Recently, some Apple (NASDAQ:AAPL) bulls have emerged touting a purchase of the stock in hopes the expected September announcement of new iPhone and iPad products will act as a positive catalyst. My first reaction to such an argument is of course to question the wisdom of making a short-term, speculative purchase of a security based heavily on "news" that the entire market is aware of. The fact that Apple is releasing new products is certainly positive news for the company, but Apple has consistently released new products every September like clockwork - the market should have long since priced in such an event. But to explore this argument further I did some analysis - have Apple product launches adhering to the standard September release schedule historically drove the stock higher than would have otherwise been expected (as measured by both the market return over the same period, and Apple's long-run average compounded growth rate)? Is Apple simply a stock which is so driven by sentiment that it allows for this pricing inefficiency to reliably occur? And secondly, is Apple cheap enough at current prices that speculators have little to lose? I examine this issue and present my thoughts on the attractiveness of Apple's current valuation.
Apple's Announcement Returns
First, I analyzed Apple's historical returns surrounding its product announcements. Of course, such an analysis is immediately subjective because returns will vary materially depending on which days surrounding the announcement we look at - maybe the proper strategy is to buy two weeks before the announcement and then sell three days after, for example. Dozens of "strategies" could be analyzed, but to keep things simple I focused on three periods: Apple's return over the one month prior to the product announcement, its return 1 day later, and its return 1 week later.
To ensure that the analysis was focused solely on Apple and not macro trends, I also analyzed the returns of the S&P 500 over these same periods, and then compared the return of Apple's stock to the broader market. For the last five iPhone launches, this is the summary of the data:
On first glance, investing in Apple around its product launches seems to be a great strategy - the stock has, on average, returned 4.23% in the 1 month prior to iPhone announcements, 0.86% between the day of the announcement and the next, and 1.12% in the week after the announcement. These returns are not mind-blowing, but one could have on average made a 5-6% return investing in Apple a month prior to its announcements and selling a week after new products were announced.
Comparing Apple's return to the S&P 500's return during the same period, however, reveals that Apple stock actually underperformed the market during the 1-day and 1-week periods. Apple stock did significantly (+5.73%) outperform the S&P in the month leading up to the announcements.
So does this mean that we should buy AAPL one month prior to its product launches? Not so fast. First of all, recall that the period we are analyzing (between May 9, 2008, a month before the 3G iPhone was announced, and September 19th 2012, one week after the iPhone 5 was announced) saw a tremendous increase in Apple's stock price - from $183.45 to $702.10. During this 51-month period, the compounded average gain in Apple's stock price was 2.67%, making the 4.23% average return during the months leading up to product launches not so unusual. Also, it's worth noting that of the five data points we have, only three show positive returns over the 1-month-prior period, and our average is heavily biased by the 11.4% return leading up to the 3GS announcement. Given our small sample size, there is no reason to believe the 1.56% (4.23% - 2.67%) of outperformance over Apple's average 51-month return is significant.
Based on the historical data, there is no reason to believe that purchasing Apple's stock during any period surrounding its iPhone announcements will give you a higher return than simply purchasing Apple stock during any other period. Apple's average outperformance over the one month prior to its announcements is too small to be meaningful and the stock has actually underperformed both the market and Apple's 2008-2012 average compounded returns in the one day and one week after products are announced.
Is Apple so Cheap at $490 that Speculation is Safe?
Speculating by purchasing stocks is usually never a good strategy and speculators risk serious loss of capital, but are Apple's fundamentals strong enough to make speculating relatively safe?
The answer is no, for two reasons - first, speculators are typically focused on entering and exiting a stock in a short time period, and stock prices are driven more by sentiment than fundamentals over such time windows. Second, Apple faces significant risks and really isn't that cheap.
The first reason should be easily understood - while most investors agree that stock prices are driven by fundamentals in the long-run, this clearly isn't the case in the short run. We don't have to look beyond Apple to find support for this - Apple's stock has fallen by as much as 45% since it peaked last September, and while there has been a dramatic shift in sentiment for the stock, the fundamentals have changed only marginally. Yes, 2013 profits are down and the company is finally facing some competition in the smartphone and tablet markets, but most of that competition had already arrived by September 2012, when the stock reached its peak. More recently, Apple's stock moved by about 5% based largely on a tweet announcing a $1B investment in the company.
Apple is perhaps the best recent example of a large company's stock price swinging wildly as a result of investor sentiment. Thus, even if the company is significantly undervalued at $490, speculators with short-time horizons can't take much comfort - the stock could easily swing down to the ~$400 range again, and I imagine in such a case most speculators who purchased shares with a quick, easy profit in mind will become fearful and sell at depressed prices long before the market recognizes Apple's fundamental value.
