The New York Times recently published an article about Apple (AAPL) and the Law of Large numbers wherein the Pulitzer-prize winning author compares (without offering his direct opinion) Apple's probable fate to the previous market darlings like Cisco (CSCO). Using the "Law of Large numbers"; it inferred that Apple's growth may eventually slow down over time and revert to the mean...
Mark Hulbert also recently chimed in about the "risk" of holding too much cash....
Here is the rub: Apple is so big, it's running up against the law of large numbers.
Also known as the golden theorem, with a proof attributed to the 17th-century Swiss mathematician Jacob Bernoulli, the law states that a variable will revert to a mean over a large sample of results. In the case of the largest companies, it suggests that high earnings growth and a rapid rise in share price will slow as those companies grow ever larger.
But a compelling case can be made that a huge cash hoard actually represents grave danger for the company. That much cash creates almost irresistible temptation for management to do something with it, which in turn increases the chances that it will do something foolish.They must be right; after all, they all have made a name for themselves and I'm just a casual blogger! A little bit of perspective will help...
- Apple, at their recent AGM, announced that they aren't paying any dividends nor are they thinking of splitting the stock. For those of you who have been following my blogs, this isn't a surprise as I wrote about it here last year! Interestingly enough, the stock didn't sell off after the AGM.
- Apples' cash continues to attract armchair quarterbacks; it is, however, interesting that we aren't provided with any disclosures of their holdings.
- Apple, instead of selling off after earnings, continues to make a new high and have now surpassed XOM in terms of market capitalization. How many sharks have we jumped?
- Rumors of iPad3 launch in March and iPhone5 during the fall keeps on surfacing.
- Despite the 4S' torrid sales results, Apple has barely scratched the WORLD mobile market related to Android.
After the Los Angeles Lakers lost to the New York Knicks recently, Kobe Bryant said this of Jeremy Lin:
"Players don't usually come out of nowhere," Bryant, who scored 34 points for his team, said after Friday's game. "If you go back and take a look, his skill level was probably there from the beginning but no one ever noticed."Asians, like most Caucasians aren't supposed to be good ballers; there was even a movie about this kind of stereotyping - "White Men Can't Jump" (just like Independent bloggers aren't supposed to outperform their Wall Street counterparts)! Why is it difficult to accept that he "can" play ball regardless of race, background or IQ level? Why is difficult to accept Apple can rise above its current 52 week high? What is the price of Berkshire (BRK.A) stock?
The Detroit Red Wings, a professional US Hockey team, have won more Stanley Cups amongst franchises based outside of Canada. They have made the playoffs in 25 of the last 27 seasons! This is incredible given that they haven't had a notable #1 pick in the first round since Kronwall was picked 29th in 2000! NFL's Green Bay Packers have won more championships than any other team since the 1920's! Isn't the rule of large numbers suppose to catch up on these teams?
Do stereotyping or personal biases have any impact on our investment performance (or lack of)? Here are some of the generalizations directed against Apple:
- It has gone up by "x"; therefore, it may only have "y" left to go.
- All the good news must be reflected in the security already as it is already trading at "x" multiple.
- Apple's cash hoard is putting a drag on its performance...
- Apple should pay a dividend to attract Funds who only invests in dividends; this will push the stock up...
- The "experts" are valuing it at "x" multiple; they must be right.
- This "fund" or "big name investor" bought it; I'll buy it too!
- It cannot go on like this; price should change because "I believe"...
- "I believe" the growth curve is not sustainable...
- Useful investment articles should be dry and "serious"; it shouldn't be fun to read!
- Seriously, can a $390 stock rise even more? It can't be bigger than Exxon (XOM)!
- We cannot compete with program trading...
- The law of large numbers can prove that it cannot continue its growth and earnings trajectory...
Apple recently closed at an all time high of $526.29 (14x PE ttm) despite the Greek default drama around the time of writing. Where did all this buying power come from to push it at an all time high? Remember when I wrote about it here and here?
informal are based on premises fail to support the proposed conclusion, but the argument is structured properly) or formal (logical structure is flawed).
The theory of the Law of Large Numbers, when taken at face value, is linear. Simply stated, if a six-sided dice are rolled, the average of their values is likely to be close to 3.5, with the accuracy increasing as more dice are rolled. This is irrefutable.
