Apple – A History Lesson in the Making

I have been following Apple for quite a while now, and its trading history for the past year reflects the fickle sentiments of the market.

There was little doubt that under Steve Jobs, Apple was a fantastic company: a poster child of innovation, brilliance and cutting edge technology, combined with incredible returns on capital and a solid balance sheet to boot. I recommend reading Steve Jobs by Walter Isaacson to see the incredible amount of influence Jobs had on the corporate culture of Apple.

2012 was a challenging year for Apple. The emergence of Samsung as a dominant player in the Smartphone industry and the bumbling of key releases such as iOS 6 and the maps fiasco were just some of the challenges it faced. For me, the transition in leadership was the most pivotal.

Apple is unique in many ways: it enjoys an unparallel following, not only by its customers, but by those that purchase its stock. Following on from forum chatter and reports from industry analysts, it’s not hard to deduce that Apple has some of the most ardent supporters in the industry.

For me, the decision to not invest in Apple was quite simple. I think that Apple is a brilliant company. My family owns a number of devices: the iPhone, various renditions of the iPad, and I personally understand Apple’s appeal. It has an unparalleled track record at allocating capital and for persistent growth, despite operating in a highly competitive and notoriously unstable industry.

What worked against it as an investment were two variables: valuation and the sentiment surrounding the company. Around this time last year, the projections of Apple’s growth were absurd in my opinion, with rumors and news stories flying around about whether Apple was going to release the next version of the iPhone, the iPad mini etc. Furthermore, Apple’s touching a market capitalization of $500 billion was another red flag to me.

Jim Rogers once opined that very few people make money by buying at historical highs. While this alone is not a conclusive factor, it does weigh heavily. Logically it is much harder for a company to go from $500 billion to $1 trillion than it is for a company to grow from $1 billion to a $100 billion. At some point in time, you run out of customers to sell to and your economies of scale disappear. Whether Apple had hit this point is up for debate, but the probability of this certainly weighed against the company.

Finally, the growth projections that were laid out were in my view highly dubious. I have a very low opinion of projections into the future considering that analysts do not even know what products are definitely going to be released. My worry, as with all growth stories, is what happens with companies who fail to meet growth projections. No company has ever consistently met projections and for that very reason, history is littered with businesses that failed as opposed to those that have succeeded. The odds are just heavily skewed against your favor if you choose to invest with the tide.

Fast forward to today, the sentiment in Apple has swung to the other side. Analysts are no longer as bullish as they once were with margins being squeezed. And yet it is in this that to a contrarian investor such as me the greatest opportunity lies. While I am not longing to invest in Apple at the point of writing, it certainly is far more attractive at $450 than at $700, and I will certainly be watching closely as events further unfold.

 

Opportunities in Secondary or Little-Know Issues

This post is based on Chapter 50 of the Sixth Edition of Security Analysis – ‘Discrepancies between Price & Value’. It’s an invaluable chapter that provides a systematic method for investors to seek investment opportunities in the market, something that is not covered extensively in The Intelligent Investor.

Most financial analysts and investors expend the greater part of their time and effort on determining the future prospects of selected companies; that much is a given. What most people fail to note is that Graham’s method was different. His focus was on the previous performance record of the business itself, and he placed little emphasis on attempting to predict the future performance of the selected business. Although this distinction may seem subtle, it carries significant repercussions for the way an investor should shape his research process.

Although Buffett and Graham shared a common way of thinking, the method by which each investor implemented his strategy was poles apart, as is night and day. Whilst Graham was content to focus his efforts on finding statistically cheap companies that had a high probability of generating a return greater than the market averages, Buffett concentrated his research on finding businesses with sustainable competitive advantages since he was buying into the future cash flow that the business would generate.

There is no “right” method per-se; each investor has to contend with the strengths and weaknesses of each approach. For the purpose of this discussion, I will be focusing on what Graham refers to as “secondary issues” as this is the key area of my investment research.

