Friday, May 3, 2013

Apple's Debt Offering: Investor Enthusiasm for Bonds Continues

Earlier this week, Apple (AAPL) sold the largest corporate non-financial bond deal in history.

Apple sold, in total, $ 17 billion in new corporate debt.

It wasn't just historically large, the cost of the funds themselves were historically low.

The huge decline in Treasury interest rates -- a key driver of corporate debt -- has led to some incredibly cheap funding for companies. Some that don't, in many ways, even seem to really need it in an operational sense but, if your stock happens to be cheap (or you'd like to refinance some expensive debt), quite an opportunity.*

The 10-year Treasury currently has a yield of ~1.75%. This compares to a little over 15x earnings for stocks in the S&P 500 according to these estimates. Of course, expressed as an earnings yield (inverse price  to earnings) that would be ~ 6.6%.

A quick summary of Apple's debt deal:

3-year variable: $ 1 billion at .33%
5 year variable: $ 2 billion at .53%
3 year fixed: $ 1.5 billion at .511%
5 year fixed: $ 5.0 billion at 1.076%
10 year fixed: $ 5.5 billion at 2.415%
30-year fixed: $ 3.0 billion at 3.883%
Total: $ 17.0 billion at a 1.85% blended rate**

Forbes: Apple Bond Summary

Let's step back a bit. This Wall Street Journal article points out that, according to Lipper (a unit of Thomson Reuters), a record $55 billion flowed into bond mutual funds and investment-grade bond ETFs over the first 17 weeks of 2013.

So there's plenty of demand these days with investors buying especially the higher quality corporate bonds undeterred by the rather low yields.

Well, as a comparison, consider this article written back in February of 2000. It points out how willing investors were to invest in aggressive, high-risk equity funds at a time when stock were quite expensive and, as it turned out, near their peak.

"...investors are gravitating toward--not running away from--high-growth, high-risk sectors thus far in 2000."

So there was plenty of demand for stock funds especially the riskiest variety:

"...Janus, Fidelity, Vanguard and Invesco, reported extremely strong flows in January, a month that saw much market volatility. Much of the money is going into technology, telecom, biotechnology and/or growth funds, company officials say.

In December, 'aggressive-growth' funds attracted $11.5 billion in net new money, whereas more conservative "growth-and-income" funds saw net redemptions of nearly $6 billion.

'That's just unheard of,' said Carl Wittnebert, director of research for the Santa Rosa, Calif.-based research firm 'The public has developed this wild appetite for risk.'

Meanwhile, investors have all but lost their appetite for bond funds, coming off a year in which rising interest rates hurt the principal value of many bond portfolios. Taxable bond funds saw outflows of $6.2 billion in December."

At that time, stocks were already expensive by any measure -- a number were selling at 30x, 40x, 50x earnings and much more -- and the 10-year Treasury was 6.6% (coincidentally, same as the S&P 500's earnings yield right now). So back then, it was pretty close (though not exactly) to the opposite of where we are today as far as valuations go. In the year 2000, investor enthusiasm for stocks was rather high and money was flowing into stock funds -- especially the riskiest variety -- when they were quite expensive.***
(Keep in mind that the riskier funds would likely have owned stocks selling for higher than average multiples of earnings -- if there was any earnings at all -- at that time.)

Now, the enthusiasm is for bonds and record levels of money is flowing into bond funds -- especially the seemingly safest variety. Instead of the "wild appetite for risk" that existed in 2000, many investors seem to have a "wild appetite for safety".

Or, at least, perceived safety. The problem is that safety might be mostly illusion.

I'm not suggesting stocks, in general, are cheap these days. To me, they are not generally cheap though there certainly are some not particularly expensive individual securities.

It's just that investors who are now pouring their money into bonds these days should be considering carefully whether today's yield really provides sufficient compensation considering the risks. Bonds may be perceived as generally safer than productive assets (i.e. businesses, partial ownership of businesses via marketable stocks, farms, real estate etc.) but the risk an investor is taking always comes down to the price one has to pay. I'm guessing how bonds have performed over the past several decades has only reinforced the perception of relative safety. I mean, yields going from where they were three or so decades ago to where they are now has been a tailwind to say the least. Who knows when that tailwind reverses in a meaningful way, but when it does it will not be pleasant. For bonds or currency-based investments more generally, I think Warren Buffett said it best in last year's letter:

"Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as "safe." In truth they are among the most dangerous of assets."

