Friday, September 27, 2013

Apple's Record-Breaking Launch

Apple (AAPL) sold nine million iPhone 5S and 5C smartphones over this last weekend topping the former first weekend record sales of five million for the iPhone 5.

Or did they?

Apple's 9 million weekend

Some are arguing that the numbers are inflated while others maintain that the nine million number is a sound one (and maybe even understated).

Apple analysts and the nine-million iPhone kerfuffle

The company also separately announced that revenue and gross margin would be near the high end of their previously provided range.

So, I guess, it'll take some time for the dust to settle on this. I'll happily leave that for others to sort out. Whether they sold a bit more or less than nine million that's an awful lot of business -- rather profitable I might add -- in one weekend.

Eventually Apple's cumulative product execution will matter massively, of course, but the company's intrinsic business value and how it may change certainly can't be figured out based on one product launch.
(Though this reality no doubt won't stop some from trying to make short-term bets on price action based upon perceived the success/failure of a particular launch. Nothing wrong with that, of course, but my interest in that sort of thing happens to be effectively zero.)

If the nine million turns out to be a reasonably good number then that's, give or take, more than $ 5 billion in just one weekend. This assumes something close to the $ 581 price per iPhone from the previous quarter roughly holds up.
(The unsubsidized/unlocked price is, of course, much higher than the suggested retail price with a two-year contract.

iPhone Price and Specs

The question is how many upgraded phones were purchased and the related product sales that might have occurred.

The 16GB iPhone 5S sells for $ 649. The 32GB and 64GB versions each sell incrementally for $ 100 more.

The 16GB iPhone 5C sells for $ 549 with the 32GB version selling for $ 100 more.

With that pricing in mind the $ 581 per iPhone assumption doesn't at all seem a stretch.

This is especially true considering that the 5S apparently outsold the 5C by more than 3x.

Consider that $ 5 billion plus sold in one weekend, if correct, in the context of Apple's sales history. For some perspective, Apple's sales across everything it was selling back in 2003 was $ 6.2 billion over the course of a full year.

So, during a product launch, they can now nearly sell in a bit more than a few days what roughly a decade ago would have taken all year.

Keep in mind that what they are selling has far more attractive margins -- at least for now -- than what they were selling a decade ago.

In fact, Apple was barely turning a profit back in 2003.

Who knows how well the newer smartphones will perform long-term, but whether they're sustaining price, attractive margins, and high returns on capital is far more important than unit volume.

As the negative reaction to the pricing for the 5C reveals, some don't necessarily agree with this premise.

The reaction is unsurprising but enlightening.

Shares of Apple slide, analysts cut targets in disappointment over iPhone 5c pricing

It's, in part, a belief that not so profitable growth early on will lead to big profits later; a belief that market share is king.

That is a strategy (and sometimes maybe even the right one).

So is making sure your product earns then maintains a premium position in the market. It is not easy getting price back once you've given it up. It's not easy to get back a premium image once you've sold something for cheap.

I'm not suggesting I know the correct way to go for Apple. I certainly do not. I'm suggesting it's not a straightforward call and they may just be doing the right thing. Time will tell. Those who confidently assert Apple needs a lower priced iPhone should probably at least be a little less confident.

It's not easy to maintain price in the business they are in. I'm more than a little bit amazed they can do it. I'll be surprised if they pull it off longer term.

Still, if anyone can it's probably going to be Apple.

Market share matters to an extent, of course, but so does profit share.

Apple takes 53% of smartphone profits, Samsung at 50%, remainder lose money

This article has a useful chart on how mobile phone operating profits have changed in the past five years or so through the end of 2012.

Apple has roughly half the profit share with just 13.5% market share. Half the profit share might be impressive, but that is down compared to the previous quarter and where it was in 2011 and 2012.

As I've said on prior occasions, I'll just never be very comfortable with tech stocks as long-term investments.*

Occasionally they become interesting in small doses if they're selling at a very large discount to my own conservative estimate of per share intrinsic value.**

Essentially it has to be a price where nothing particularly great has to happen to get a good result.

Prices like that don't emerge everyday but they do occasionally emerge.

It's patience and discipline followed by decisive action.

While I admire the way a business like Apple can change the world, as an investor I'm just no fan of businesses that reside in such a fast-changing and competitive industry landscape -- a place where the core economics can change quickly. When, over roughly just five years, the distribution of industry profits can change as dramatically as the article and chart above shows, it should make no investor comfortable about the next five or ten years. The best businesses reside in industries they dominate with no such profitability dynamics.

