04 Jan There Is No Such Thing As A Forever Stock
A recent transaction in one of our internal stock strategies prompted me to pull together a brief update that addresses why a stock like Apple (NYSE: AAPL) would be sold. Furthermore, my intention is to give clients (and the broader investment community) insight into our investment process, which I believe is differentiated in an era of passive index migration and benchmark hugging. It is our belief that investment firms possessing a researched, fundamental understanding of a company’s value stand to reap outsized benefits in the coming years where index performance will likely remain challenged.
Some might ask, “Why sell a stock that is down from its recent high? It wouldn’t appear that Apple’s business has dramatically changed. AAPL has experienced declines of a similar magnitude in recent history. Shouldn’t a recovery in price similar to 2016-2017 be expected?” In our view, a rapid price recovery (while possible) is not likely in AAPL for a variety of fundamental reasons. Listed below are just a few of our concerns that began to materialize over the course of the last six months:
- In its recent November earnings report, AAPL indicated that they would no longer be giving certain information to investors pertaining to unit sales across their product line. Instead, they indicated they would only give total revenue by product line. Whenever a company decides to give less information than previously provided, this is the first warning signal that there may be a problem with the company. This announcement moved AAPL from a buy to a hold in our portfolio.
- For the first time in 20 years, on January 2nd, pre-announced earnings/revenue numbers to the investment community were significantly lower than previous estimates for the upcoming period. This act indicates a company is having difficulty forecasting their business, which was another warning signal.
- AAPL remains a hardware company, with an enviable profit margin in a shrinking market. Despite the financial wherewithal, AAPL has consistently passed on transformative acquisition opportunities, instead preferring to hoard cash on its balance sheet (currently to the tune of ~$200bln). The lack of a visionary leader like Steve Jobs is a critical issue for the company. In the technology world, those companies that fail to reinvent themselves on a continual basis ultimately end up irrelevant (e.g., Hewlett-Packard, IBM, and Nokia).
- Apple’s one standout growth driver, the services business, could be under pressure over the long term as competitors are finding ways to circumvent the App Store (most recently Netflix), cutting out a key recurring revenue stream. More companies will follow suit. This weakness creates doubt in the long-term sustainability of above-average growth in the services segment.
- On the surface, AAPL shares appear to be trading at a reasonable valuation level. For example, the price/earnings ratio over the last twelve months for AAPL shares is 12x (versus ~14x for the S&P 500). Based on this difference, there are some who believe AAPL shares are “cheap” relative to the market. However, with earnings now trending lower from $11.90/share in 2018 down to potentially $10.90/share in 2019, a 12x P/E would mean that shares should trade at $130……instead of $142. However, similar to the recent experience of GE shares, a “cheap” stock can get even cheaper if the earnings are in a downward trend.
All of the above is to say that we see risk in shares of AAPL at the current share price level, and we see better opportunities in other stocks. However, being value investors, should shares in AAPL get overly cheap for some reason, we’d likely revisit the investment opportunity.
Investment Process Guardrails
As part of our effort to be a prudent investment management organization, we have processes in place that are designed to help our investment team identify and account for cognitive biases. Recent work in the field of behavioral finance (spearheaded by economist Richard Thaler) have identified a number of mental shortcuts (a.k.a., cognitive biases) that prevent optimal investment decision-making. In the case of AAPL, I’ve had the opportunity to speak with many clients and outside investment managers about the company and its prospects over the years. In those conversations, I’ve discovered most investors in AAPL carried subtle biases in their thoughts about the stock. What follows is a sample of biases I’ve observed:
- Endowment Effect – the tendency for people to ascribe more value to things merely because they already own the asset or it has made them money in the past. I’ve heard this rationale the most over the years. The fact that AAPL has made someone money in the past has no predictive value for future returns.
- Confirmation Bias – focusing only on information that confirms existing preconceptions. This bias is a tough one to overcome, as company fundamentals typically change at a glacial pace. However, the market discounts those changes with far greater speed (witness the recent drop in AAPL shares). Most clients and peers with whom I’ve discussed AAPL stock have an iPhone. Does that mean the iPhone is the best smartphone product? Does it mean that people in India (the next potential market for growth) are likely to view the iPhone positively despite the high price point?
- Anchoring Effect – relying too much on the initial piece of information offered when making a decision. For those who purchased shares in AAPL five years ago, the reasons to purchase then (dominant smartphone maker, expanding margins, visionary leader) are dramatically different from those likely used today (low valuation, attractive dividend yield, all-star board, Berkshire Hathaway holding). My point here is that AAPL in 2019 is an entirely different investment idea from what it was in 2014.
One of the methods we utilize in the investment team to help mitigate the above biases is continuous monitoring of company fundamentals and relating those fundamentals to investor expectations. In this way, we are able to roughly gauge the sentiment in the company’s share price and assess whether there may be exuberant sentiment (e.g., Tilray, Nvidia) or undue pessimism (e.g., International Paper, Target) priced into shares.
In all, AAPL has been a stock that (1) is loved by many, (2) made many people a lot of money over the last 10 years, and (3) recently became the largest company on the planet. Yet, recent price performance in companies like AAPL (or even GE, IBM and Sears) should help reinforce the idea that there is no such thing as a buy-it-and-forget-it stock. In the current equity environment, price movement alone isn’t providing much information. Rather, an understanding of a company’s fundamentals helps relate price movement to changes in intrinsic value. Using this understanding, we anticipate there will be many opportunities in the coming years to purchase stocks for less than their intrinsic value.
 According to industry data, smartphone unit sales peaked in 2016, declining -0.3% in 2017 and -0.8% in 2018 (est).
 An interesting corollary to the leadership handoff at AAPL from Steve Jobs to Tim Cook is when Louis Gerstner, Jr., handed over the CEO job at IBM to Samuel J. Palmisano.
Todd Jones, MBA, CAIA®
Gratus Capital is an SEC-registered investment adviser. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of January 2019 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. Examples provided are based on current market conditions, and there is no guarantee that any applicable condition will remain in place. Portfolio holdings are subject to change at any time and may differ materially in the future from case studies presented. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.