Great Stock = Great Company + Great Valuation (Apple vs Coke)
June 22, 2016 – Excerpt from Q2 2016 letter to IMA’s clients
Valuation – margin of safety (discount to fair value) – solves a lot of global problems. Let’s take Apple as an example.
Today Apple is mostly an iPhone company: two-thirds of its profits come from that product. In 2014 it sold 169 million iPhones, and in 2015 iPhones sales jumped 37% to 231 million. In 2015 the mobile phone market grew somewhere around 6-10%. iPhone sales for 2015 were driven by many extraordinary factors. Apple introduced larger-screen iPhones at the end of 2014, and China Mobile – the larger wireless company in the world – started selling the iPhone.
In 2015 the iPhone took market share from Android, but also and more importantly it brought forward some sales from 2016 and maybe even 2017. In the first two quarters of 2016 iPhone sales are expected to decline about 15-16% from the 2015 level. In our worst-case scenarios, we are assuming a 16% decline in iPhone sales for both 2016 and 2017. We are also punishing Apple’s margins by 3% for the cheaper iPhone 5SE it introduced in 2016. In addition, we are still growing Apple’s R&D expense 25% a year.
After all of this punishment we get earnings per share of $6.50. If Apple does not come out with any categorically new products this or next year, we get the worst-case 2017 value of around $90 per share (10 times $6.50 worst-case earnings = $65 plus $25 of net cash per share). Let’s put our $6.50 number in the right context: Apple is followed by 46 Wall Street analysts whose lowest earnings estimate for 2017 is $7.46 per share (the highest is $10.10 per share).
It gets better. In 2016 Apple will spend $10 billion on R&D. Let’s put this number into perspective: In 2007, the year Apple introduced the first iPhone, Apple’s R&D stood at $782 million. The company’s R&D investment over the last three years more than doubled, but outside of increasing iPhone screen size (which required millions not billions of dollars to accomplish) and introducing the Apple Watch, Apple has not introduced any significant new products.
We don’t exactly know which specific products the increase in R&D is flowing to. Our best guess is an electric car and virtual reality technology. Our $6.50 worst-case earnings factors in much, much higher R&D, which is an expense, but no new products from it, thus no additional revenues or profits.
We are going through this exercise to show that at the right price a high-quality company can handle a lot of headwinds – which makes it a great stock. We are looking for stocks that we or the global economy cannot kill.
Though we have not made a lot buy decisions in your portfolio in 2016, we have made hundreds of decisions – you just didn’t see them because they were decisions “not to buy.” We looked at looked at hundreds of companies. Some companies failed the initial quality test, and many of the ones that passed were not cheap enough and went on our watch list – future buys. In fact, the companies we did buy were on our watch list.
We are acutely aware of the large cash position we have in your portfolio. This cash is not a result of our trying to time the market, not at all. Neither we nor anyone else knows how to put market timing into an investment process, and do so in a repeatable way. Our cash balance is a byproduct of a dearth of attractive buying opportunities at present. The overall market is very expensive; it is even more expensive once we start stress testing stocks for lower global growth.
We can always find great companies, but we are looking to buy great companies at valuations that can withstand the headwind of a very uncertain economy. In other words – we are looking for great companies at great prices, and finding a full portfolio of them is quite challenging today. But this is why patience is so important now.
Leonard Bernstein, the famous conductor and composer (West Side Story), talked about how conducting is “a preparation between the beats.” The conductor’s role is to communicate to the orchestra what to do before the next beat comes. Once the beat arrives it is already too late – the orchestra has played that beat. We look at our role as that of a conductor. The portfolio is the orchestra, and the “beat” is the external environment. Unfortunately, unlike a conductor who has a score that lays out every beat, we have to patiently wait for ours.
Addendum: Coke – A Good Company, Not a Good Stock
Unlike the US government, Coca Cola doesn’t have a license to print money, nor does it have nuclear weapons. But it is a strong global brand, and so investors are unconcerned about Coke’s financial viability and thus lend money to the company as though it was the US government (Coke pays a very small premium to Treasury bonds). Investors ignore what they pay for Coke; they only focus on a singular shiny object – the dividend yield, which at 3% looks like Gulliver in Lilliput (fixed-income) land.
And as investors do so they are ignoring an inconvenient truth: they are paying a very pretty penny for this dividend. Coke is trading at 23 times earnings. They are starting to look a lot like the investors who bought the stock in 1998, were down 50% on their purchase ten years later, and have not broken even for more than fifteen years.
A problem with shiny objects is that they don’t shine forever. Investors are paying 23 times earnings for a very mature business – consumption of Coke’s iconic carbonated product is in decline in health-conscious developed markets. If Coke’s earnings grow 3% a year over next ten years, then at the end of that period it will trade for 15 times earnings, and Coke’s price will have declined about 1.6% a year. Thus more than half of the dividend would be wiped out by Coke’s P/E erosion.
Coke to some degree epitomizes the US stock market. If over the next ten years, despite all the headwinds that come with the decline of consumption of its fizzy drink, Coke is able to grow earnings at a faster pace than 3% and interest rates remain at current levels (so that Coke’s P/E stays at the current I-want-this-3%-dividend-at-any-cost level – or even increases), then Coke’s stock will provide a decent return.
But Coke’s if interest rates rise and/or consumers continue to shift from drinking high-margin sugary drinks to low-margin (commodity) water, then Coke will be hit from both sides – its earnings will stagnate and its P/E ratio will mean revert to a much, much lower level. You’d be wishing you did not know how to spell that four-letter word.
We are using Coke just to demonstrate the importance of differentiating between a good company (which Coke is) and a good stock (which Coke is not).
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Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).