During normal markets, where prices are neither too high nor too low, there are more often than not a great number of “secondary issues” i.e. small-to-mid capitalization companies which possess:

1) High current and average earnings relative to market price

2) Reasonable satisfactory exhibit of earnings, selling at a low price relative to their net current asset value (NCAV) whereby NCAV is defined as Current Assets – Total Liabilities

Indeed Graham had such success with (2) that he made the systematic buying and selling of businesses vending below their NCAV his main priority.

The benefit of investing in these issues is that they are often overlooked and ignored by most institutional and retail investors. One must realize that institutional investors by sheer virtue of their size, can only invest in a small number of businesses listed. It would not be cost-effective or practical for them to build up stakes in smaller capitalization companies. Furthermore, with such little attention focused on them, many of these companies are often mispriced, therefore providing ample opportunity for exploitation by astute investors.

In a nutshell, you can be sure that the majority of investors will expend the best part of their effort attempting to locate the next Apple or Microsoft by means of predicting the company’s future prospects. These investors will then try to purchase company shares at unattractive valuations in the process.

Those who choose to invest by making a commitment to a diversified group of “bargain issues” with only moderate prospects are few indeed. However, my own personal view is that such a technique has provided investors with more than a satisfactory return since its inception and I have thus made it the foundation of my own work.

I highly recommend my readers to pick up a copy of Security Analysis to enjoy a fuller discussion of the points made by Graham & Dodd.

Further Reading:

A Test of Ben Graham’s Stock Selection Criteria by Henry R. Oppenheimer

Benjamin Graham – Wiley

Value Investing: Tools and Techniques for Intelligent Investment by James Montier [Book]

 

Tay Fund Semi-Annual Letter

Our macro thesis for investing in financial institutions was laid out earlier on in the following posts:

Tea with a macro-investor, thoughts on the financial sector

Tay Fund Commentary 2011

, and more specifically, our investment thesis for Bank of America,

The Compelling Case for Bank of America – Research Report

I feel somewhat vindicated that our scenario has played out as it has been thus far. However, let us not get too far ahead of ourselves as the recent run-up in banks has in large been due to

(1) the apparent orderly restructuring of Greek debt,
(2) the success hence far of the ECB’s LTRO refinancing operation, and its consequent effect of driving down the yields of sovereign debt,
(3) the latest results of the Federal Reserve’s bank stress test.
 

Indeed, it is this slew of good news that has led to a dramatic advance of the major indices since its October 2011 low, to achieving new highs in both the S & P 500 (1400 points), and the DJIA (13,000 points) not seen in years. Whether investor optimism is misplaced remains open to question. I however, continue to ignore economic forecasts as part of my investment framework, and have little faith but much distrust in the predictions of those who proclaim to know the future.

What I feel that investors should take heed of is the tendency of the markets to swing from a state to unwarranted pessimism, to one of unjustified optimism, and the short time frame in which it occurs. There are few certainties that exist in the market. However, the inclination of the masses to swing from extreme states of emotion is one that existed for centuries,  and is certainly in my view, one that can be counted upon reliably to repeat itself in the future, lest human nature changes (highly improbable).

With the markets assuming a “risk-on” position, it is perhaps prudent to take a moment to reflect whether the situation has improved to such an extent to justify such a dramatic increase in price levels. Unemployment has been slowly edging downwards, the housing market in the US is showing some signs of recovery after what was mostly certainly a depression (just the property market and its associated industries), and the European Union appears outwardly at any rate, to be getting its act together. However, on a note of caution, we are not out of the woods yet and there remains many headwinds that can derail the recovery.

My own personal view is that high quality equities in the US are priced at reasonable levels to give a satisfactory, if not unspectacular rate of return in the coming years. However, the recent run up in prices of financial institutions have made them far less attractive than they were 6 months ago. In the long run, I expect them to outpace the average return of the market. However, investors should bear in mind that  returns will be volatile, and further irrational advances in prices will skew the risk/reward ratio against the favor of the investor. If that happens sooner than later, will take appropriate steps to close our positions.