Some businesses that change the world end up being wise investments; some do not.

I mean, what's been better for the world, airlines or tobacco companies?

Yet just compare their long-term returns.

The price that's paid (margin of safety) and whether durable advantages exist (to protect attractive core economics) should mostly determine long-term investment outcomes. An investor has to judge future prospects and value well then pay a smart price considering the risks.

I'm not suggesting that product announcements are irrelevant. I'm suggesting that the next product announcement -- even a relatively important one -- should matter a whole lot less than the bigger picture. Some may find the obsessive hyperactive focus on near-term events in combination with betting on how the stock might react to be an entertaining exercise.

Well, hopefully it is entertaining because for most, if not all, it seems unlikely to produce great results over the long haul.


Long position in AAPL established at much lower than recent prices

* Though I'm not suggesting all tech businesses are somehow poor long-term investments or are created equal. It's just that technology businesses tend to have a wider range of outcomes. Some of those outcomes will be phenomenal even if often difficult to reliably predict beforehand. Some are no doubt very good at judging the long-term prospects of tech businesses while others might be overestimating their ability in this regard. I try to avoid making the latter mistake whenever possible.
** Of course, my estimate of value -- especially with a tech stock that tends to have a wider range of outcomes -- could easily be wrong. That's where the larger margin of safety requirement comes in. Sometimes the future is so difficult to figure out that no margin of safety is sufficient. Eventually the investment process needs what is effectively a go/no go gauge.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, September 20, 2013

Deadly Sins of Investing - Part II

A follow up to this post.

In that prior post, I covered the first three of what this Wall Street Journal article calls The Seven Deadly Sins of Investing.

Deadly Sins of Investing

Here's the final four:

4 Wanting to Join the Club

The Wall Street Journal article relates this investing "sin" to envy.

Well, here's how Warren Buffett looks at envy:

"Being envious of someone else is pretty stupid. Wishing them badly, or wishing you did as well as they did -- all it does is ruin your day. Doesn't hurt them at all, and there's zero upside to it."

He adds that, if anything, better to pick a sin "like lust or gluttony. That way at least you'll have something to remember the weekend for."

Not surprisingly, Charlie Munger shares a similar view.*

Some might be drawn to an investment because it feel exclusive. Well, envy is at the very least a contributor to this. Access to an exclusive club that, at least in perception, is making lots of money apparently draws in more than a few investors.

That, in part, might help explain hedge fund industry growth over the past twenty five years or so -- from $ 40 billion in the late 1980s to apparently something like $ 2.3 trillion these days -- and maybe even some of the recent Ponzi schemes.

Yet, considering the amount of evidence that hedge funds overall haven't performed all that well, it becomes just a bit harder to understand why they'd be considered such a prestigious place to put money. From this Bloomberg Businessweek article:

"As their returns have fallen, the biggest hedge funds have started to seem more like glorified mutual funds for the wealthy, and those rich folks might start to take a harder look at whether they're getting their money's worth."

Of course, there are a number of fine professional money managers. It's just not always easy to tell beforehand who's actually doing a great job of managing the risk of permanent capital loss relative to the returns being generated.

Also, there's also just no way around the typically high expenses among hedge funds.

What matters is the likelihood of at least satisfactory returns relative to the risks of permanent capital loss.

What matters is whether the investment is understandable to a particular investor.

Prestige and exclusivity should never enter the equation.

Envy just leads to trouble.

Sir Isaac Newton made what was then a good chunk of money, and rather quickly, early on during the South Sea Bubble. He bought early, sold early, and earned quite a nice amount. Well, in case some might think IQ is the most important factor in investing, Sir Isaac ended up later losing what he'd made early on plus not a small chunk of his fortune basically because he couldn't stand to see his friends getting rich quickly while he was not.**

The end result? Well, he put a whole lot more money in -- including some that was borrowed -- during what turned out to be the later stages of that bubble and got financially crushed when the bubble burst.

Isaac Newton, The Investor

Chart: Isaac Newton's Nightmare

As the Wall Street Journal article points out, this tendency also applies to things like exuberance toward getting in on the next hot initial public offering.

Related: Hedge Funds Severely Underperforming This Year

5 Failing to Admit Failure

This partly comes down to loss aversion or what is an innate preference for the avoidance of losses compared to gains. Psychologically, studies seem to suggest that losses are twice as forcefully felt as the equivalent gains. Loss aversion is just one of many cognitive biases that can have an adverse impact on investment results. Awareness of this particular bias (and others) then understanding how to manage the embedded wiring can lead to more rational investment decision-making.