Buffett later added this:

"Right now bonds should come with a warning label."

What's sensible and low risk at one price is risky at another price. It is as Seth Klarman said in his 2010 annual letter:

"Risk is not inherent in an investment; it is always relative to the price paid."

The right time to buy or sell any asset is likely to rarely if ever obvious ahead of time.

The right price to pay for an asset may not be an easy thing to figure out but is, by comparison, at least doable with some work.

Those that try to get the timing and price right are making the job more difficult than it needs to be. When something becomes plainly expensive, avoid it. When something becomes plainly cheap, buy it. Do that consistently well and timing things right becomes far less relevant in the long run.

I'm not suggesting that the enthusiasm for bonds is the equivalent to the extreme enthusiasm for stocks in the late 1990s up until they peaked in 2000. Whether that's the case will likely only become broadly obvious at some point down the road.

Still, what does seem clear is that bonds provide little in the way of margin of safety these days and have lots of downside long-term bought near prevailing prices.

Some other items of note on the Apple bond offering:

- The bond offering was Apple's first in almost 20 years.

According to Reuters, the offering brought in than $50 billion in orders. So lots of demand to say the least.

- The company was able to borrow at nearly triple-A rates but not quite. Apple's debt is rated AA-plus by Standard & Poor's.

- Microsoft (MSFT), with its AAA debt rating, sold 10-year bonds at a yield of 2.413% last week; almost the exact same rate as Apple with its slightly lower debt rating.

- Apple sold the three year floating-rate bonds at 0.05 percentage points over the 3-month London interbank offered rate (LIBOR).

- Apple sold the five year floating-rate bonds at 0.25 percentage points over the 3-month LIBOR.

This borrowing will help, in part, fund a plan to return $100 billion to shareholders (dividends plus $ 60 billion in buybacks) by the end of 2015.

Apple has tons of cash, of course. More than enough to fund a buyback and pay the dividends they have in mind. The problem has been that much of it is overseas and not accessible without incurring taxes (if the funds were brought back to the United States). Raising cash in the bond market helps the company avoid that tax bill.

The 1.85% blended rate is less than Apple's ~ 2.7% current dividend yield (and much less than the company's earnings yield, of course), so each share repurchased will eliminate more in dividend payments than the borrowing cost of the funds themselves.

Keep in mind that interest is tax deductible, while dividends are not. So, with interest being tax deductible, the 1.85% blended after-tax cost to Apple will naturally be even less.

In any case, at least near current prices, the company comes out explicitly ahead when a share is repurchased (and will continue to as long as after-tax interest expense < dividend yield).

In the long run, as always, what matters to continuing long-term shareholders is whether shares can be repurchased comfortably below Apple's per share intrinsic value. Well, at least for me, Apple's per share intrinsic value isn't that easy judge even though its economic performance has been quite impressive to say the least in recent years.
(It would be more easy to judge value if recent performance could be considered reliably indicative of Apple's future economic prospects. When financial results improve as rapidly as they have for Apple in recent years, it's not a bad idea to at least have some healthy skepticism about it being sustainable. Ben 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 still do just fine, but their recent exceptional margins on substantial revenue increases may have to continue normalizing -- as they already have been to an extent. Someone else might be more convinced that the recent performance should be considered more indicative of future prospects, of course, and, who knows, they may just be right.)

Apple clearly has many fine, difficult to replicate, business attributes (and what they have accomplished in a short time is rather astonishing) but that doesn't change the fact that it competes in fast changing markets against well-financed, capable competitors (not unlike, if not quite equal to, Apple itself) and sometimes against fresh competitors (who occasionally seem to come out of nowhere); it doesn't change the fact that it depends heavily on rapid innovation; it doesn't change the reality that not always easy to predict technology shifts do occur. Businesses with durable competitive advantages often have characteristics, and are dealing with industry dynamics, that are mostly just the opposite of this.

