Apple: Listen To Buffett And Hold It Like A High-Yielding Farm

Summary

• Buffett compared his elephant Apple position to owning a farm for the long term.
• If you have to closely follow its day-to-day stuff or even its year-to-year yield fluctuations, you should not own it in the first place.
• Although you do need to check that over the years that it is well tended to and hope the yields get better.
• This article shows Apple’s R&D yield and shareholder yield are both exemplary, and that is why Buffett can be so hands-off, and more importantly, why you should too.

Lauren DeCicca/Getty Images News

The investment thesis

Warren Buffett was once asked about his Apple (NASDAQ:AAPL) position during an interview given his large and concentrated stake – even by his own standard ($125B, or 43% of his portfolio). You can see the full interview here, full of typical Buffett-style wisdom and a sense of humor. The following is an excerpt and the highlights are added by me.

Yahoo Finance: how closely do you follow the company? You know, people are concerned they really have not introduced any new products.

Buffett: Well, if you have to closely follow the company, you should not own it in the first place. If you buy a business, say you buy a farm, do you go up and look every couple of weeks to see how far the corn has grown up? Do you worry too much about whether somebody says this year is going to be a year of low corn prices because exports are being affected or something? You know, it does not grow faster if I go and stare at it… Although I do care over the years that it is well tended to in terms of rotating crops. And I hope yields get better.

Following the wisdom of such a large Apple shareholder, this article analyzes Apple’s R&D yield and shareholder yield. You will see that AAPL is indeed a high-yielding farm, producing both truly spectacular R&D returns and also shareholder returns at the same time. You will see what gives Buffett the confidence to be so hands-off on his Apple investment. And more importantly, why you should too – just leave the farm alone and let it grow!

Source: DataRoma

Apple and our retirement

A bit of general background about myself and AAPL. My family is in the final stage toward retirement (after about 15 years of work). Through our personal journey, we feel that anyone can achieve the same, i.e., comfortable early retirement after ~15 years of work. You do not need to be lucky and have bought AAPL in 2008 (we bought our own AAPL shares during 2015). All you need is a disciplined investment approach for the long term and the right tools to make sure you stay disciplined.

Now specific to AAPL, you may feel a bit strange that we hold a stock like AAPL in our retirement portfolio. It is not the typical retirement stock. Its dividend yield is only about 0.55%. The tech sector is not the typical “safe” sector that retirees go for.

A key lesson we’ve learned is that you ALWAYS, at any stage of life, need to clearly delineate short-term issues from long-term issues. So contrary to the popular advice of building “a” retirement portfolio or “the” perfect retirement portfolio, we suggest you always build 2 portfolios - one for the long term and one for the short term. The long-term portfolio is to take care of ourselves when we live to 90 years old (which we all have a good chance of) and for planning out estates for our kids and grandkids. And the short-term portfolio is to take care of our immediate needs (e.g., a visit to the ER next month). This is diversification at a grand level!

Under this background, hope it now feels less strange why we hold AAPL in our retirement portfolios. We hold it for its long-term prospects, not for its current income or short-term gain. We are only concerned about its long-term yields – in the general sense, not only dividend yields, as discussed below.

AAPL’s R&D yield

As Yahoo Finance commented, many people are concerned about AAPL because they really have not introduced any new products in a while. Buffett is not concerned at all, and he openly commented that he does not understand (nor care) what is going on in its labs. I do not care myself (though I probably understand it a bit better than Buffett given that he just ditched his flip phone and learned to use an iPhone) and we suggest you not to care either, for several reasons.

First, I do not invest in AAPL because I have high confidence in certain products that they are developing the pipeline. In other words, I do not bet on a few particular ideas. Instead, I feel more comfortable betting on the process. I've studied many high stake R&D cases in detail and have been involved firsthand in quite a few of them myself. There are a few key lessons that I've learned. First, the success or failure of a given project is largely a matter of chance and luck - no matter how much resources we throw at it and how high a priority management has assigned to it. Second, the successful cases are only made to appear as a planned success - AFTER they become successful.

An illustrating example here involves Pfizer's (PFE) Viagra, a huge blockbuster drug. But did you know that Pfizer's original goal in that project was to develop a drug to treat cardiovascular problems? It certainly was not a successful project as a cardiovascular drug for many reasons. However, a negative and unintended side effect, accidentally discovered by a nurse, made the drug into the success as we know it today.