Unchecked, it can cause an investor to hold onto something that was a bad decision that should be sold. They hold in an attempt to get their money back to avoid the pain of admitting mistakes and taking on the associated losses.
(Not temporary drops in price where one is justifiably confident in estimated value. Instead, it's when value was misjudged or too high a price was paid.)

On CNBC yesterdayMeryl Witmer (a Berkshire Hathaway board member) talked about what some successful investors she knows had in common (including Warren Buffett, of course). Among other things Witmer highlights confidence, humility, optimism, the ability to change one's own mind when new information comes in and, yes, to admit when mistakes have been made.

"I think they're all confident but they're humble. And I think they're humble because they're very logical. so, you know, they -- they're confident, and they look at the facts, they have opinions, but when they're presented with new information, they're willing to change their minds, which, another way you could put that is they're willing to say they're wrong. And that's a pretty rare trait amongst people. A lot of people they stake out a claim, they'll defend it until they fail." - Meryl Witmer

Rigidity and loss aversion combined turn small mistakes into big ones.

6 Living For Today

Putting off savings an investment for even a relatively small amount of time -- in the context of long-term investing that is -- can be very costly. A one time $ 10,000 investment today that ends up returning 7% per year will be worth a bit over $ 200,000 in 45 years. That same amount of investment invested ten years later with otherwise the same annual return will grow to more like just over $ 100,000. So the same amount invested but half as much at retirement. Creating a sound approach early on that works for an investor's necessarily unique circumstances makes a huge difference. Sooner than later pays off in not small ways.

"Remember that money is of the prolific, generating nature. Money can beget money, and its offspring can beget more, and so on. Five shillings turned is six; turned again it is seven and threepence, and so on till it becomes a hundred pounds." - Benjamin Franklin in Advice to a Young Tradesman

The magic of compounding. For an investment portfolio, there's just no more powerful tailwind longer term. What's difficult in the short run becomes incredibly less so when this force is put to work.

7 Following The Herd

The tendency to do what the crowd is doing contributed to what happened in the tech bubble and, on the other end of the spectrum, during the height of the financial crisis. Buying, en masse, when stocks were expensive in the late 1990s; selling, en masse, when stocks were cheap during the scariest days of the financial crisis.

As Warren Buffett once said: "You can't buy what's popular and do well."

Buffett certainly has some other quotes along these lines.
Awareness of the above investing "sins" along with the right response can counteract the damage they tend to inflict on investment portfolios. This may take some work but is well worth the trouble. Taken seriously, it might even go a long way toward avoiding disastrous investment results or, at least, not missing the chance to benefit from the magic of compounding.

"Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It's not a competency if you don't know the edge of it. And Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer

The above hardly represents a comprehensive list but at least some of these pitfalls aren't a bad place to start if one would like to eliminate the "standard stupidities".

So what's in these two posts isn't exhaustive by any means.

Instead, in the context of attempting to achieve at least satisfactory long-term results, it's more of a simple framework to cover some of what tends to get in the way of meeting investment objectives.


* During this CNBC interview back in 2010, Becky Quick asked Warren Buffett about envy. First, something that Charlie Munger had said in a separate interview was played:

MUNGER: Envy is a much more serious mischief-maker than greed.

BECKY: How so?

MUNGER: There's something in human nature that just can't stand even if you are making $5 million a year, that dumb bastard down the street is making 7.

BECKY: So those were his comments. He thinks envy is the biggest problem, not greed.

BUFFETT: Yeah. We saw a lot of that at Solomon. I mean you'd say how could a guy that's making $3 or $4 million a year be unhappy? And he's not unhappy until he finds the guy next to him who he thinks he's smarter than making a few dollars more. And as I always said, envy seems to me the silliest of the seven deadly sins. The other guy doesn't feel it. You just feel worse. You are sitting there with your stomach churning because you are envious. It doesn't make a lot sense.

I have always said, you know, if you are going to pick some sins from the seven deadly sins, go with gluttony and lust and you can have a hell of a weekend.

** Sir Isaac apparently lost what would be roughly $ 4 million to $ 5 million in current terms or practically all (if not quite all) of his stake in the South Sea Company. While the losses he suffered from the South Sea Company was enormous compared to his total wealth, he apparently still did not end up poor by any means. So the investment in South Sea Company itself was, give or take, basically wiped out (something like roughly 90% of his stake) but did not destroy Newton's entire fortune.

That's my understanding of what happened but whether he lost a bit more or less specifically isn't necessarily of the greatest importance. It's just a good lesson in (and example of) how human nature can get the best of a very smart man.

