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How I'm Playing Q3 Earnings

Summary

Current price represents an opportunity for long-term Apple (AAPL)w2 investors.

Background

I have profited financially and intellectually from this site and hope that others may benefit from my experience (or at least learn from my mistakes). I am long AAPL, GOOG, and AMZN as part of a portfolio of mobile and cloud-based hardware and software companies.

The following is my current approach to managing an overall long position in AAPL while taking advantage of near term opportunities.

Investing in Apple: Signal to Noise

To a novice investor, AAPL seems like it should be the easiest trade in the world (at least it did to me a few years ago): The company has consistent growth, recognizable products, and high liquidity. Of course, nothing is ever as easy as it looks. With AAPL's growth, it seems every technology blogger has become a sage of the market and every financial pundit has suddenly become a software or hardware engineer.

AAPL's current volatility is almost exclusively the result of expectations for sales of the iPhone5 (and to a lesser extent the iPad). However, virtually all of the essential details of the iPhone were known before the late September launch (the "custom" processor being a notable exception). iOS 6 was released to developers over six months before the launch and since that time, speculative tweets, pics, and blog posts coalesced into an ultimately correct conclusion (likewise with the iPad Mini). Updates to the iPod Touch and Nano were not as widely tracked but generally anticipated. There are few analysts with truly deep sources inside Cupertino and/or specific insight into Chinese, Taiwanese, and Korean supply chains. As a result of its success, more is known about AAPL than almost any other company.

The upside is that the playing field is about level as you can hope for as an independent investor. The downside is the volume of constant speculation--a classic signal to noise problem. I have followed AAPL for many years and daily since 2008. Over the last few years, a few analysts have noted patterns of volatility surrounding AAPL product announcements and earnings reports. This time is no different, although once again many investors and pundits seem taken by surprise.

To continue the signal to noise analogy: Although the amount of noise increases as AAPL grows, much of it effectively cancels out. Despite the fervent amount of blogging and hand waving, there is a remarkable amount of consensus in the views that contribute to market sentiment.

Currently, expectations are focused on number of devices sold. The fact that the device is consistently sold out in numerous locations indicates that fears regarding the new design or maps are unjustified. Instead, the iPhone 5 appears to be supply constrained with labor and quality issues at Foxconn as the most likely cause. This is preferable to constraints caused by a specific design or component defect as labor and quality are more easily remedied. While it could be argued that designing a device that is difficult to manufacture is itself a defect, the problem appears to have been quickly addressed thereby reducing any long-term concerns. The design of the iPhone4 antennae was arguably a more significant "defect" but did little, if anything, to dampen demand.

Nonetheless, the fact remains that AAPL could have sold more iPhone5s than it did. Initial estimates ran as high as 10 million, while recent estimates suggest 5-6 million. Verizon's Q3 call suggests that it sold around 650k iPhone5s, somewhat less than some analysts forecast. Other potential sources of weakness include margins for the iPhone 4 & 4s that are now being sold at a reduced price. I was unable to find definitive information regarding the price that AAPL is selling these devices to vendors. AAPL's international growth has been a positive source of earnings in the past and Asia could be a bright spot once again. However, slower growth in Europe reduced earnings last quarter and a change in that region is unlikely.

Counting the Votes

The adage "Buy the rumor, sell the news" is appropriate to describe AAPL's cyclical volatility, but its not always clear which rumors to buy and which news to sell. Graham famously described the market as a "voting machine in the short-term but a weighing machine in the long term" and this provides an effective framework for a solution to this problem.

A strategy built on this framework that has worked consistently well since 2008 is the view that much of AAPL's volatility around earnings is the result of essentially long-term players locking in gains in the face of an unknown short term outcome. Therefore, a certain amount of selling can be expected approaching product launches and earnings. In fact, it would be much more unusual (and therefore a stronger signal) if selling did NOT increase.

Recent selling resulted in a closing price of $613 on October 23rd, 2012, down from the September high of $705. While a drop of $92 per share does not feel trivial, the overall drop is less than 15%. Keep in mind that the 52-week low is still an astonishing $363. The gradual decline in price over the last month does not indicate a rush for the exits. Rather, the drop appears consistent with reduced estimates resulting from generally agreed upon views (aka consensus). As the price drops, market participants eventually identify a price as being lower than their long-term expectations and enter the market. This can be enough to slow the downward trend but not enough to reverse it. A detailed analysis of bid/ask and volume data from October 17-19 appears to support this theory, with selling in (relatively) small amounts yielding to the downward trend but with occasional large bids temporarily slowing the trend.

To summarize, recent negative "votes" do indicate a view that AAPL's earnings will not be as strong as they might have been. However, this decrease in price and increased volatility is expected, and not sufficient to indicate a significant deviation in the overall outlook. In other words, it is notable that the market views earnings as potentially weak, but it is more important that there seems to be relatively strong agreement in this view.

What Next?

What will happen after earnings are announced? Fundamentally, the market appears to be setting itself up for reduced expectations against an optimistic horizon. Expect a drop below $600 if earnings come in at less than street consensus. A significantly larger drop to $560 or lower is possible if AAPL fails to meet its own, notoriously low guidance or overall numbers indicate a weakening of demand. In some scenarios, a buying opportunity will be present. A large, immediate drop after earnings are announced is actually the preferred outcome, as it would provide both a superior opportunity as well as reduce the amount of debate (effectively clearing market sentiment). The downside is that if a significant drop is experienced and there is not a strong (and fairly immediate) response, the stock could languish in the $500s for another quarter. Of course, AAPL could exceed all expectations and the stock could rise immediately. This is possible but not probable for the present quarter.

Scenarios where immediate buying opportunities may NOT be present is if there is acknowledgement of an ongoing supply chain issue for the iPhone 5 or if iPad demand slows unexpectedly. Supply chain issues would be taken as evidence of diminished operational capability in Jobs' absence and unexpected demand issues would call previous guidance into question. Either event would likely require several weeks of trading and/or action AAPL until the situation is fully priced in.

Thank You For The Strategy, Now Please Give Tactics

With tongue firmly in check, let me say that this is where most articles seem to conclude by saying "Therefore, it is clear that you should execute a trading strategy consistent with your risk tolerance while also putting appropriate hedges in place." Instead, here's my specific buy/sell plan for the next 2 weeks. This is a current iteration of the patterns that have served me well since 2008.

Assuming earnings are within the range of what is already expected, I will be buying daily on sustained drops greater than 1.5%. My definition of "sustained" can be inelegantly defined as the amount of time it takes me to receive the alert, check news and Twitter feeds, do a bit of math, and watch the ticks for a bit. Purchase targets are roughly equal to the proportion of the drop relative to the overall value of my holdings. For a hypothetical $100,000 portfolio, this strategy yields a target of buying $1500 in shares. Rounding is obviously a factor-it used to be 2 shares-in a few days it could be 3!

If we get back within 10% of 52-week highs, I will reduce accumulation and if we get back to within 5% of the high, I will take gains based the size and speed of the price increase. I'm still crunching numbers for if/when we hit $700 again but right now I am planning to sell around 15-20%. I sold around 10% near the last peak. Although I believed a retreat was very likely, I did not fund myself sufficiently for the current opportunity and ended up spending more time than I would have liked reallocating capital from other holdings.

Source: Let Negative Sentiment Help You Get Long Apple