However, what would happen if there were 2 dice rolled instead of one? Would the average expected value still be 3.5? What if we increased the number of dice to 3 and so on and so forth? One can also argue that regardless of how many dice are rolled, it will "revert to the mean". This conclusion is also irrefutable. What is missed, however, is that the "mean" changes as you introduce more dice into the mix.
- How many known product lines does Apple have today; do all these product lines have the same life cycle and contribute the same way to the bottom line?
- The theory does not immediately account for the impact of any product refinements. Look at the evolution of the iPod to the current iPod Touch; if it didn't evolve...its sales figures would have ultimately reverted to the mean.
- If we kept on waiting for Apple to revert to the "mean" when it only had the iPod or when it hit $100, would we have gained?
- Apple's PE multiples haven't expanded since 2007 as I've written about it here before; ironically, the PE has moved inversely proportional to its earnings and revenue growth. How does this compute? Shouldn't we expect its PE to revert to its historical mean (which would be higher)?
What did Bill Clinton say when he was asked about his sexual relationship with Monica Lewinsky? What conclusion would you have derived from listening to his answer? "Technically" speaking, was his answer the truth? What is the "average" life expectancy of a North American male? Does it follow then that if we are "x" years from that average, we should quit enjoying life and start planning for death?
Hulbert, in his article, attempts to walk the fine line by using a "generality" i.e. there are some companies who use their cash irresponsibly to conclude that Apple may follow that path. He then cites a study (based on data from 1963 to 1998) on how dividend changes drive future earnings growth but does not provide an allowance that some non dividend paying stocks can grow its earnings better than dividend stocks as well. While I'm not a fan of big brokerage houses, I find this article by JP Morgan to be more "realistic" in its opinion on dividends wherein it concludes that:
Dividends, however, are not appropriate for all firms. Executives should review the full range of capital allocation alternatives available to them, maximize their understanding of future growth propects, and assess any impact of future economic or regulatory outcomes before defining or altering their shareholder distribution policies.
Apple, since the 2nd coming of the late Steve Jobs, has been very prudent with how it spends its cash. Until, it does, it is difficult for me to understand why it is being lumped in with incompetent management. I think dividends are great; however, I find it amusing (to put it kindly) for the peanut gallery to tell Apple's competent management team what to do with its cash! Enough of the Linsanity already; the kid can flat out play!
So, what "actionable" direction can you derive from this article?
- Fundamental and Technical analysis (just like scouting reports and tryouts), regardless of the source, isn't an exact science. Whether it is Apple or with any other stock, having an open mind (specially when it runs contrary to your thinking) can help you make better decisions when supported by facts.
- To insist that your current approach/perception (like scouts that cannot pick talents consistently) is the "only" way to go may prevent you from achieving better returns.
- Stocks Break Out, Break Down or Trends sideways. You can make money in any of the 3 scenarios; the hardest one to trade (for me) is when a stock trades sideways (or consolidates).
- Perception is unique to every individual. The ability to filter out the "noise" keeps you in the game.
Given Apple's recent run; a retracement wouldn't be unreasonable. You would then watch the $490's for a breakdown or the $510's for the continuation. So, if you missed the run; don't worry, the train will make a pit stop sometime this year! Who cares if Apple didn't declare a dividend or a stock split; we've written about it and it doesn't really impact our original thesis on why we bought the stock in the first place!
Who knows what were the drivers behind Apple's recent run; the fact is, it blew away most of the "biases" behind the thinking about why it couldn't provide you with a decent return over time. It didn't make any difference with our thesis then; it shouldn't now. If it happens, it will just be additional gravy for us! I'm glad Tim didn't give in to the armchair quarterbacks!
The Rashomon effect will always be there regardless of how "grounded" we "think" we may be. I recently missed an opportunity to trade Salesforce.com (CRM) at $115nish due to my own biases; I thought it was too richly valued and was bound to break down!
Just like Lin having a "bad" game against New Orleans or Miami, we can chalk this (missed CRM trade) up to experience and a reminder that no one is immune to biases!
Disclosure: I am long AAPL.