet or exceed industry comps. The risks presented by analysts, which would cause the multiples to decline, get little attention and the stock enters share price levels that make sophisticated investors wary, as they refuse to pay the higher multiples for these specific risks. These levels, unfortunately, are also the levels that make retail investors very comfortable for different reasons. Observing the historic growth, they now firmly believe that the particular asset will continue its climb. This is the part of the investment cycle when less sophisticated retail investors begin piling their hard-earned dollars into the stock as they believe that the asset is somehow bound to perpetually grow. It also happens to be the exact time sophisticated investors begin placing trailing stop orders on their investments in an attempt to take very attractive profits and begin the cycle of searching for more attractive values, elsewhere. What I described above is a common investment cycle that causes precarious valuations, crowded trades, and even bubbles -- ones that lead to extremely dangerous levels of risk. Apple, of course, is no stranger to this phenomenon. During the dot com bubble, its stock was valued at a price/earnings of 40x and within months that price/earnings eroded to the high single digits, shaving off much of the stock's market cap. Also note that much reliance is placed on the industry averages while the industry multiple averages themselves often exceed their true values.
While technical trading is not my forte, I have learned that there is certainly much truth to the art, as there is now a large enough community of such traders that all follow the same charts and trends. While it is possible that the next uptick or downtick could be predicted using these fancy charts, I personally don't prescribe to this practice as I can't imagine I will ever have the confidence of placing my hard-earned dollars at the mercy of a generally supportive community.
The question then is, how do I gauge a stock's price and what price am I willing to pay for the next Apple share? I will briefly summarize my take on Apple's offering (you can find much more comprehensive articles here on Seeking Alpha!) and then I will offer my own approach to trading assets.
Apple is unique!
The first thing I will say is that Apple is a truly unique company.
First, despite being the largest component of the S&P 500, a comparison of the daily closing prices of Apple, Google (GOOG), and MSFT (MSFT) to the Index, shows that Apple is the least correlated stock to the S&P 500 in that group.
Additionally, the Apple stock has a very unique offering that is rooted in its robust ecosystem more so than in its impressive hardware. Many investors continue to miss that point. That ecosystem is being favored by even an exec of Apple's hardware competitor, as the MIT Technology Review reported not long ago that Samsung's (OTC:SSNLF) Chief Strategy Officer Young Sohn favors the Apple products for personal use over the products produced by his own company!
New Products? Not so fast!
I personally feel like it is too early in the product life cycle for Apple to roll out a new product as they are still in the mid-to-late stages of the iPhone's growth cycle and somewhere between the introduction and growth stage of the iPad's curve. Additionally, new geographic segments actually rewind the product to earlier stages of these curves as they create robust additional segment growth. China's net sales alone were up 725% from 2010 to 2012! Apple's discipline of waiting in rolling out new products has not satisfied many shareholders, but I find such discipline impressive! Make no mistake about it, Apple has a lineup of products in its lab ready for rollout. However, now is not the time for these products to be rolled out. My position is that analysts want too much too fast. That will only set Apple up to fail in the longer-term. Let the shareholders wait.
That brings me to competition. Who are Apple's true competitors? Google? Samsung? Microsoft? I would argue that none are true Apple competitors. Samsung offers impressive hardware, as evidenced by the Galaxy S3 and the Note2, but the stock is already priced for long-term success. Any failure in future iterations, as is quite possible in such a competitive hardware environment, and users could easily switch to a different product. A lack of an ecosystem creates a very serious risk for Samsung as switching costs remain very low for its users.
Google and Microsoft are at the early stages of creating their own ecosystems that are not nearly rivals at this stage to Apple's. While Samsung's products are great receptacles for Google to grow its Android share among users, Google's stock is priced at the higher end of the investment cycle I described earlier. I believe that this is where Apple was in September and risks are not being fairly captured in Google's stock. Additionally, Google's dependence on Samsung has now too become a substantial and very real risk. Any attempt by Samsung to backward integrate and create its own ecosystem would backfire against Google as it would lose a substantial share of its Android users.
The True Value
How do I find true value? Aside from going through a rigorous exercise of making sure that Apple is fundamentally strong versus its industry comps (I would use the likes of Google and Microsoft here since there is a lack of true competitors), I also go through additional steps of making sure I properly account for substantial downside risks. While analysts disclose that their target prices could be impacted by specific risks, these risks are often times not quantified and are not truly reflected in the share price. I consider this an enormous mistake. Therefore, my approach is what I would call a fundamental approach with a true risk management technique.
