Wednesday, June 1, 2011

Is Apple a Value Stock?

Like any stock, Apple (AAPL) has its own unique set of risks yet seems oddly inexpensive (despite how well the stock has done in recent years) considering the competitive position of its existing businesses, excellent economics, strong brand loyalty, and future prospects.

Below, in an excerpt from a recent interview in Barron's, Michael Lippert explains why he likes Apple's business and the stock.

Lippert is manager of the Baron Opportunities Fund (BIOPX), a fund that has outperformed 99% of its peers in the past decade.

Before we look at Apple though, for some context, let's quickly look at an entirely different type of investment.

Junk bonds.

In his latest memo Howard Marks, the Chairman of Oaktree Capital, says he received a letter in January 2004 from Warren Buffett. According to the memo here's what Buffett wrote:

"I've commented about junk bonds that last year's weeds have become this year's flowers. I liked them better when they were weeds."

Warren's phrasings are always the clearest, catchiest and most on-target, and I thought this Buffettism captured the thought particularly well. Thus for Oaktree's 2004 investor conference we used the phrase 'Yesterday's Weeds...Today's Flowers' as the title of a slide depicting the snapback of high yield bonds. It showed the 45% average yield at which a sample of ten bonds could have been bought during the Enron-plus-telecom meltdown of 2002 and the 6% average yield at which they could have been sold in 2003; on average, the yields had fallen by 87% in just thirteen months.

Now, keep in mind that the extreme valuations of junk bonds also occurred during the more recent financial crisis.

They became, once again, priced for armageddon. That didn't happen.

Now they seem priced for a permanently serene world. That won't happen either.

Often a crisis or euphoria is behind the strange pricing of an asset.

What's interesting is that Apple seems not at all expensive but just does not fit that model. There is neither crisis nor euphoria surrounding the stock.

I certainly get some of the reasons behind Cisco's (CSCO) and even Microsoft's (MSFT) low valuation.

Apple is much harder to explain.

Michael Lippert points out in this Barron's interview that Apple is selling for ~10 times earnings for this year and more like 7 times expected earnings for next year.

So why is Apple valued this way?

It may be for reasons, like the junk bonds above, that have little to do with fundamentals. Who knows. I'm sure there is a good thesis or two out there why it should be cheap. One of them no doubt involves Steve Jobs and his future at Apple.

If you buy an asset with an appropriate margin of safety you don't have to know. That's the good news. There is always a good thesis out there why something deserves to be extremely cheap (or expensive). It's only after the fact that everyone seems to realize the justification was clearly nonsense. So even if you don't know specifically why something has become mispriced, the important thing is to know when enough evidence has emerged that it is mispriced and take action.

Buy at a price that leaves room for the inevitable negative surprises.

It's not like evidence of this reality doesn't pop up fairly often. Market prices for extended periods of time often have little to do with the fundamentals for any given asset.

What's surprising about this situation is that Apple's price is not extreme on the high side. Apple seems the perfect candidate to be one of the many currently over-hyped and very overvalued stocks in the market today.

So, while as an investment Apple may have very different risks than a junk bond, the reason it may be at least a bit cheap is simple:

In the short-to-intermediate run markets often misprice assets.

If you wait for it to be crystal clear the opportunity is missed. I have no idea what Apple will be worth in five or ten years but, for my portfolio, there is enough margin of safety here and possible upside to warrant some limited exposure.*

So market prices frequently have little to do with the actual economic value of an asset. Assuming there must be a logical reason for every extreme valuations can lead to missed opportunities (doing more than a little homework goes a long way). 

In the end what will matter is long-term business performance. Sometimes a business will swim with the current, other times against it. The same goes for the stock.

The reality is variation in market prices reflect changes in those currents more so than changes in intrinsic business value. Best to ignore that noise. Instead, figure out what something is conservatively worth (and, at least roughly, how it is likely to increase in intrinsic worth over time) and have the patience and discipline to decisively buy at a nice discount.

There's high correlation between business performance and the stock price in the long-run but not so much in the short run.

Adam

Long position in MSFT and CSCO established near current prices. Long positions in AAPL established at lower prices.

Related post:
Technology Stocks

* As I've said before, there's just no technology business that I'm comfortable with as a long-term investment. Occasionally, certain tech stocks have sold at enough of a discount that it made me willing to own some shares. In other words, the price was cheap enough relative to the per share cash generation (and, in some cases, net cash on the balance sheet) that it provided a substantial margin of safety. Even then I'm only willing to slowly accumulate very limited amounts. They've always been and always will be, at most, very small positions. Most are involved in exciting, dynamic, and highly competitive industries. That's precisely what makes them unattractive long-term investments. It's just too difficult to guess what the economic moat of most tech stocks will look like in the long run.
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