Quality Value Stocks: Apple

Summary

• Simplicity is the ultimate sophistication, and smart investing decisions don’t need to be too complicated.
• Long-term investors generally focus on buying solid companies for an attractive valuation.
• Quantitative indicators based on financial quality and valuation levels can be remarkably effective at picking outperforming stocks.
• Apple offers particularly strong metrics in terms of quality and value combined.
• The long-term picture in Apple stock looks quite favourable in the years ahead.

You can’t build a complete investment thesis for a company by looking solely at the numbers. It’s important to understand the main business drivers behind those numbers in order to fully evaluate the main risks and potential return in a particular stock. However, quantitative indicators can be tremendously powerful tools when it comes to identifying investment ideas with superior potential.

The following quantitative system is based on two simple return drivers: quality and value. In a nutshell, we want to buy companies with strong fundamentals and trading for convenient valuations, so the system averages down multiple ratios and indicators to find the companies that look more promising in terms of these two characteristics.

The quality factor is based on metrics such as gross margin, operating margin, free cash flow margin, return on investment, return on equity and long-term growth expectations. All else the same, it's easy to understand why companies with high profitability levels and above-average growth expectations should deliver superior returns over time.

The value factor in the ranking system includes metrics such as price to earnings, price to free cash flow, and enterprise value to EBITDA, among others. The lower the entry price, the higher the potential returns for investors.

The following backtest picks the 50 stocks in the S&P 500 index that have the strongest combination of quality and value indicators, and it builds an equally-weighted portfolio with those names. The portfolio is annually rebalanced, so turnover is quite low, and it has an assumed annual expense ratio of 1% to account for trading expenses. The benchmark is the SPDR S&P 500 Trust ETF (SPY).

Backtested performance numbers are quite strong. Since January of 1999 the portfolio recommended by the system produced an average annual return of 12.16%, far surpassing the 6.16% produced by the SPDR S&P 500 Trust ETF in the same period.

Backtesting data and charts are from Portfolio123.

In other words, a $100.000 investment in the portfolio recommended by the system in January of 1999 would have a current value of $901,400, and the same amount of capital allocated to the index-tracking ETF would we worth only $314,600.

Please keep in mind that backtested performance numbers are for the portfolio as a whole, that doesn't mean that every stock in the portfolio necessarily produced market-beating returns. Besides, backtested performance should always be interpreted with caution, since past performance does not guarantee future returns.

Nevertheless, it makes sense to expect above-average returns over the long term when investing in stocks with strong quantitative indicators in key areas such as quality and valuation. Speaking of which, Apple (NASDAQ:AAPL) is one of the stocks currently selected by the quantitative system, and the stock looks well positioned for solid returns going forward.

Apple By The Numbers

Apple doesn’t need much of an introduction, as the company has one of the most recognized brands in the world. In fact, Forbes considers Apple the most valuable brand on Earth, with a calculated brand value of $170 billion.

Brand value means a particularly loyal customer base for Apple, and the company benefits from exceptional pricing power, which is translated into superior profitability and financial performance for shareholders in the company.

The chart below compares Apple versus the average industry player based on a multiplicity of financial quality indicators. Apple comes ahead of the competitors across all of the indicators considered: revenue growth, net income growth, operating margin, net margin, return on assets (ROA) and return on equity (ROE).

The consumer electronics industry is notoriously challenging, since demand is quite cyclical, and sales in a particular quarter depend considerably on variables such as the evolution of the product launch cycle and the competitive landscape. In spite of this, Apple has delivered outstanding financial performance over the long term.

AAPL data by YCharts

Management said in the most recent earnings conference call that the company’s active installed base of devices reached 1.3 billion units in January, marking new all-time highs. This represents a 30% increase over two years, and it’s a huge positive for Apple in terms of opportunities for renewal sales over the years ahead.

The services division is now the company's second-largest segment behind the iPhone, and it delivered $8.5 billion in sales last quarter. This represents a year-over-year increase of 18%.

The services business looks like a promising growth engine for Apple going forward. Besides the services segment is remarkably profitable, so a growing share of total revenue coming from services should have a positive impact on Apple’s already exceptional profitability levels.

All this comes for a fairly convenient price. Wall Street analysts are on average expecting Apple to make $11.44 in earnings per share during 2018 and $13.09 in 2019. Based on these forecasts, the stock is trading at a forward price to earnings ratio of 14.6 times earnings expectations for 2018 and 12.75 times expected earnings in 2019.

As a reference, the forward P/E ratio for companies in the S&P 500 index currently stands at 16.5, which is actually the lowest level for the ratio since late 2016. It’s interesting to note that forward looking valuations for the market as a whole have pulled back substantially in the past several weeks due to a combination of strong earnings growth expectations and falling stock prices.

Source: Thomson Reuters

Back to Apple’s valuation, the company is also sitting on mountains of cash in its balance sheet with a net cash position of $163 billion. In addition, the business generates over $52.3 billion in free cash flow per year. This means that almost 20% of the company’s market capitalization is justified by net cash reserves alone, and the business generates massive amounts of cash on a recurrent basis.

The new tax legislation allows Apple to repatriate cash held overseas at a conveniently low cost of 15%, and management has already indicated that the company will become cash neutral over time. While the details of the new capital allocation program have not been disclosed yet, it makes a lot sense to expect growing dividends and increasing share buybacks from Apple in the future.

Since the inception of its capital return program in 2012 Apple has now completed over $240 billion of it’s $300 billion program, this includes $176 billion in share repurchases and $64 billion in dividends. This is a gigantic amount of money, even for a gargantuan corporation such as Apple: $300 billion in cash distributions represents nearly 35% of the company’s current market capitalization value.

Based on the company’s financial strength and track record of cash distributions, Apple has both the capability and the willingness to make generous cash payments to investors, and the new tax legislation is providing an opportunity for Apple to boost it’s capital return program for a conveniently low tax cost.

It’s one thing to say that a stock is undervalued based on accounting earnings or even in comparison to cash generation or cash reserves in the balance sheet. That sometimes sound like too ephemeral and theoretical to many investors. On the other hand, when a stock is undervalued based on cold-hard cash distributions, then such undervaluation becomes far more tangible and material.

Analyst’s Disclosure: I am/we are long AAPL. 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.