At $700, Apple was trading at 16x P/E and was close to the industry's average. Not only did I feel like the actual industry was priced slightly unfairly towards the upside, but I also felt that discounts to Apple's multiple were warranted for the following reasons:
- Investment cycle: During the 4th quarter of 2012, the Company's investors were entering the later stages of the investment cycle, the one described earlier - and I felt that I could find better value elsewhere at that point. I placed a trailing stop at $700 and took attractive profits and $685. The exception to the investment cycles is in true value stocks, however, even aggressive growth that places the value stocks above its peers should be treated with caution.
- Cash management: Apple had too much cash and I did not believe that the company should have bought back own shares at the premium price. In fact, I did not know what Apple could do to make investors happy at that point unless they were targeting a specific company. Cash management at $700 warranted a discount.
- Political instability: there was a lot wrong here, but in general, I thought the industry was priced unattractively. I felt that Apple was especially facing trouble as investors were looking to take long-term capital gains at lower tax rates knowing that their rates would spike in 2013. This really troubled me and I felt that it warranted a discount.
- Competitive pressures: while I truly believe that Apple is absolutely a fantastic company for the longer-term, there is certainly shorter term risk of competitive pressure in missing hardware sale estimates. I always feel that discounts are warranted here.
While this is not a comprehensive list, making such lists and quantifying the discounts is the only way to invest. Many strategies could also be used if you believe that exposure to the stocks are justified given the risks by adding out-of-the-money options to your portfolio, but this in itself should be limited to sophisticated investors. Perhaps one day I will outline my own strategies in further articles.
In terms of Apple's share price today, I believe many of the above mentioned risks are not imminent.
- The company is again at the early stages of the investment cycle as we are again seeing retail investors fleeing and many sophisticated investors piling back in.
- There is much upside to Apple's cash management. At the current share price, this should NOT be discounted in my opinion. Having so much cash while your stock trades at a discount is truly fascinating. The best approach in which Apple could treat its cash, in my opinion, is for the company to heavily buy back own shares at a true discount to industry. This will create an extremely positive perception among investors regarding the value of Apple's stock and it also happens to be an excellent way to spend cash. I do not prefer iPrefs. In fact, I believe this would be longer-term strategic mistake.
- Political instability, while still exists, should not be as large of a risk as it was at the end of 2012, especially since the capital gains tax issue is now ironed out.
- The competitive pressure continues to exist and should be discounted, I believe. My opinion is that Apple's shares should be priced somewhere between today's multiple and the industry comp, between 13.5x to 14.5x trailing, which would be at $600-$650. It is currently valued at less than 10x or 6.5x market cap-ex cash, so a nice upside value still exists.
I would like to repeat that these are only some of the risks traders should observe. I believe that every investor should go through an exercise of listing similar risks when trying to gauge a company's value.
What also makes me comfortable is reviewing a company's historic share value and observing periods in which the asset's shares lost as much relative value as they did during the last six months. In Apple's case, only 3 times since 1990 has Apple lost more than 34.8% during a 6 month period, the same amount it lost during the last 6 months (if observing monthly closing prices). One instance occurred when John Sculley succeeded Michael Spindler as CEO in 1993. The second time was when the dot com bubble burst. The third time was during 2002 when Apple unexpectedly raised prices on its iMacs. Analysts did not appreciate that and the stock slid to $7.14 a share. These of course all predated Apple's "ecosystem" and of course, even at today's 40% drop from $700, Apple is up 5922% since 2002, so all worked out okay. Historic growth, however, is not a guarantee of future growth, which is why I call this a nice "comfort" tool.
Last night, I learned that vast amounts of money was lost by average citizens piling money into Apple stocks following the advice of an unqualified author who seemed to believe that Apple was a money printing machine. We have learned too many times in history that this is the wrong approach to investing. While the investment cycle I mentioned above could experience longer-term trends, why not account for risks, take profits when risks are high, and look for better valued stocks elsewhere? People should be protective of their money and manage their risk appropriately. Perpetual growth does not exist and no analyst is a prophet. Invest with prudence and always consider the risks!