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Mike Arnold, CFA
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My investment philosophy is similar to how I live my life: acquire a few prized possessions at the right price, minimize clutter and maintain flexibility.
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  • Message In A Bottle: Why I'm Avoiding Apple At $600 0 comments
    Apr 26, 2013 1:38 PM | about stocks: AAPL

    NOTE: I wrote this article in July 2012, but never published it. I find it interesting to read now, unedited since then (save for a few grammar corrections). To me, its a lesson in the nature of irrational markets, and how to preemptively detect a bubble by being objective about the collective thoughts of market participants. I didn't publish the article out of fear that it appeared Apple, in fact, was going to $1,000/share in July 2012 and that I was in for a potential shellacking in the comments section for a distinctly contrarian view. Call it article market timing/hedging, call it being chicken, but its interesting to see how market sentiment has changed so much in 9 months time.

    By the way, I have never owned Apple (except through mutual funds), but may go long Apple soon. I am waiting for extreme pessimism, mostly from retail investors.

    Original Post:

    Apple (NASDAQ:AAPL) is a terrific company. There is no question about that. A NY Times article "Apple Confronts the Law of Large Numbers" piqued my interest with respect to Apple as an investment opportunity. Full disclosure: I'm a satisfied owner of a couple phenomenal Apple devices. But I'm avoiding owning Apple stock at $600/share valuing the company at $565 billion.

    Price and value.

    Every stock has a price ascribed to it by market participants, and every stock has a value which is made up of its proportional claim on the underlying assets of the business and its future earnings. Price and value can and do diverge quite often, mostly because of investors' animal spirit: euphoria created from investment gains, and panic from sudden and falling security prices.

    That's why price diverges from value: investor behavior is quite erratic and drastically can influence security prices whereas the value of business is more stable. Investors must always assess price in relation to value, and invest only when price is at a substantial discount to value.

    Apple valuation.

    For $600/share, investors are buying the underlying assets and future earnings of Apple. Apple's equity appears reasonably valued at $600/share based on a number of measures. It trades at about 18.5 times 2011 earnings, and 11 times consensus 2012 earnings. Those multiples look like those ascribed to 'value' stocks, not 'growth' equities. And Apple's growth has been nothing short of stunning. Just look at Apple's performance from 2007 through September 30, 2011:

    Apple: Selected Financial Data

    Apple grew sales at a 44.5% compound annual growth rate ("CAGR") and earnings per share (NYSEARCA:EPS) at a 63% CAGR from 2007 to 2011 which occurred during arguably the worst economic climate since the Great Depression.

    Its hard for me to get my head around Apple's business performance: Apple's 2011 sales are fully 4.4 times what they were in 2007, thanks to wildly successful product launches (iPhone and iPad) and the expansion of its computing ecosystem.

    Its cash, equivalents and marketable securities hoard expanded from $15.4 billion in 2007 to $97.6 billion as of December 31, 2011, its most recently filed Form 10-Q. That equates to about $105/share of cash, equivalents and marketable securities, or about 20% of Apple's market capitalization. Apple carries zero debt on its balance sheet, so all the cash flows and future earnings generated are attributable to equity shareholders.

    Investors buying Apple shares at current price levels are really purchasing it for about an adjusted $415/share, after backing out the cash, equivalents and marketable securities. To be certain, Apple's financial position is solid.

    But I still don't want to own Apple shares. Past performance is not a good indicator of future business performance and I will save you the suspense: Apple will not sustain a 44.5% sales CAGR or 63% EPS CAGR over the long run. But there is no doubt that Apple is a very valuable company (the most valuable in the world based on market capitalization, in fact).

    Again, investors must consider price in relation to value. Apple's share price has enjoyed a similar substantial increase just like the underlying value of the business: On February 9, 2007 investors could have purchased Apple shares at $83 and would have generated a very healthy 527% total return (44.5% CAGR) under a buy and hold strategy. Price, therefore, appears to have followed in close correlation with the increasing value Apple represents.