This poses real challenges for someone trying to narrow down intrinsic value -- or really what has to necessarily be a range of values. That doesn't mean Apple isn't a great company but the focus here is on investment outcomes. It just means, for the investor, that the estimated range of values seems almost certainly rather wide for a company like Apple.

So, the tough part -- at least compared to some alternatives -- is figuring out how Apple's competitive advantages might change over time and, as a result, what its core economics will look like many years down the road.

Judging what Apple is likely worth isn't impossible but there is definitely a wider range of outcomes. To me, that means an obvious and more substantial than average margin of safety must exist if it is to be bought at all. Some have the legitimate concern margins will inevitably decline meaningfully; that even the somewhat reduced margins compared to the recent peak are unsustainable. If they turn out to be correct -- and they just may be at least in part -- what now seems cheap may turn out to be quite a bit less so or worse.

Apple has no doubt created a great brand around products and services that have earned the trust and loyalty of its many customers. For that reason, it seems impossible to not admire Apple as a company. Yet, the reality is that Apple is a highly dependent on innovation business (their own innovation and that of others) even if the company has many rather impressive qualities. So, as far as the investment process goes, that makes long run economic prospects harder to gauge.

It will never be a favorite investment of mine but the brand strength combined with the earned trust and loyalty of it's customers -- if not violated -- is, undeniably, real and valuable.

Having said that, it won't surprise me at all if Apple's business does very well. It's just that, as a long-term investment (not a speculative trade), the company can't be put in the same category as those with more plain to see long-term durable advantages.

Businesses that possess competitive advantages that are likely to persist for many years (if not decades) generally have a far more narrow range of attractive long-term economic outcomes.

Margin of safety still matters for the businesses with durable advantages but -- at the very least -- just a bit less.

I have no idea whether the more optimistic or pessimistic views of Apple's future prospects will turn out to be correct.

All I know is it's better to not be reliant on a favorable outcome to justify the price that is paid.

Instead, better to pay a price that's low enough to provide an attractive investment result even if nothing great happens with the business itself (and even accounts for some of the worst business outcomes).

There'll be no complaints if the business does surprisingly well.

Not complex, but the difficulty can arise out of the necessity for inaction -- sometimes for extended periods of time with the risk being not owning something sensible, or owning too little of something sensible -- until the right margin of safety emerges; it can arise out of the necessity to wait until there is an opportunity to buy only what's understood well; it can arise out of not knowing when to act decisively; it can arise out of thinking you understand something better than you actually do. It is balancing things like this that becomes the challenge. If it were just down to the numbers and a compelling "story" the investment process would be a whole lot easier.

"A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success." - Charlie Munger in Kiplinger's

It's the patience and discipline (to wait for the right price) followed by decisive action (when that price finally becomes available) and sticking to what you truly know well.
(Try to understand three hundred different businesses well, and the result will likely be understanding none of them well.)

It's less about brilliant insight, more about the right temperament and, of course, the ability to judge business economics well, and knowing what to pay for those economics.

This all depends on a realistic self-appraisal of individual limitations and strengths.

"A money manager with an IQ of 160 and thinks it's 180 will kill you," he said. "Going with a money manager with an IQ of 130 who thinks it's 125 could serve you well." - Charlie Munger in San Francisco Business Times

"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger's 1998 speech to the Foundation Financial Officers Group

Highly capable individuals with optimistic self-appraisals are more likely to get into trouble investing even if they happen to have all the other necessary characteristics and skills going for them.

It's knowing what you really know and avoiding the pitfalls of overconfidence.

Some will no doubt underestimate this.


Bloomberg: Apple Raises $ 17 billion in Record Corporate Bond Sale

Long positions in AAPL and MSFT established at much lower than recent prices

* These low cost funds should eventually lead to more acquisitions and maybe even some incremental investments (capital expenditures, new business ventures, etc.) once animal spirits return with greater force. Who knows when but, sooner or later, it generally comes back.

** With 3 month LIBOR at current levels for the variable portion.
*** It was not just tech stocks that were expensive, even if it was their valuations that were the most extreme. Coca-Cola (KO) and General Electric (GE) are just two examples of non-tech stocks that had extraordinarily high valuations.
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