Apple: Time To Reduce An Overweight Position

| About: Apple Inc. (AAPL)
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I have owned Apple (NASDAQ:AAPL) shares for just under a year now. My one year anniversary is coming up in about 2 weeks. As with any of my holdings, as they approach the one year mark, I reevaluate the position to determine whether I should hold, sell, reduce my position, or buy more.

Apple has been a great "growth at a reasonable price" stock. Being a value investor I don't often buy companies with such high growth rates, and typically many of my holdings are companies which are out of favor in the market when I buy them. Apple violated both of these points. Apple has always been a bit special though, as this was a company that was growing at an incredible pace, but one that actually had reasonable valuation metrics. This got me interested in the company as an investment in the first place, and when I combined this with my knowledge of their products (I've owned an iPhone for several years, I also have an iPad 2 and a Macbook) I knew that the company was in a very unique situation. I was so confident in it last year in fact, that I went overweight on the stock, purchasing 3x more than my average holdings.

The primary reason I made this choice, was because of one simple concept: Usability. I'll spend a minute to discuss this, because I think it's a very important point with Apple. As an IT professional, I've learned over the years that consumer technology products are successful when they are easy to use and understandable by a wide audience. There are many great technology innovations in the past decades which have not caught on in the broader consumer market because the user friendliness is just not good enough for mass audiences. A good example of this is the Unix/Linux operating system. This is a fantastic OS that is widely used in enterprises as reliable server systems running mission critical applications. Most IT folks will tell you the OS is more stable and reliable than others such as MS Windows. However outside of IT circles, the average consumer doesn't use it, simply because the user interface is not consumer friendly. There have been some versions of Linux where they have tried to improve this (an example is Ubuntu), but nothing has been able to catch on in a mass scale.

A number of years ago when I was in college majoring in IT, I took a course on usability of technology. In this course we had a testing lab where we took several software applications and had users unfamiliar with the products run several test scenarios. Each scenario would give them an instruction, e.g. "attach an image and email it to someone". We would then observe the users from behind one-way glass where they couldn't see us. The exercise would time how long it took them to browse through the menu options of the program to figure out how to do the action, and also to observe their behavior (e.g. would they get visibly frustrated, tap their pencil, etc). In one example we used a instant messaging program that was popular at the time among techies, because in one interface you could connect to all of your messaging programs at once (MSN, AOL, ICQ, etc). Technically this was very handy, however as we discovered, the program had so many sub-menus and functionality, it was great for techies but the average user found it overly complex and would take a very long time to find options in the nested menus. Users became visibly agitated after a matter of minutes with the program.

When I first picked up an iPhone a few years ago, I had these usability simulations in my mind. Within a matter of minutes of using the phone, I knew right away that Apple had something special. This was a superior product without a doubt.

So 1 year ago, based on what I felt was my strong circle of competence in Apple's products, their superior usability, and also the attractive valuation metrics on the company I decided to purchase an overweight position.

This decision as it turns out was a good one, as I've achieved a 1 year return of around 60%, my best holding year to date. This also taking into account the recent ~10% drop in the past few weeks.

What has now changed my thinking on Apple?

Don't get me wrong, Apple is still a wonderful company. Without a doubt I will continue to hold a position, as I believe the overall risk/reward ratio is still good.

Although I still love the company and love using their products, as a value oriented investor I'm always trying to avoid too much downside risk. I also cannot get out my head the famous phase from Warren Buffett: "be greedy when other's are fearful, and fearful when other's are greedy".

I would be blind to ignore the fact that clearly Apple mania has continued to grow, and very few people (if anyone) is currently "fearful" of the company. Virtually all analysts and pundits are pounding the table to buy, buy, buy (telling you to be greedy). What other company has 46 analysts covering it, and only 2 with underperform/sell ratings?

Although I expect the company to continue to execute well, and continue to increase in value the coming year, there will at some point come a time when either the company makes a misstep, or a competitor finally comes out with a serious threat to the iPhone's dominance.

I'm not going to try and speculate when either of these events could occur, but for sure it is inevitable that it will happen one day.

Even with the likely new products coming into the mix (the rumored iPad Mini or even a TV), there will come a time when some event occurs which causes growth expectations to be lowered and the stock price will suffer.

At the height of inflated expectations, I therefore feel it is only prudent to be a bit more fearful, and reduce my position to equal-weight.

Why I'm continuing to hold

I will not consider selling out completely at this time, because as I mentioned there is still a good risk/reward ratio. By taking some profits off the table I feel I can lower my downside risk but still benefit from continued successes the company is likely to have in 2013. As long as Apple continues to "tick the boxes" on my most important stock selection criteria, I will hold it. I've summarized the points in the table below as to why I feel it is still a good investment.



Good Business Prospects

Apple continues to dominate with the iPhone and iPad. Tablets are expected to grow at a CAGR of more than 66% from 2010 - 2014. The iPad is by far the major player in this market.

Smartphones will continue to grow at a CAGR of 19% through 2016. With a steady or increasing market share, Apple will see continued high growth in earnings.

Competitive Moat

Due to usability superiority, and the "cult" like following of the Apple brand, the moat and pricing power that comes with it is un-matched in the industry.

Shareholder Friendly

Company now pays a dividend and is repurchasing billions of dollars of stock.

Conservatively Financed

With around $100 billion in cash and no debt, it doesn't get any better.

Predictable Earnings

Continued strong growth for the coming years combined with competitive moat makes earnings quite predictable in the next few years.

Valuation (Margin of Safety).

PEG ratio of only 0.61, EV/EBITDA of 10.46. Forward P/E is less than 12. Still definitely some value in the shares.

In conclusion, Apple is a great company that deserves a place in your portfolio. However as the growth continues at astonishing rates and we are at the height of inflated expectations, I advise to be prudent with your investment and minimize risk by not over allocating. Only consider going overweight in Apple if the price drops down significantly lower (e.g. <$500/share). Even then, only buy if this drop occurs because of a broader market downturn, not because of company specifics.

Disclosure: I am 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.