What I find more disconcerting are the price levels of lower quality companies, and more specifically, recent stock offerings of social media companies which trade in great multiples of what little earnings they generate. Paying for the promise of future earnings, especially one that is projected to grow generously is reminisce of the dot – com bubble. This investment strategy has worked out poorly over the years for the vast majority of the public, which has shown itself inclined to enter the market in droves at the very worst possible of times.

I would caution investors that investing in such issues would in no way qualify as an investment operation by Graham’s definition – “An investment operation is one which, upon thorough analysis promises safety of principal, and an adequate return.”

Admittedly, areas such as real estate, commodities such as gold and silver and common stock offerings are not my area of expertise. All I can say is “Be sure it’s yours before you go into it.”

I would like to end the letter cautiously optimistic. By a conservative standard, the S & P 500 is moderately valued. However, it’s encouraging to see that high quality companies paying a reasonable dividend yield can be purchased at some of their lowest price/earnings ratio in years, providing the chance of reasonable return over the next decade.

On the same thread of thought, I would caution investors against locking in their capital in long term bonds at record low rates. Although there may appear to exist a safety of principal, such investments offer little protection against inflation which I suspect that many people are underestimating. This will most certainly lead to a substantial loss in purchasing power over a protracted period of time. Ultimately, I do not believe that investors are being compensated adequately for the risk that they are tasked with assuming.

What Should You Do With Your Money?

Since the blog’s inception in December in 2010, it has garnered over 15,000 views – something which I am both amazed and humbled at. Looking back, it has been an exhilarating journey of refining my mental models that I use to approach investing. Although the basics of what I do is still grounded firmly in the work of Graham and Dodd’s The Intelligent Investor & Security Analysis, experience has allowed me to refine their methodology to form my own investing style. The fact that The Intelligent Investor, which was published in 1949, is still relevant today is testament to the timelessness of his work. I recommend everyone who is interested in investing to read it from cover to cover as many times as possible (I own two copies of the book myself).

One of the things that I noticed over the years is that the average investor is poorly equipped in dealing with the barrage of financial choices with regards to what they should do with their money. The problem that plagues investors now is not a lack of information, but an overwhelming barrage of senseless and useless disinformation. I have increasingly come to the view that the average investor should not invest in common stocks. The average investor simply does not have the time nor the interest to engage in security analysis in a diligent and disciplined manner whatsoever. Speculation is not investing, and unless you are genuinely interested in it, the chances that you are going to outdo the market are slim at best. You should also give other speculative products, such as day trading and leveraged ETFs (or worst, double leveraged ETFs!!!),  which masquerade as investing a wide berth. Chances are if it’s too good to be true, it probably isn’t.

My views on investing in other assets such as commodities are property are best reflected in a letter written by Warren Buffett. You can check it out here.

http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/

Before I go onto what I think the average investor should do, I like to bring up a discussion point that I think many people miss out (it’s covered in great detail in the link above too). The phrase “Cash Is King” has been taken widely out of context by too many people. Cash is useful, especially when one is waiting for the right opportunity to deploy it. But as an asset class, cash is probably one of the worst investments ever. I had many people tell me that stocks are risky and that you risk losing your capital as a result of price gyrations, and for that reason, bonds or similar investments are safer because they promise safety of capital.

What investors are not taking into account here is the effect on inflation on their purchasing power. Even assuming a reasonably low average rate of inflation in the next few years of 3%, putting your money in fixed rate bonds, or in the fixed deposit at 1% guarantees a loss of purchasing power of 2% per annum. That might not sound like a lot.. but I hope the table below illustrates how corrosive inflation is.

2000 $10,000.00
2001 $9,800.00
2002 $9,604.00
2003 $9,411.92
2004 $9,223.68
2005 $9,039.21
2006 $8,858.42
2007 $8,681.26
2008 $8,507.63
2009 $8,337.48
2010 $8,170.73
Assuming Decline of Capital at 2% Per Annum

At the end of the day, what should the average investor do?

