Should You Sell Google And Buy Apple?

| About: Apple Inc. (AAPL)

Apple (AAPL) has fallen five percent in the past month and investors are scratching their heads. Apple started 2012 with a strong run but has been one of the worst performing stocks recently. Optimism surrounding the company has vanished and the media is now extremely critical of Apple. Now more than ever it is important to monitor developments for Apple and its competitors. Below I will layout the reason why I continue to recommend Apple and, as a supplement, present complementary option strategies. For details on my methodology please consult the first article in the series as well as my Instablog.

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(Source: Yahoo! Finance)

If you have not heard the news, Google (NASDAQ:GOOG) is the new technology king and Apple is approaching obsolescence. That may not be entirely true but it certainly appears that way from reading the headlines. Google Glasses have been anointed as the next big thing and the stock has been on a straight line up from $650 in November to $830 today. As you can see from the chart above, since December the performance of the two companies has diverged and it appears as if investors have been buying Google at the expense of Apple. Google Glasses and self-driving cars are cool but not that cool, at least yet.

The big news this week was that Google surpassed Apple as top mutual fund holding according to Citigroup's list of top fifty mutual funds at the end of 2012. I know this is an oversimplification but stock price is a battle between supply and demand, as basic economics would dictate. When Apple was at $705, there were not enough buyers to propel the stock higher. In reality there were far more sellers than buyers and that ultimately led to the stock's tumble. As institutions buy Google, they are likely selling Apple as the two companies are both technology leaders. Apple investors should see Google's 86% institutional ownership as a good sign as it helps to explain the steep decline in Apple's price. Unfortunately it is going to take a major catalyst to break the pessimism surrounding Apple. Just as Apple was the "must own" stock for investment managers, Google has quickly taken the crown. But is that justified?

Google has a forward P/E of 15.6 versus 8.6 for Apple as the market is rather confident that Google will be able to grow tremendously in the future. Shockingly the gap between historic P/Es for the two firms is the largest it has been in almost eighty years. Do you think that the firm's future prospects have separated that drastically to justify the premium? Despite Google's side projects, it is still primarily a search company. Google might be one of the most vulnerable $400B companies you have ever seen, as it is highly reliant on strategic partnerships with the likes of Samsung (OTC:SSNLF) to keep its software and search relevant. In fairness to Google, the company has been very proactive in releasing its own hardware recently whether it be the Nexus phones and tablets or the Chromebook as it knows that it cannot be entirely reliant on third party partners [a fate that Microsoft (NASDAQ:MSFT) has learned all too well]. Google has strong growth prospects ahead but I believe the recent rally has gotten ahead of itself. I have been long Google uninterrupted for years but I am strongly considering reducing my position. Fortune reports that at least one analyst shares my opinion. Lawrence Isaac, chief market strategist at Oracle Investment Research, provided these key reasons why Google is primed for a sell-off:

  • From a P/E perspective, GOOG is the 10th most expensive in the S&P 100 at 24.6x
  • At 3.8x P/Book, it's the 31st most expensive
  • With a PEG ratio of 1.20, it's trading at a premium of its growth rate, whereas Apple's PEG ratio is just 0.55x (the 5th lowest in the entire S&P 500)
  • Over the past 5 years, GOOG has been compounding retained earnings at only 6.74%, whereas Apple has been nearly double that at 11.88%
  • GOOG's return on Assets has been declining at -6.47%/yr compounded rate, whereas Apple has been increasing by 11.7%/yr

I agree wholeheartedly with all points except two and five as assets for intellectually property heavy companies can be misleading. On one hand you have Google, which has made large acquisitions in its history (i.e. Motorola). Conversely, Apple has not made any large purchases and instead prefers to buy smaller upstarts. These two points aside, it is apparent that Google is trading at a significant premium to both its rivals and the larger S&P 500 peers.

The New iPad (the Retina iPad) launched a year ago this week and I am somewhat surprised that we have not seen more iPad rumors or even had a firm announcement date. It is true that Apple has refreshed the New iPad for a faster chipset, lightning port, and even expanded the memory offering to 128GB but the model is still essentially the same one year later. I still believe that Apple will be launching a fully refreshed iPad that is much more similar to the iPad Mini in form but we will have to wait and see. The iPad is still the unrivaled tablet king for its screen size but a refresh is always appreciated by consumers and thus investors. I believe Apple can experience at least a minor pop simply by announcing the iPad refresh.

Apple finished a relatively quiet news week and was essentially flat on the week. As I continue to stress, Apple will be under pressure for most of 2013 and I do not expect the stock to have a huge pop without a cash policy change or radically new product. For this reason, selling covered calls or cash secured puts is a potent strategy. For example, if you sold the AAPL March 8 $440s last week you would have pocketed $3.75 and kept your Apple stock. If Apple had climbed above $440, you would have been forced to sell or close the open option but you could easily repurchase Apple on any dips. I am encouraging investors to get defensive regarding their holdings and continually selling out-of-the-money options is a way to reduce your cost basis and mitigate losses.

Below I present three possible scenarios and the potential returns for the Apple options:

  • Apple Down 5%
  • Apple Unchanged
  • Apple Closing at 50-Day Simple Moving Average

These scenarios are forecasts and there is no guarantee that they will come to fruition. For more information on the fundamentals of covered calls, consult Investopedia. I utilize conservative covered calls to simultaneously generate income and reduce your effective cost basis.

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Additionally, if you would like even more information, I have prepared a sensitivity analysis for absolute return and percent returns, respectively. After studying the information above, these two charts make it easy to pick a strike price based on where you believe Apple will close at the end of the week. Estimate where you believe Apple will close and select the strike price with the highest return.

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With this information, executing a buy-write on AAPL March 16 $440s is the preferred risk-return strategy as an opening Apple transaction. The option has a potential return of $3.10 (time value) and should provide coverage against a slight drop. This strategy is excellent for long-term Apple investors who want to generate income while still staying long the stock. An alternative approach is to sell out-of-the-money $420 puts and collect the premium without having to purchase the stock outright. The $420s are currently trading around $2.10 and appear to offer the best risk-reward profile for the week. Note that if the stock declines to the strike price, you are obligated to buy the stock (or closeout the position). You should always consider the risks (particularly with naked calls or puts) raised in this article in light of your personal circumstances (including financial and taxation issues) in consultation with your professional financial adviser.

Disclosure: I am long AAPL, GOOG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Author is long AAPL June $500 Calls. Please refer to profile page for disclaimers.

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