Apple: Stock of the Century?
While we are all a-buzz with iCloud and WWDC talk, let me say a few words about AAPL stock. On Mining and Metals and METAR there is a poster who talks about silver (and specifically Silver Wheaton) as the "trade of the century". I am starting to feel that way about AAPL stock. There are lots of times that I've recommended a stock or not recommended a stock. But I'm starting to be of the opinion that AAPL is just fundamentally mispriced in the market and I have been thinking a lot about how to best take advantage of that situation.
First, let me make the case about why I feel that it is mispriced. At the heart of my argument is the fact that the P/E for AAPL is currently 16. Andy Zaky talked about this on Seeking Alpha a few weeks ago and I couldn't agree more. ( http://bit.ly/mO9y12 ) In fact, if you take out the roughly $70 in cash, AAPL has an enterprise value/earnings value of 12.6 ! How can we have this ratio of 12.6, for a company that just posted revenue growth of 83% percent and earnings growth of 95%?
Apple is growing at rates that even start-ups would envy. The iPad is selling as fast as they can be made and the iPhone is dominating a fast growing smartphone market (more on that later). Even Macs are growing at 28%, a phenomenal rate for such a mature market. Strong margins, nearly triple digit growth, growth markets, these are the kinds of factors that lead to triple digit P/Es.
And this doesn't even include the fact that AAPL has completely created a new product market three times in the last decade (iPod, iPhone, iPad). It's shocking how much profit AAPL is making on a tablets, a market segment that didn't even exist two years ago. Smartphones certainly existed before the iPhone, but I think it is more than fair to say that the iPhone complete re-invented the market. The iPhone was first introduced 4.5 years ago, and now it is the biggest revenue generator for Apple. I find the second graph from this asymco post amazing: it shows each Apple product's percentage of overall Apple sales over time. Look at the absolute explosion of the iPhone and iPad. http://bit.ly/lXW4P7
Apple continues to show the ability to complete redefine itself and the market. It's entirely reasonable that Apple might introduce some whole new segment in the next year. There isn't a consumer electronics product that I can't see Apple completely re-inventing. And why limit Apple to consumer electronics? In the software space, I think that the App Stores are amazing. Apple is on the verge of taking a 30% margin on it's entire ecosystem with the App Stores, the profit potential is amazing. And it's not unreasonable to think that iTunes might completely disintermediate the cable companies.
Given all of these facts, it would make more sense to me if AAPL traded for 2000 rather than 335. So I ask to ask myself why the market is valuing Apple this way? Horace Dediu from asymco makes the interesting observation that there is no correlation between Apple's earnings and its share price, but that there is a strong correlation between Apple's assets and its share price. http://bit.ly/izQ7z0 I think this is a clue.
Apple obviously isn't just a set of facts and figures. It's a company with a troubled past. A company that was on the brink of obsolescence. Until ten years ago the press almost always used the word "beleaguered" in any reference to Apple. Apple was a company that looked dominating, but then had it's business model crushed. Apple was a company that looked dominating, but then lots its key leader. And Apple is a company that is in the process of cannibalizing the product that saved it, the iPod. How many times can Apple pull off completely re-inventing itself?
The market obviously fears Android doing to iOS the same thing that Windows nearly did to Mac OS. Over and over again we hear the press talking about how "inevitable" an "open" system like Android will be the victor. But I argue that it is neither inevitable (look at game consoles for a counter example), nor even that bad an outcome if it did happen. It the "PC" space, Microsoft has all of the volume and Apple has all of the profit. I'll take "failures" like the profits on Mac sales any day. I can easily see the opportunity for someone less knowledgeable about the smartphone market to be fearful. But one only has to take a trip on a plane to see how much iOS continues to dominate the high end (read profitable) segment of the market.