I am afraid I offer no shining insight into this matter, and my recommendations are the same as that laid you by Benjamin Graham in the 1950’s and more recently, a host of successful investors such as Warren Buffett & Yale Swensen. The dirty secret of the fund management industry is that most funds fail to even beat the index over an extended period of time. The very nature of the structure of funds are at fault, with most funds charging excessive fees that end up enriching their managers, not their shareholders.

My recommendation for the investors who wish to take a hands off approach is to find & invest your money regularly into low-cost index funds or ETFs of a similar nature. You should be very watchful of costs as some indices are poorly constructed and some fund companies charge very excessive fees as they eat into returns, especially over extended periods of time.

PS: Much of what I have covered in this post is featured in greater detail by the modern commentary of The Intelligent Investor written by Jason Zweig. I recommend you check it out for more information and research.

Tea with a macro-investor, thoughts on the financial sector

I was very lucky to meet a good friend of mine, Daryl Chia, for tea to pick his mind and share ideas. He’s a very talented and hardworking investor who was featured in the Business Times. You can check out his site here. You can expect great things to come from him in the future.

Even though he and I share different investment philosophies, having a chat with him is refreshing. I focus on investments on a much more “micro” level whereas he takes a much more “macro” approach to investing, which leads to interesting discussions.

To me, there is nothing more important than someone who is willing to take the opposite view point. It forces you to compose you own thoughts and articulate your views to defend your viewpoint. If you can’t do that, than you need to think twice in whatever you’re doing. There is nothing I find more important in investing than logic and critical reasoning. Defending your view points forces you to think with clarity to elucidate your argument. The same rigorous thought process should be involved whether the sum involves ten thousand, a hundred thousand, or a million dollars.

What I love about investing and financial markets is that there are so many ways to go forward. As a value investor, I naturally gravitate towards fundamental data regarding the companies in question. However, for the serious investor, this does not give one the right to ignore the macro picture. One only needs to look to 2007 – 2008 to see the folly in doing so. Many prominent value investors such as Bill Miller were burnt badly as they failed to estimate how the macro factors would impact their investments in financial institutions.

Moving onto financial institutions, we share differing viewpoints. My own personal view is that the financial sector is severely undervalued whereas Daryl see’s more pain in store for financials. I do agree with Daryl’s assessment that in the next few years, all bets are off especially if the EU faces a breakdown of sorts. One of the things I learnt is that unlike conventional companies, financial institutions have a nasty habit of reacting in unpredictable ways and its close to impossible to predict what might happen. Conventional wisdom was turned upside down in 2008. There is an old saying that tells us that those who forget history are condemned to repeat it.

However, with that in mind, it’s easy to extrapolate past events and assume a similar fate awaits us. In my view, there are some bright spots that allow me to be optimistic about the future:

  • The US banking system is recapitalized and in a much stronger position than before
  • Just about everyone is on the edge trying to resolve the crisis with 2008 still seared into our memories
  • Valuations for healthy banks are historically attractive levels
  • Intense regulation will decrease profitability.. but force banks into more traditional and safer forms of revenue generation that discourages excessive risk taking. Just don’t expect to see the out sized returns on equity that you saw in 2005 – 2008

This isn’t a post where I dive into the nuts and bolts of the financial industry but consider the following facts. For years, people have paid for the right and privilege to own Goldman Sachs for 1.5x – 2.0x tangible book value. Now, you can own Goldman Sachs for 0.7x tangible book value. Bank of America, according to the news, somehow single handly caused the financial crisis and represents just about everything that’s wrong with America apparently. Today, you can purchase a much leaner, better capitalized and well run Bank of America for close to 50 Billion.. just about the same price at its bottom in 2009. The current share price does not take into account that the Bank of America you see today is a much different company than it was two years ago. You can check out my investment thesis in my early post.

I believe that the returns for these companies are bright for the long term investor that’s willing to wait it out 3 – 5 years. However, that being said, I only recommend that you look at financials if you’re already familiar with these companies generate their revenues and how they work, and that you do your due diligence when combing through their  financial data. Investing is all about knowing your circle of competence, and at the end of the day, you don’t need to invest in financial institutions to earn a good rate of return.