Newton should have known better -- the basic arithmetic needed to figure out the extreme valuation wasn't hard at all compared to the complex mathematics (calculus) he at least helped to invent -- but envy and other aspects of his nature apparently led to a huge misjudgment.

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, September 13, 2013

Dow Jones Adjusts Roster

On Tuesday, it was announced that some roster changes would occur among the 30 components that make up the Dow Jones Industrial Average (DJIA).

What's in:
Goldman Sachs (GS)
Nike (NKE)
Visa (V)

What's out:
Alcoa (AA)
Hewlett-Packard (HPQ)
Bank of America (BAC)

The changes become effective on September 23rd.

This Barron's article explains why the recent changes to the widely known index might be ill-advised.

It's not difficult to argue that, even before these changes, the index had a more than somewhat bizarre weighting for its components.

Well, the recent changes certainly haven't come near to solving that particular fundamental problem.

The Barron's article points out the following:

- Five stocks will now make up roughly 33% of the index.

- Four stocks will now make up less than 5% of the index due to their relatively lower stock prices.

Now, consider that the combined market value of the five stocks is ~ $ 720 billion, while the combined market value of the four stocks is ~ $ 670 billion.

So maybe not quite an equal combined value, but close enough that the 33% versus the less than 5% weighting plainly makes little sense.

In fact, those four stocks that make up less than 5% of the DJIA have nearly 9x the combined market value relative to Goldman Sachs alone.

Yet they'll have less influence on the DJIA than the investment bank.

At first glance (and, well, even a second one) some rather tortured logic appears required to explain why such a weighting discrepancy should exist in a closely-watched benchmark.

This all comes down to the DJIA being a price-weighted index instead of a capitalization-weighted index.

The index has each of its 30 components weighted by their stock price.

So it is a bit of a strange index.

At current prices, IBM (IBM) has the largest influence on the index (followed by Visa then Goldman).

Microsoft (MSFT), with more than 3x the market value compared to Goldman, will have roughly one-fifth the influence due to the price weighting.
(Goldman's shares price is roughly $ 163; Microsoft's is closer to $ 33.)

The list of quirks like this related to the weighting by price goes on...

Visa and Nike are fine businesses, and certainly seem to be reasonable additions, though it's worth mentioning they seem not at all cheap.

Both companies sell at P/E ratios comfortably north of 20x.

Goldman, on the other hand, seems an imperfect choice considering alternatives. It's not a traditional bank that mostly makes its money from lending and related services. Instead, it is primarily involved in trading and related activities.

That kind of activity certainly has its place in the world but hardly makes Goldman the ideal candidate.

To me, there are other public companies that provide more broad-based insight into the U.S. economy.

The fact that Goldman will have an outsized impact on the index because of its stock price only makes the situation worse.

The removal of Alcoa seems a vast improvement and long overdue. Its low stock price has meant its influence has been small. There are, and have been, many superior blue chip companies out there to take its place.

With J.P. Morgan Chase (JPM) already in the index, it's not hard to understand the removal of Bank of America.

Hewlett-Packard has had its fair share of difficulties but, with several big cap tech companies already in the index, it also seems sort of redundant.

Of course, HP is selling for an extremely low multiple and at least so far, despite the difficulties, has continued generating lots of free cash flow. On a multiple of earnings basis, both Visa and Nike would need to roughly triple their earnings before they catch up to what HP is already earning now.
(And/or HP earnings could shrink, of course.)

So Visa and Nike have a much greater index weighting with much less earning power. I can understand a growth argument here, but that's a whole lot of growth just to catch up earnings-wise.
(Or, again, some kind of collapse in earnings for HP.)

The bottom line is that the stocks being removed have an average price of $ 15/share while those being added are more like $ 140/share. This should be irrelevant but, due the price weighting, it is not.

The Barron's article argues that Berkshire Hathaway (BRKb) would make a logical addition since it has broad exposure to many aspects of the U.S. economy.

Hard to disagree with that.

It would need to be the Berkshire Class B shares of common stock, of course. At roughly $ 170,000 per share, the Class A shares would totally dominate the price-weighted index.

Economically, the Class B common shares are equal to 1/1,500th of the Class A common shares.* So, at more like $ 113/share, they'd work just fine.

DJIA remains quite an idiosyncratic index yet, for many, it remains the proxy for overall stock performance and the U.S. economy more generally.

Despite its oddball weighting system, for better or worse, it's still a widely followed index even if less so for Wall Street these days.