The market also obviously fears the departure of Steve Jobs. They saw Apple nearly implode after his last departure. They see his cult of personality. With Steve's health so precarious, is not Apple's future in jeopardy? Of all of the fears, this is the one that most concerns me. But all signs appear to Apple having learned from its history. Apple is investing heavily into defining its executive culture. They even hired a professor to help them craft an internal "university". ( http://bit.ly/jhx7vV ). Steve now always shares the spotlight with his other executives during keynotes in order to build a bridge to a coming era without him at the helm. I think it's safe to say that Apple will never have another executive who sees sell Macs as the same as selling Pepsi again.
And for all of the fears about how quickly the technology market needs to re-invent itself, this is true for all technology companies. It is true for all of these 100 P/E tech start ups. Is it not true of Facebook and Google and Groupon and Netflix? The only thing unique about Apple is how many times they have successful done it. And how quick they are to cannibalize their own products. (A smart decision, but one others have often failed at.)
And so I think we have a market that is fundamentally mispricing Apple out of fear. The market refuses to assume that the earnings growth will continue. Starting in 2008, the market changed from valuing Apple at 35-45 P/E to valuing Apple at 15-25 P/E. The market is predicting that within a couple of years this explosive growth will be over.
They market too much uncertainty to value the potential earnings, and thus they only value the immediate returns resulting in a strong correlation with asset growth. I visualize it as the market being dragged kicking and screaming into higher valuations. Every new earnings report with 75% growth forces the P/E ratio down to ridiculous levels and the market is forced to concede that there will be another couple years of explosive growth.
Andy Zaky notes that even with 0% growth Apple will have $300 in cash by 2015. ( http://bit.ly/lKjzhh .) With the stock trading at $335 today, I just can't see any way that the stock can drop over a significant period of time. Even if they had to do it without Steve. Even if they had to do it with 5% iPhone marketshare. Even if they had to do it with all of their product lines "failing". And, although the market may be dragged into it kicking and screaming, how far can we be from $2000 a share? According the the cash predictions of Andy Zaky, no later than 2015 and probably much, much sooner.
In Parts One and Two I presented my hypothesis that Apple is fundamentally mispriced. That the market is fearful, but it will be dragged kicking and screaming into higher valuations over time. That eventually Apple will trade at $2000 rather than $335, and that there is a near floor on the current price of Apple due to its low P/E. That the price of the stock is predicting a near tragedy, and that the stock will grow every quarter that tragedy doesn't happen.
The part will focus on what to do with that information. The most obvious answer is to buy Apple stock. And I have done so, Apple makes up a larger portion of portfolio than I typically am comfortable with. The benefits are obvious: every quarterly earnings report I should get a nice bump. If it reaches $2000 in 2016, that's a nice 43% return rate. In 2013, that would be an amazing 144%. With 20-25% of my portfolio in AAPL, it's a nice amount of potential profit.
But with my degree of confidence so high, so high that I claim "stock of the century" I have to wonder if there is a better way to leverage my investment. It makes me a bit greedy. Is there a way I can retire based on this stock? I seem to recall a regular poster on this board (GreggThurman?) basically making his retirement on the back of AAPL call options. It's easy to imagine this possibility. If we know that AAPL is going to be at $500 in January, we can buy calls with strike prices of 400 for Jan12 for around $9. We could turn $90,000 into $1,000,000 in just a half a year. (Yes, the volume would be too much to drop on the market suddenly, we'd want to spread it around a little, but you get the idea.)
But our problem is that our hypothesis tells us that the price will be dragged kicking and screaming. AAPL @ $500 is easy to imagine, but it could happen 2 months from now or 2 years from now. stevenjklein already responded to my part two post with the John Maynard Keynes remark that “Markets can remain irrational a lot longer than you and I can remain solvent.” And call options carry a steep premium because of the volatility. Our fictional option play doesn't even break even until the stock rises 22%. Even in a more conservative in the money option play, such as strike prices of 330 for Jan12, we won't break even until after a 9% gain. And if we have one of our "bad news" scenarios happen, it's easy to see the price stall for a few months. It's too easy to lose everything.