So instead, I focus more on the process with the understanding that if the process itself is sound and efficient, sooner or later a good idea will be developed into a successful project as long as there are plenty of ideas to be tried. And I am betting Buffett is thinking along this same lines.

Then second, how effective is AAPL R&D’s process? The short answer is that it is extremely effective. The next chart shows the R&D expenses of Apple. As seen, AAPL does not spend that much on R&D earlier in the decade. Partly because AAPL products were so disruptive at that time and enjoyed a quasi-monopoly status. Partly because Steve Jobs himself did not believe in R&D spending. He commented that “Innovation has nothing to do with how many R&D dollars you have. It's not about money.”

Tim Cooks transitioned to a different model, a model that Buffett obviously thought to be more sustainable in the long term. You can see a more comprehensive comparison of the Jobs’ era vs. Cook’s era AAPL in my earlier article here. In terms of R&D, Cook’s followed a different philosophy, and as you can see, he more than doubled the R&D expenses since he took over. The R&D expenses are on average about 5.7% of sales now, on par with other large tech companies. Particularly in 2020, Apple spent a record $18.75 billion on R&D, equivalent to 7% of its sales.

Source: Author based on Seeking Alpha data.

Now let’s see how we quantify the yield of Apple’s R&D expenses. The purpose of any corporate R&D is obviously to generate profit. Therefore, it is intuitive to quantify the yield by taking the ratio between profit and R&D expenditures. This way we can quantify how many dollars of profit has been generated per dollar of R&D expenses. However, in reality, the analysis has a few caveats that need to be ironed out before we take the ratio.

Firstly, there are many ways to measure profit, ranging from net profit, to gross profit, to before-tax earnings, etc. In this analysis, we will use the operating cash flow. In my mind, this is the best representation of a company’s earnings power. Secondly, most R&D investments do not produce any result in the same year. They typically have a lifetime of a few years. Therefore, this analysis assumes a 3-year average investment cycle for R&D. And as a result, we use the 3-year moving average of operating cash flow to represent this 3-year cycle.

With these, AAPL’s final R&D yield is shown below. As you can see, the R&D yield for Apple has been more than $10 in 2013, and it has declined to a range between $4.0 and $5.0 in recent years. You might interpret the decline of its R&D yield as bad news. However, keep in mind that A) the level of profitability AAPL enjoyed in the early part of the decade is simply unsustainable, B) the decline is only relative to its own glorious past. In recent years, Apple has been generating on average $4.7 of income for every one dollar spent on R&D. This level of R&D yield is still very competitive even for the overachieving FAAMG group. Take Microsoft (MSFT) as an example, its R&D yield has “only” been averaging about $2.9, about 60% of AAPL’s yield.

Source: Author based on Seeking Alpha data.

AAPL’s shareholder yield

After examining its R&D yield (which is kind of the input), now let's examine its total shareholder yield (which is kind of the end result). Many investors only consider dividend yield as “yield”. Admittedly, for investors who seek current income, a cash dividend matters more and AAPL’s cash dividend yield is quite low, around 0.55%. However, for other long-term investors, the overall earnings yield, or total shareholder yield, is what’s really matters. The reason is that it doesn't really matter how AAPL uses the earnings (paid out cash dividends, retained in the bank account, reinvested in R&D as aforementioned, or used to repurchase stocks), as long as used sensibly (as AAPL has done in the past), it will be reflected as a return to the shareholder in the long term.

In my opinion, the most effective method to analyze total shareholder yield, with the least amount of ambiguity, is the so-called $1 test invented by Buffett himself. It relies on two of the most easily obtainable data with the least amount of ambiguity: retained earnings and market capitalization (“MC”) of the business. For readers who haven’t paid much attention to retained earnings, you can either find them in the balance sheet or directly calculate them by subtracting the dividend payments from earnings. Once you calculate the retained earnings, then the $1 test is simply to see if the stock price has appreciated at least by $1 for every $1 of earnings retained. As Buffett said himself in his 1984 shareholder letter (the highlight was added by me):

“Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

The following table shows the scorecard of AAPL on this $1 test. The first two rows show the annual retained earnings and the average market cap, respectively, as already reported in the previous chart. And the third row shows the annual retained earnings as a percentage of the average market capitalization for that year. Because the market price is obviously volatile, the table shows the average MC over a period long enough (five years) to filter out the noises and be able to draw meaningful conclusions. The fourth row shows the 5-year cumulative retained earnings (in $B), and the fifth row shows the 5-year cumulative MC change (in $B). Then finally, the last sixth row shows the ratio between the cumulative retained earnings and MC change.

