david einhorn

During the presentation at David Einhorn’s Greenlight Capital annual Partners’ Dinner, we talked about a number of stocks that have suffered multiple compression, where businesses have performed nicely, but have not seen a corresponding uplift in their share price. Apple Inc. (NASDAQ:AAPL) is the clearest example of this. In 2011, Apple Inc. (NASDAQ:AAPL)’s revenue grew 66% and earnings per share grew 78%. Both of these growth rates greatly exceeded market expectations and even our own expectations, which were considerably more optimistic than consensus. Nonetheless, the stock appreciated by only 25%. As a result of this mismatch, Apple Inc. (NASDAQ:AAPL)’s P/E multiple compressed by about one third.

Several other names in our portfolio including General Motors Company (NYSE:GM), Microsoft Corporation (NASDAQ:MSFT), Delphi Automotive PLC (NYSE:DLPH) and Arkema (France: AKE) also suffered multiple compression in 2011. This trend reversed in the first quarter, with all of these companies enjoying rising share prices that reflect both current earnings performance and some P/E multiple catch-up from last year. None of our long portfolio investments have recovered with as much fanfare as Apple Inc. (NASDAQ:AAPL), which surged from $405 to $600 per share in the quarter, bringing its P/E back to where it was at the end of 2010. Yet not everyone agrees that Apple Inc. (NASDAQ:AAPL)’s stock price is merely playing catch-up to its fundamentals. Some see the stock surge as a bubble, while others go so far as to mock that Apple Inc. (NASDAQ:AAPL) is its own asset class.

 Here are some of the common concerns we have heard:

1. Too many hedge funds own Apple Inc. (NASDAQ:AAPL).

2. If Apple Inc. (NASDAQ:AAPL)’s share price doubles, it will have a $1 trillion market capitalization, and everyone knows there can be no such thing as a $1 trillion company.

3. Motorola, Research in Motion and Nokia were all market leaders that proved unable to hold onto their dominant positions and healthy margins; this too will be Apple Inc. (NASDAQ:AAPL)’s fate.

4. Apple Inc. (NASDAQ:AAPL)can’t possibly maintain its current hyper-growth trajectory.

Let’s address these one at a time:
1. Too many funds. It’s not clear what the objection is here. We suppose the worry is that there is a herd mentality among hedge funds, and that when one fund sells, there could be a cascade of hedge funds selling shares and the stock price will collapse. Moreover, if everyone already owns Apple Inc. (NASDAQ:AAPL), who is left to buy it? Collectively, hedge funds currently hold less than 5%2 of Apple Inc. (NASDAQ:AAPL)’s outstanding shares, and no hedge fund ranks among the top 40 holders of the stock. The average hedge fund has less than 2%2 of its equity assets in AAPL versus Apple Inc. (NASDAQ:AAPL)’s 4% weighting in the S&P 500, which means hedge funds are actually underweight Apple Inc. (NASDAQ:AAPL).

2. A trillion dollars? We’ve scoured the Nasdaq listing rules, reviewed the Securities Exchange Act of 1934, and engaged a leading numerologist. We can’t find any prohibition on trillion dollar market capitalizations.

3. All empires must fall. This concern, while not as arbitrary as the first two, reinforces our belief that the skeptics have a fundamental misunderstanding of Apple Inc. (NASDAQ:AAPL). Their view suggests that AAPL is a hardware company. We disagree.

4. Growing pains. Apple Inc. (NASDAQ:AAPL) shares are not priced for growth. Its current valuation is justified without it. The latter two concerns merit further discussion. Despite its size, Apple Inc. (NASDAQ:AAPL) remains one of the most misunderstood stocks in the market. AAPL is a software company. The value comes from iOS, the App store, iTunes and iCloud. A Motorola RAZR phone was a one-time winner because when someone else made a phone that was just a little better, RAZR sales stopped. In contrast, a consumer with one AAPL product tends to want more Apple Inc. (NASDAQ:AAPL) products. Once the user has a second device, AAPL has captured the customer. At that point, a future competitor has to make a product that isn’t just a little better, but a lot better to get people to switch. The high switching cost makes Apple Inc. (NASDAQ:AAPL)’s business much more defensible than that of its predecessors.

Further, Apple Inc. (NASDAQ:AAPL)’s ability to consistently offer innovative features (as opposed to marginal improvements on the current features) encourages users to upgrade every couple of years. This provides a recurring revenue stream. And because Apple Inc. (NASDAQ:AAPL) embeds its software into its hardware, it doesn’t face Microsoft’s piracy problem. If the Chinese want Apple Inc. (NASDAQ:AAPL), they have to buy Apple Inc. (NASDAQ:AAPL). Rather than view Apple Inc. (NASDAQ:AAPL) as a hardware company, we see it as a software company that monetizes its value through the repeated sales of high margin hardware.

2 Goldman We continue to hold Apple Inc. (NASDAQ:AAPL). Not only do we think the skeptics are misguided, we believe the shares remain cheap. Apple Inc. (NASDAQ:AAPL) trades at a lower multiple than the average company in the S&P 500. A below-market multiple implies that this is a below-average company. We have a hard time seeing how anyone ranks Apple Inc. (NASDAQ:AAPL) as below average.