Here's one way to gauge this. Apparently, something like $ 30 to 35 billion is indexed to the DJIA while approximately $ 1.6 trillion is indexed to the S&P 500.

So only 2 percent or so as much in funds is indexed to the DJIA versus the S&P 500.



* Though the Berkshire Class B shares have only 1/10,000th of the voting rights compared to the Class A shares.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, September 5, 2013

Deadly Sins Of Investing

This Wall Street Journal article, The Seven Deadly Sins of Investing, covers some things that tend to get investors into trouble; things that lead to reduced returns, or worse, maybe even disastrous results.

Here's a quick summary of the first three "Deadly Sins":

1 Chasing Recent Performance

"People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them." - Warren Buffett in Fortune, December 2001

Chasing what has done well in the recent past just isn't likely to be a path to riches. During the tech bubble many market participants couldn't get enough of the high flyers -- stocks that went from already very overvalued to valuation extremes rarely seen -- while many bonds and other much less exciting marketable securities were rather more reasonably valued if not cheap.
(At least by comparison cheap if not absolutely cheap.)

"Recency bias" can be very expensive for investors.

That crazy time in the stock market wasn't solely caused by recency bias, of course, but the tendency played at least a supporting role.

2 Being Overconfident

It's easy to mistakenly believe more is known about something than is actually the case; to think that what will happen can be reliably predicted when, in reality, there is a rather wide range difficult to gauge future outcomes.

Outcomes that few if anybody can predict with consistent success.
(Though, no doubt, someone in the prediction business who correctly -- even if mostly through random good luck, less via skill -- predicts an outcome they will heavily tout the accomplishment for marketing purposes.)

"The illusion that we understand the past fosters overconfidence in our ability to predict the future." - Daniel Kahneman in his book Thinking, Fast and Slow

In any case, for investors, thinking that future business prospects can be understood to a greater extent than is possible is no small pitfall.

As Warren Buffett has previously explained:

"If a business is complex or subject to constant change, we're not smart enough to predict future cash flows."

Buffett goes on to say that the best way to combat this reality is to 1) own simple, understandable (to oneself...that's necessarily unique to each investor), and stable businesses while 2) always buying with a margin of safety. An acute awareness of limits doesn't hurt. What matters is not how much the investor knows; it's rather how well they understand what they do not know.

That might make sense for someone who rightly concludes they can pick individual stocks. John Bogle would more than suggest too many kid themselves in this regard. 

Hard to argue with that.

Related: Fighting Investors' Greatest Enemy: Overconfidence

3 Overlooking Costs

Frictional costs of all kinds, if minimized, play a huge role in achieving satisfactory or better long-term returns.

As John Bogle said in this Frontline report earlier this year:

"What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It's a mathematical fact. There's no getting around it. The fact that we don't look at it, too bad for us." - John Bogle

Bogle: High Investment Costs Destroy 'Magic Of Compounding Returns'

2.5% in annual frictional costs means that way too much of investment returns does not go to who is putting the capital at risk. A large proportion of the long-term compounded returns is going to someone who isn't exposed to the risk of permanent capital loss.

Wait, isn't 2.5% too high? Mutual funds usually charge a whole lot less than that, right?

Well, explicitly yes, but...

According to John Bogle, if you include all the costs -- some explicitly visible, some less so -- it's more like 2.5% or so.*

Here's what Bogle had to say in this not at all recent but still very relevant PBS interview:

"...the financial system -- the mutual fund system in this case -- will take about two and a half percentage points out of that return, so you will have a gross return of 8 percent, a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000. One hundred ten thousand dollars goes to the financial system and $30,000 to you, the investor. Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return, and you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed."

So what does Bogle say to those that think they can "beat the averages"?

"I say, don't kid yourself, pal."

He also said the following in this Forbes interview:

"I look at [the] investment system as being deeply troubled. Our system costs too much and does not provide enough value. The more you pay, the less you get net. If the market gives 8% return and it costs 2.5%, you get 5.5%. That's what is called 'the relentless rules of humble arithmetic.' There is too much cost in the system and not enough value.

There is too much speculation and not enough investment."

Absolutely true. Still, whether this is well enough understood or not, it seems likely that way too many investors will continue to incur these huge costs.

Unfortunate, but it's not like there isn't convenient ways to not incur these costs.

Three down, four to go.

More in a follow up.


Deadly Sins of Investing - Part II

* Anywhere from 2% to 2.5% has been used by John Bogle at various times from what I've read. Either way, it comes out to quite a material amount of money over the long haul.
This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.