Apple - Stay Objective And Aware Of Threats

| About: Apple Inc. (AAPL)
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High conviction is not overconfidence. Overconfident investors are not prepared for what can go wrong. An investor making a high conviction trade is quick to recognize when to be even more aggressive and is equally fast to sense danger and get out.

The purpose of this post is to make the reader aware of a couple of things that could start to go seriously badly for Apple (NASDAQ:AAPL) over the next couple of years. I am not recommending you sell Apple today. I believe that a good investment process involves anticipating scenarios that could lead to failure. Most financial analysts tell you all the reasons why their favorite stocks will go up and then end their reports with a list of risk factors.

Instead of listing risk factors as an afterthought, I prefer to visualize disaster and then work backwards to think about root causes. These visualization exercises help me to build conviction in my investment decisions and help me to develop the intuition necessary to sense danger (preferably earlier than others). Hopefully, after reading this, you will feel higher conviction in your Apple investment, since you will be more prepared to quickly sell (or possibly aggressively add to your position) when the time is right to do so.

Successful technology companies often find it difficult to make revolutionary changes. This makes them very susceptible whenever a revolutionary change does occur in their niche. Professor Clayton Christensen of Harvard Business School describes this as "the innovator's dilemma." For example, when Research in Motion (RIMM) was the leading smartphone company, it had many customers that liked its physical QWERTY keyboard. Its customers primarily used its products for mobile email. If Research in Motion diverted its research and development focus towards products that did not have physical keyboards, it risked damaging many of its existing customer relationships. As a result, RIMM's research effort mainly concerned incremental improvements. After Apple introduced the iPhone, it was clear that RIMM's dominant market share would be at risk.

Moreover, product cycles in the smartphone industry are very short - consumers tend to replace their phones every couple of years. Technological change happens rapidly with new handset models being released by each manufacturer every year. Consequently, when RIMM fell behind, the company found it very difficult to catch up.

While Apple has a great brand, I do not think that AAPL is immune to the innovator's dilemma. People who buy phones are not brand loyal. If they were, Motorola would still be selling RAZRs and Nokia (NYSE:NOK) and RIMM wouldn't be having such a tough time. People buy the best phones that fit their needs. If you primarily want to use a phone for email and messaging, RIMM probably offers products that are better for you than Apple. Apple and Android smartphones took a lot of share from RIMM, because most consumers went from primarily using smartphones for email to using them as general computing devices that access apps. Note that, similar to RIMM, Apple now only makes incremental changes to the iPhone. I haven't seen the iPhone 5 yet, but the latest available version of the iPhone appears relatively similar to the very first version. If Apple were to make a revolutionary change, it would risk alienating its app developer community.

Apple only makes incremental changes to the iPhone (and iPad), because the company wants older applications to work on any new hardware it sells. Therefore, like RIMM was, Apple is now susceptible to a revolutionary change in the smartphone industry. Until such a change happens, Apple will probably continue to do well. It is possible that a radical change never happens again in this industry. However, any investor following Apple needs to be paranoid about spotting a major technological shift earlier than others.

One possible revolutionary change could be wearable computing. It is clear that people are interacting with their phones a tremendous amount and that the trend is only for much more interaction. At some point, it will make sense for a more intimate computing experience so you don't have to waste time pulling out your smartphone and so you can more easily walk and interact with applications at the same time.

Anyone who saw the opening ceremony of the Olympics probably remembers many athletes walking around holding up their phones. They were recording their eye-witness experiences. It would have been much more convenient for them to be using a pair of Google glasses. If you haven't seen the YouTube video on project glass, you should see it now. The video has had over 17.5 million views already.

Google (NASDAQ:GOOG) is not alone in developing a wearable computing device. Several companies including Apple, Microsoft (NASDAQ:MSFT), Motorola Solutions (NYSE:MSI) and even Oakley have plans for "smart" glasses, "smart" watches, "smart" ski goggles, etc. I expect wearable computing to be a major theme at the next Consumer Electronics Show (CES) in January.

So what happens if wearable computing becomes the next big thing in consumer electronics? There is one argument out there that it makes the smartphone more important since it can be the brains and hub of various wearable devices. However, there is another argument that the smartphone risks becoming commoditized. It risks becoming more of a modem / connection device as opposed to being the center of your mobile computing experiences.

I don't know which hypothesis is correct, but it would obviously be very bad for Apple if their main product becomes more of a commodity. The vast majority of Apple's operating profit comes from iPhone sales. iPhones represent over half of the total revenue but they also have a much higher gross margin than the corporate average. Furthermore, if another company like Google winds up taking the lead in wearable computing, it is possible this creates a halo effect for Android based smartphones. Google and Apple appear to have very different visions for the future of mobile computing.

Sergey Brin, co-founder of Google, has said that he is spending about half his time on the Google Glass project. According to Nick Bilton of The New York Times, Apple is focusing more on a device that could fit on your wrist. Who knows which company has made the right bets? But, shareholders of Apple should monitor whether or not the company is right. If Apple bets incorrectly on the direction of wearable computing, it risks being like RIMM and having to play catch up in a fast-changing, hit driven industry.

The convergence of laptops and tablets will also be interesting to watch and will have major implications for Apple. I currently use both an iPad and a laptop. I generally find the iPad better for consuming content and the laptop better for creating content like this article. While I like the iPad's instant-on, touch screen and form factor, I find it much easier to type using a physical keyboard. File management and switching between applications is also far superior with my laptop. What I ultimately want is one device that offers the best of both worlds.

Like the iPhone, Apple has just made evolutionary changes to the iPad. It has remained a device that is poor for producing content. This puts the company at a serious risk. Traditional PC companies and upstarts are not standing still and if someone else can produce a tablet that does both well, Apple's tablet business will be at risk. Microsoft will be starting to sell its new tablet with a physical keyboard soon. I don't know if Microsoft got it right, but it is certainly a step in the right direction. It will be interesting to see how it does.

So here is what I am looking out for when it comes to Apple over the next couple years. I am looking to see if Google Glass or other wearable computing products gain momentum with consumers. That could indicate whether Apple made the right long term technology bets. I will be monitoring the success of Microsoft's competitive tablet offering and see if any other tablets come out that offer a good experience for producing content.

Apple is a great company, but whenever a short product cycle technology company gets to the stage of being more evolutionary than revolutionary, the risks to its business rise. Some may point out how Apple's ecosystem of app developers, iTunes, etc. creates a strong barrier to entry. I may be underestimating this, but my point is that the ecosystem is a double-edged sword. It is also the reason why Apple can only make evolutionary changes and is susceptible to a revolutionary change.

Microsoft also has a strong ecosystem, especially with corporate users who have over 4 million applications written on Windows. Nevertheless, most people do not seem to view their chances favorably long term at all. The more aware investors are of these risks, the more prepared they will be to make correct decisions.

I may be very early in starting to worry about these things, but better to be worried about them than not. I like to feel in control and know what to do when certain events happen than feel like the market controls me.

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. I have no business relationship with any company whose stock is mentioned in this article.