So, what other choices do we have? If we think that the prices will be dragged slowly and volatility premium on call options too high, perhaps buying more stock and selling covered calls? This lets us take the risk of a falling stock price (which we consider mispriced) and get paid a nice premium. Taking the reverse of our previous scenario where we buy the stock and sell calls with a strike of 400 for Jan12, we have lots of upside and still can take home a nice 2.7% cut from the options.
That option is interesting, but doesn't appeal to me. It doesn't fit our desire for more leverage, first of all. We are still buying the stock. And, on top of that, we are essentially betting against AAPL with our calls, which violates the entire spirit of the "stock of the century" prediction. If the market wakes up and we get a $2000 stock price we've missed the boat.
If buying calls doesn't work, and selling calls doesn't work, how about put options? If we are confident that the stock can't drop significantly then maybe we can't make some money selling insurance against the stock dropping.
Let's look at strike prices of 350 for Jan12. These currently sell for around $39. Meaning that if we write these options and sell them, and the stock stays above 311, we are making money. If the stock rises even 5% in the next half a year, we get to keep that $39 as pure profit. This still isn't ideal: we still really aren't leveraged. But without being able to predict when the rise in the stock price will happen, this may be our best choice. Let's look at some scenarios:
Scenario #1 : Steve retires or some other short term tragedy happens. Our theory says that even there might be a short term drop, it can't drop for very long. With a 2012 earnings pace of $25-$30 a share, let's say that worst case is $300 a share in January. Our options are exercised and we "lose money", with our options ending up with a value of $50. But, in this scenario, we just let the options exercise. Our "punishment" is that we end up buying AAPL for an equivalent of $311 rather than $300. At that point I'd want to be increasing my position anyway. Obviously we lose a little money on paper, but I think this is a more than acceptable scenario, as we end up adding to our position at a significant discount to today's price. In this scenario, I'd probably keep the shares but use in the money, short term covered calls to reduce myself back to my desired position.
Scenario #2 : Price stall. We get only moderate growth. Perhaps tragedy doesn't happen, but concerns increase. Let's say we end up with a Jan price of $350. In this case our options expire worthless or nearly worthless, giving us pure profit on the options. We make out like bandits in this scenario. We make even more money than if we had increased our equity position.
Scenario #3 (most likely): Getting dragged kicking and screaming with each earnings report. P/E stays about the same, but we continue to get 50-100% year or over year growth. Let's say that this would result in a stock price around 425. Our options expire worthless, giving us pure profit on our options. We would have made more money just buying more stock, but we made our $39 without having to have a full $335 of cash invested. I think this is more than acceptable because we've increased our profit without having to outlay any additional cash: that's a lot like more leverage.
Scenario #4 : Stock soars. Not only do earnings go well, but the P/E starts to return to historical levels. Let's say the price rises to $600. Our options expire worthless, and we get pure profit from writing them, but we are kicking ourselves for not buying more stock. In some ways, this is the scenario that I fear the most. :-) If we knew that the price would rise short-term, there are much better plays than selling put options. But since we do own a good amount of stock we can drown our sorrows with expensive drinks.
Note that our call option scenarios break down tragically in Scenario #1 and #2. Although we'd love to reap the profits from leveraged call options, without knowing the timing of the rise, owning the equity seems to the best way to profit from the upside.
In summary, I think buying AAPL outright is the smartest play right now. I'm buying as much as I can stomach the risk/cash for. But if you want to make a little more profit, but don't want to spend the cash on more outright shares, consider writing some puts. You still need to have the cash (or margin capacity) to fulfill the options, and bear the risk, but it gives you the ability to make a little extra money from the volatility even if the price rises slowly.
Disclaimer: I am long AAPL, as stated. I also have written put options. Mine are shorter term than the Jan12's I use as examples, but the principle holds.