As seen, AAPL has passed the test with flying colors. The business has created an average of $1.58 of MC for every dollar retained from 2015 to 2019. And the ratio further shot up to astronomical levels of $5.48 and $6.35 in the recent two years. Overall, during the period of 2011-2021, AAPL has retained a total of $433B of earnings (a mindboggling amount of cash) and its MC has increased for a total of $1.96T (almost 1/10 of the annual US GDP). So during the past decade, AAPL has created $4.52 of shareholder value for every $1 of earnings retained. By the way, for more visually-oriented readers, the plot below shows the same information in a bar chat.

To put things into perspective, BRK itself has created $1.17 worth of shareholder value for every dollar of earnings it has retained in the past decade – a very respectable level by itself already but still nowhere near the level of AAPL. And if you consider that a good part of the $1.17 of shareholder return created by BRK per dollar of retained earnings actually just came from its AAPL holding, this consideration would make the comparison even more favorable towards AAPL.

Source: Author and Seeking Alpha data.

Source: Author and Seeking Alpha data.

Risks

First and foremost, I do not see any structural risk associated with AAPL at this moment. Remotely, there might be an anti-trust regulatory risk. But even if it comes to that, I am not entirely certain if it will be bad for AAPL investors for sure. If it really comes to that and the company has to be broken up, the market would be forced to value each of its business segments separately. And such a complete and transparent valuation may or may not result in a lower valuation.

There are some risks for investors with a shorter investment timeframe (and are largely irrelevant for long-term investors). These risks include:

• Post-COVID economy recovery. The biggest short-term risk as I can see is the pace and degree of the post-COVID economy's recovery. Although the vaccination is progressing extensively and the economy is re-opening at a steady pace. However, the pandemic is far from over yet and uncertainties like the delta variant still exist.
• Second, there can be significant short-term volatility risks too. Regardless of AAPL’s scale and business model, the valuation is at a high level and the overall market itself is also near a historical record valuation. Such a combination of volatility and high valuation certainly could cause some short-term risks.
• Third, AAPL also is facing short-term risks associated with the ongoing interruptions of the global supply chain. With China still in quasi-lockdown mode, the supply chain shock is still unfolding and could develop in many possible directions. The supply chain headwinds are estimated to cause a ~1.5% to ~3.5% reduction for AAPL FY 2022 revenues. But again, this will be a temporary risk in the short term only.

Conclusion and key takeaways

This article analyzes AAPL under the context as the largest purchase and also largest holding in Buffett's portfolio. This analysis particularly focuses on why Buffett can be so confident and hands-off with an investment of such an elephant size – even by his own standard. The key wisdom we can learn is to only invest in businesses with excellent long-term prospects so we can ignore any short-term noises. In particular, the key takeaways are:

• If you have to closely follow a business's day-to-day stuff or even its year-to-year yield fluctuations, you should not own it in the first place.
• Although you do need to check that over the years that it is well tended to and hope the yields get better.
• Two of the key metrics to gauge the yield of a business like AAPL are the R&D yield and the overall shareholder yield. And AAPL has been exemplary in both areas.
• For its R&D efforts, Tim Cook has transitioned to a different model, a model that Buffett obviously thought to be more sustainable in the long term. And AAPL’s current level of R&D yield is very competitive even for the overachieving FAAMG group. As an example, MSFT’s R&D yield is “only” about 60% of AAPL’s level in recent years.
• For its overall shareholder yield, AAPL has created on average $4.52 of shareholder value for every $1 of earnings retained in the past decade, a truly stellar yield again even for overachievers like the FAAMG group and Buffett’s own BRK.

Disclosure: I/we have a beneficial long position in the shares of AAPL either through stock ownership, options, or other derivatives. 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.