Friday, February 22, 2013

Amazon, Apple, and Intrinsic Value - Part II

A follow up to this post.

Amazon, Apple, and Intrinsic Value

This Fortune article compared Apple (AAPL) and Amazon (AMZN) that also provides some useful charts.

Apple vs. Amazon: Bizzaro valuations revisited

In the prior post I wrote this about Apple:

...Apple may still have more than respectable future prospects but, whenever there's a huge jump in earnings capacity (and going from $ 4.8 billion to $ 41.7 billion in five years certainly qualifies), it creates real challenges for any investor who's trying to figure out the intrinsic value of a company.

It's usually not a good idea to assume that such a jump in earnings will be persistent or that the recent exceptional performance should be extrapolated then used as a basis for valuation.
(Benjamin Graham makes this point in Chapter 12 of The Intelligent Investor. It's often better to use a multiple year average especially when there's been a recent earnings spike.)

That doesn't mean Apple won't continue to do very well. It's just unwise to assume -- in order to avoid big misjudgments -- that the most recent peak somehow represents normalized earnings or, even worse, that the recent growth rates can be logically extrapolated forward.

This recent article is a useful exploration of Apple's valuation and why margins seem likely to decline over time. It makes the point, among other things, that Apple's net margins went from 1.1% in 2003 to 25% in 2012. Likely too low in 2003. Probably too high in 2012.

There are legit reasons to think those net margins won't go back to 1.1% anytime soon. Yet, it's a good example of the underlying challenge that exists when it comes to figuring out Apple's valuation. Margins may not go back to 1.1%, but the premium they can now charge seems unlikely to be maintained over the long haul.
(Though if anyone's going to be the exception to the rule it might just be Apple.)

These sort of concerns don't really exist in a business that's less reliant upon innovation.

So figuring out what levels of free cash flows should be considered proper basis for business valuation is a fairly daunting thing to do with Apple.

Still, between the $ 137 billion of net cash and investments on the balance sheet (an amount that makes up ~ 30% of Apple's current market value) and the free cash flow, a conservative basis for intrinsic value -- possibly within a wider than ideal range -- can be estimated. Consider this quote by Warren Buffett (one I've made reference to before):

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

Apple's recent accomplishments are impressive but I'll never really be a fan of the company as a long-term investment. They've done (and will probably continue doing) great things. It's just that they're not in the kind of business who's long run prospects are anywhere near predictable enough.

Figuring out what Apple's business will look like in ten years (or even less) seems difficult at best. That doesn't mean that the price can't get low enough to protect against even the worst outcomes.

"Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. 

Usually, the range must be so wide that no useful conclusion can be reached." - Warren Buffett in the 2000 Berkshire Hathaway Shareholder Letter

Later in that same letter Buffett adds that...

"Occasionally, though, even very conservative estimates about the future...reveal that the price quoted is startlingly low in relation to value."

What Amazon's done as a business is also impressive in many ways.

It's not hard to understand why so many think highly of the company and its future prospects.

Yet, I will always find figuring out the valuation of the company -- even within a very wide range -- to be incredibly difficult.*

Some investors are willing to pay a huge premiums for the possibility that significantly higher earnings power will someday materialize.

Some of those same investors will quickly lose interest once there is a lack of exciting growth prospects.
(Even if real persistent earnings is actually, after a long wait, now finally being demonstrated. So literally willing to pay more for the promise of future cash flow than when it actually materializes.)

Even if things work out, the premium paid on this can lead to far too little return for the risk that was taken. If things don't work out quite as expected, very real risk of permanent and substantial capital loss.

Reducing the risk of permanent capital loss is (or should be) a priority any investor. Paying so much for a promising but relatively unpredictable future would seem likely to bring unnecessary downside risks with it.

That doesn't mean I think Amazon isn't going to do very very well as a company (and I certainly won't be surprised by whatever the stock ends up doing in the near term or even longer).

Slow or no growth -- all else equal -- clearly is worth a lower price relative to normalized earnings capacity.** Good businesses are sometimes wise to endure near-term pain (what Tom Russo calls the "capacity to suffer"). Forgoing attractive near-term economics so that later what is a bigger opportunity can be captured often makes a whole lot of sense. It's just that, as an investor, paying a large premium for a promising but difficult to predict future that doesn't quite materialize can be expensive. The one or two big mistakes in an otherwise sound portfolio can seriously undermine long run compounding effects. Some underestimate this.

My preference is to pay a price where nothing great has to happen to get a good result. It seems, even if less exciting, a far more reasonable approach. If something great does happen it's just a bonus since the investor didn't pay a premium upfront in the first place.

So I find neither Amazon nor Apple all that attractive as long-term investments but the reasons couldn't be more different.

Even if Amazon pulls off "the dream" so to speak -- and I don't think it's wise to doubt that they will -- the question is whether the returns will be sufficient considering the risks. The problem is not the fundamental prospects, it's the price that was paid upfront.

Price regulates risk and, in fact, should represent a sufficient discount to value that it all but eliminate the risk of permanent capital loss (not temporary paper losses). Sometimes, the lower risk alternatives (and, yes, less exciting) can produce a similar or better result if the right price is paid.