    I just can't know for certain what the next big product launch will be to propel sales appreciably higher, and I certainly don't have an investment edge over the myriad analysts covering Apple so I will abstain from owning Apple. That's because Apple is probably close to fairly priced absent new information regarding its business strategy. If Apple stuns the investment community with another revolutionary product line, $600/share will be too cheap.

    I certainly don't possess such information, so I don't want to own Apple because I know I'm at an information disadvantage. I want to own the most undervalued securities available, the ones no one cares to follow. And as Apple's share price keeps rising, it offers new investors less potential return.

    But more important than return, investors seem to have lost sight of the fact that as Apple's stock quote keeps rising, the risk for substantial loss of investment capital increases. Granted, Apple keeps executing on its business plan and retaining its lucrative earnings thereby lowering investor risk to a certain extent because shares continue to be backed up by more cash and marketable securities held by the company. But when Apple has a misstep or it fails to create a new niche consumer product category to support an elevated stock quote, unsuspecting investors who have been lulled into an Apple bubble will be subject to share price underperformance.

    I can't tell you when that underperformance will happen, only that it will. And I suspect the average retail investor who at the last moment can't stand not to own Apple will be the last buyer before some sort of collapse occurs. Its the nature of market, made up of animal spirits and mercurial investor behavior.

    Apple: Cocktail party discussion topic?

    Apple is the best investment idea of many retail investors. Occasionally I tune into Jim Cramer's "Mad Money" in order to understand what securities capture the investment dogma of retail investors. No other company gets more attention than Apple, probably deservedly so.

    Who will be left to buy Apple stock when everyone already owns it? I perceive that investors have forgotten about risk as it relates to Apple, and only consider the outsized returns that appear to be possible considering the impressive gains shareholders have earned since 2007.

    Investors, though, should think about risk first, and return second. There are even whispers that Apple stock can be used as a place to park cash instead of US Treasuries until the cash is ready to be redeployed elsewhere.

    To me, those are reasons to avoid Apple stock. Investment bubbles are infamously difficult to detect, but when Apple is a topic of conversation at cocktail parties, then that is an implicit indicator to avoid it.

    S&P 500 Index

    Apple's first quarter profits made up 6% of the entire S&P 500 universe. Apple makes up about 4% of the S&P 500 index which is weighted by the market capitalization of its members. Therefore, investors who own a collection of mutual funds may overestimate their exposure to Apple. Most of my retirement portfolio is indexed to the broad market indices, therefore I have plenty of exposure to Apple and I don't particularly want more.

    Let's say an investor has $100,000 in assets, 50% of which is invested in S&P 500 index and the remaining 50% split evenly among Apple and four other stocks (that is, 10% each). This sample investor would have about 14% of his/her assets in the investment portfolio allocated to Apple. If Apple sustained a 30% loss to its stock quote all else remaining constant, our sample investor would take a 4.2% loss to the investment portfolio. That's a decent amount of individual company risk embedded in the sample portfolio, more than investors may think they are exposed to.

    Conclusion:

    I will probably be wrong for some time but at some point I will likely be right. Achieving superior investment results though is mostly derived from investing in undervalued investments that investors can understand and where there is less competition from others.

    My investment thesis as it relates to Apple is mostly humanistic in nature: I get concerned when retail investors are infatuated with owning a particular security because it inevitably leads to overvaluation. Likewise, with 57 analyst institutions officially covering Apple (56 of them rating it a strong buy or a buy), I feel like I am at a severe disadvantage and that passing on Apple is the obvious answer for me.

    The competition from institutions and infatuated investors is precisely why I'm avoiding Apple. Therefore, I prefer to eschew the euphoria that Apple's rapidly appreciating stock quote is generating because risk is undoubtedly mounting, and to look for opportunities elsewhere.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

    Themes: market-outlook Stocks: AAPL
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