The second point isn't so obvious, because on the surface, Apple appears to be quite cheap even after a ~25% increase in price over the past two months. At $492/share, Apple's TTM P/E ratio is only 12.3 and the company held $147B in "cash" (Cash/Eq + ST Investments + LT Investments) and $130B "cash" net of debt. I've seen some people try to strip out cash and then calculate a "P/E" net of cash; this is not logical and results in a figure which is not comparable to the P/E ratios of other firms, but especially given the developments in Apple's willingness to return excess cash to shareholders, Apple's strong balance makes its 12.3 P/E figure even more attractive than it would otherwise be. In comparison to the S&P 500 TTM P/E of ~18, Apple appears to be a bargain. The company's earnings yield of 8.1% is well above the S&P 500 yield of 5.6% as well as the current YTM on Apple's 10-yr and 30-yr bonds (3.64% and 4.91%, respectively). A company's "margin of safety" can be interpreted as the difference between its earnings yield and the yield on lower-risk investments, such as the company's bonds - Apple's common stock offers a 4.5% premium over the company's 10-yr bond yield and a 3.2% premium over the 30-yr yield. In the context of the S&P's current valuation, this is a strong margin of safety.
However, calculating margin of safety based on past earnings is only interesting to the extent that a company's past earnings are a reliable estimate of future results. The reliability of past earnings varies tremendously among different companies, and as a result, several additional factors must be looked at, including: 1) the long-run consistency of the company's earnings, 2) the presence of a "moat" to protect the company's profit stream, and 3) the history and long-term outlook of the company's business. All three of these factors are important in interpreting margin of safety. Companies which have demonstrated consistent long-term earnings power, have a built-in economic "moat" over their competitors, and operate in "safe," low-volatility industries should require a lower margin of safety than companies without these features:
1) Earnings Consistency: Apple's earnings have increased tremendously in the past five years, increasing nearly 10x between 2008 and 2012 and roughly doubling in size each year during the period. Such growth has obviously been tremendous for those holding Apple shares throughout the period, but isn't necessarily a good sign for new investors. Tremendous growth in earnings doesn't imply that future growth will continue to be significant and risk-averse investors should prefer a history of stable earnings which helps to prove that the company's profitability is not a temporary phenomenon. In Apple's case, the company's outsized profits have come largely as a result of having the first successful entries in the modern smartphone/tablet markets, and it's not at all clear that these outsized returns will remain feasible in the face of increased competition.
2) Economic Moat: Perhaps the most important feature of a value investment is the presence of a moat - a long-term, built-in advantage the company has over its competitors which helps to enable it to maintain consistent outsized profits. This is a very subjective feature - there is no number which can tell us whether or not a company has a moat. A strong brand is the easiest example of a moat, and Coca-Cola (NYSE:KO) is a great showcase. I could hand you billions of dollars of capital to start a company and even Coke's "secret formula" and you would have no chance of competing against the original. Many will disagree with me on this, but I believe that Apple enjoys only a minor competitive advantage. Apple die-hards certainly exist, but as the company has exploded into the largest in the world, most of its customers are not die-hard fanboys - they are open-minded consumers looking for the coolest, trendiest technology products, and over the past five years, Apple has simply fit the bill as the company has been the first-mover in the smartphone/tablet wars. Some claim that Apple's iOS ecosystem (especially in terms of apps) acts a significant economic advantage, but how many apps are truly exclusive these days?
3) Industry Stability: Certain industries are inherently more stable than others - the consumer electronics industry has seen more change in the past five years than the beverage industry has seen in the past five decades. Change is exciting but it is definitely not positive for investors looking to make a decision based on a company's past earnings. Apple operates in an industry where constant, yearly innovation is required to maintain a competitive position and one or two missteps can result in disastrous long-term results. Every time I consider investing in Apple, I recall that RIMM enjoyed complete dominance in the smartphone market as recently as six years ago and is now essentially dead in the water. Nobody knows where the smartphone and tablet markets will be ten years from now or even five years from now, and that is very scary if you're putting your money into a company which relies almost entirely on its smartphones and tablets. Apple could easily fall from its position at the top of the world to a position of a niche player within a matter of several years - you can't say the same for a company such as Coca-Cola, McDonald's (NYSE:MCD), or even other tech companies such as Microsoft (NASDAQ:MSFT) or Intel (NASDAQ:INTC).
Thus, it's my belief that Apple lacks all three of these important features - it does not have a long-term record of strong, consistent earnings, it does not (in my opinion) possess a very compelling moat, and it operates in an incredibly unstable industry. As a result, it should be natural and expected that Apple trade at a significantly higher earnings yield than the broader market and feature a relatively wide margin of safety. Apple has a low P/E but it is not cheap.
I do not believe there is a compelling story for purchasing Apple, whether for the purpose of short-term speculation surrounding the company's upcoming product announcement or for the purpose of a long-term investment. Short-term speculation is of course always risky and there is no reason to believe based on historical data that the market reacts positively to Apple product announcements. Further, speculators cannot take comfort in Apple's relatively strong fundamentals, as Apple's stock has continued to be prone to wild swings based purely on sentiment. Finally, while Apple appears to offer a wide margin of safety even after a 25% increase in the share price, I believe that this wide margin accurately reflects the tremendous uncertainty surrounding Apple's business and does not present investors an opportunity to achieve an outsized, low-risk return.