Any investment that requires earnings to increase at an exceptional rate should at least produce exceptional returns.

When an investor pays a big upfront premium, the arithmetic doesn't usually allow that to happen (and, as always, I'm not talking about trading on price action here).

In fact, pay a big premium upfront and exceptional business performance will more likely produce merely a good investing result.

Good business performance, a fair investing result.

Fair performance, a disastrous result.

Of course, that doesn't mean it won't work out for some who own Amazon's stock and are in it for the long-term. It also doesn't mean Amazon won't be intrinsically worth an awful lot someday. It's just that avoiding permanent capital loss starts with always having a nice margin of safety. Something that comfortably protects the investor against the unexpected and unforeseen.

Judging Amazon's intrinsic value seems, at least to an extent, like a leap of faith. If, as an investor, intrinsic value (or the range of value) is difficult to judge, how can the margin of safety be known with any confidence?

As I said in the earlier post, I don't doubt that Amazon is likely being built for the long run into something quite valuable. Just how valuable and the timing is the difficult part.

Amazon seems likely to need an extended period of spectacular business performance for investors to get just a decent fundamental investing result (and they may just do that). Yet, as an investor, something as close to the opposite of that situation is preferable when it comes to managing investment risk. In other words, buy what will deliver attractive investing results for just decent business performance.

Relatively certain favorable returns beats those achieved at higher than necessary risk.

These two companies deserve to be admired for their own specific reasons. They just generally don't fit into my own comfort zone as long-term investments. Others, of course, may know better how to judge these two investments. As always, an investor should only own what's understandable to them and in a proportion consistent with conviction levels. That's necessarily an individual thing. An investor in marketable stocks generally shouldn't be buying or selling based upon what someone else thinks. At least that is my view. Having a justifiably high levels of conviction about what an asset is intrinsically worth is crucial (while unwarranted high levels of conviction is a disaster, of course). Well, it seems unlikely that an investor will have sufficient conviction without reaching their own conclusions after having done the necessary work. Without it, the investor won't be able to hang in there when price action inevitably, even if temporarily, goes the wrong way.

Now, I have been willing to own a very small amount of Apple's stock.

That's simply a reflection of where the stock once sold relative to the company's per share net cash, investments, and stream of free cash flow (even if the future offered a far wider range of outcomes than preferred). So the margin of safety could be reasonably judged.***

Margin of safety makes all the difference but that doesn't make Apple an attractive investment for the long haul in my book. Too much dependence on innovation. Too many well-financed and capable competitors. Too much technological and industry change.

Likely very good for civilization, but not necessarily the investor.

Adam

No position in AMZN; established a long position in AAPL at much lower than recent prices

Related posts:
Amazon, Apple, and Intrinsic Value
Negative Working-Capital Cycle
Amazon, Apple, and Margin of Safety
Amazing Amazon
Barron's on Bezos: Time to Reign in Amazon's CEO?
Amazon's Jeff Bezos On Inventing & Disrupting
Amazon Sells Kindle Fire Below Cost
Technology Stocks

* Ultimately, of course, when it comes to valuation it's the cash that will be generated over an extended period that matters. Near-term earnings may or may not be a good proxy for that. As I've explained previously here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. Amazon, of course, is less of a pure tech business than Apple but, at least to me, it still has difficult to predict prospects. Occasionally, certain tech stocks have sold at enough of a discount that owning a very limited number of shares made sense to me. 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. Otherwise, the future prospects of most tech stocks just aren't predictable enough for my money. So I'm not exactly trying to anticipate the next big thing in tech. The best businesses have durable economic characteristics. Tech stocks too often generally do not. Those with seemingly attractive economics today frequently prove to have far less attractive economics down the road.
** Buffett points out in the above quote from the 1992 letter that price relative to a snapshot of earnings or book value -- whether seemingly very high or low -- often reveals little about business value. (Though, it's worth noting, Buffett has said Berkshire's book value is a rough if quite understated way to gauge the company's intrinsic value.) Otherwise, sometimes what seems a low price against current earnings or book value won't turn out to be cheap at all. The opposite is, of course, also true. Price has to be considered against the expected magnitude and timing of a long run stream of cash, appropriately discounted. Sometimes those future cash flows are just too difficult to estimate. In those cases, it's best to avoid the investment no matter how compelling the story is or cheap it appears. Judging value based upon some simple snapshot measurement will often lead to very big and costly mistakes.
*** For speculators on price action it's a whole different ballgame, of course. A stock price can do just about anything in the near-term or even longer. No opinions on that sort of thing. With speculation, it's about trying to guess whether someone will be willing to pay a higher price (for a long position) at some point in the future. With investment, it's about, for the price paid, whether an asset can produce a satisfactory level of per share free cash flow considering the specific risks over the long haul. It's about whether the cash generated will produce a good result and protect against permanent loss of capital even with the most conservative projections. It's as Keynes once said: Speculation is "forecasting the psychology of the markets." Investment is "forecasting the prospective yield of [an] asset over its whole life."
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