Oops, I wrote an article. I’m working on the book, but I took a slight detour … well, actually this article wrote itself.
Some additional random thoughts on Apple:
Being contrarian – taking a position that goes against the grain of commonly held opinion – is not easy and not comfortable. Humans take comfort in consensus. We love it when the crowd agrees with us. However, being contrarian for the sake of being different is idiotic and dangerous. People don’t normally step in front of moving trains; being contrarian in this regard would make little sense. When it comes to investing, being contrarian means trusting and following through on the findings of your research, whether you agree or disagree with the crowd.
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Bucking the crowd is rarely comfortable even for seasoned contrarians. Think of it this way: Brave people are not the ones who don’t have fear but the ones who can overcome it. When you’re making a contrarian decision, it’s not like you won’t have a tingly, discomfiting feeling in your stomach. You will. This is the time when you need to have a healthy dose of arrogance; yes, this is when you need to stick with your research and basically say “The crowd is wrong; I am right.” I have talked plenty of times about the situations in which you need to be humble, but there are times you need to be arrogant, too. And the tricky part is to know when to be which.
Recently, I felt the same tingly, uncomfortable “contrarian” feeling when we were selling the bulk of our Apple stock as I did in 2013 when were buying. Then we could not kill the stock; today … we can.
I shared a draft of the following article with a friend. He said “You’re probably right, but Apple is going to $180 first.” There is little value I can add there. But let me tell you where I could be wrong: India may prove to be a very fruitful market for Apple. iPhone penetration there is very low, Apple is building new stores, and India has a billion-plus people. I think 5G – which will allow much faster downloads – may end up creating another super upgrade cycle for iPhone. Also, Apple may come up with incremental innovations that keep people excited about iPhone, and the upgrade cycle will remain stable. Augmented reality – AR – may be another driver that I am underestimating. The iPhone may turn into a delivery device of earth-shattering innovations for Apple.
China. Well, China is supposed to a growth engine for Apple, but that may or may not be the case. WeChat is a huge problem for Apple. Someone described WeChat to me as a Chinese version of Facebook plus WhatsApp. The more I learn about it, the more I realize it is so much more than that. It is basically “the mobile internet” in China.
People turn on their phones, jump on WeChat, and don’t have to go anywhere else. It’s Facebook and WhatsApp, but it’s also an app and game store, payment platform, Yelp, and a whole lot more. From a mobile phone perspective, WeChat is an operating system layer on top of iOS or Android. If you are a WeChat user, you don’t really care about any improvements in the underlying operating system, because you barely use it. Samsung comes out with a new, spiffier phone a year now, and your switching “inconvenience” costs are almost zero. WeChat basically kills iPhone user loyalty and the recurrence of revenues that Apple masterfully developed in the West.
A more expensive iPhone will boost Apple’s earnings, but it will surely have an unintended consequence: It will likely elongate the upgrade cycle. Next week, with the introduction of the shiny new i-Object, will definitely be exciting; and as an Apple junkie (I own so many Apple products it’s almost embarrassing) I’m excited for Apple. But I’m less excited about Apple stock than I’ve been in years, and the current valuation demands more clairvoyance than I possess.
New iPhones are not enough to keep Apple’s stock going, it needs a new category
It is hard to find a bigger Apple stock cheerleader than me. I’ve been writing Apple stock love poems for years. For a long time, it was easy to love the shares because they were unloved by others and it was cheap.
Until recently, when Apple stock was still trading in the low $100s and at single-digit multiples, we were buying current product categories at a discount and were not paying for future product categories.
At today’s price that is not the case anymore. That is true with any company – the more expensive the stock gets, the more clairvoyance investors need to discern the company’s future growth.
At Apple’s size it is very hard for the company to increase its earnings significantly. Macs, iPads, and even iPhones are mature products.
The iPhone may have a few growth spurts left, but not many. It is facing an unavoidable headwind: the elongation of its replacement cycle. The iPhone improved substantially over the years, but as the i-marvels piled up, the incremental improvements that motivated people to buy a new phone every two years or so became less and less significant.
At some point the iPhone will face the fate of the iPad – its replacement cycle long in the tooth and sales stagnant and declining.
Will the iPhone’s sales stop growing in 2018, or 2020? I don’t know, but from a long-term perspective of the company’s valuation, a few years don’t make that much difference.
(A new iPhone is expected to be unveiled next week. The stock fell slightly Wednesday on concern supply disruptions could cause shipping delays with the new phone.)
Services is the only segment that can grow at a double-digit rate for a considerable period of time, but it only represents 13 percent of revenue. Even the Apple Watch doesn’t really move the needle.
They need another genius
But can Apple come up with new product categories? Let’s ponder on this question in the context of the following quote:
“Talent hits a target no one else can hit; Genius hits a target no one else can see.” – Arthur Schopenhauer
Apple has a lot of talented people designing and redesigning products in the categories that Apple already dominates. They are hitting a lot of targets no else can hit. Apple’s brand is as healthy as ever, and so is product satisfaction.
However, to create a new category of products Apple needs to “hit targets no one else can see,” and this requires a genius. But in an organization of this size with a lot of bright and talented people, it also requires a benevolent dictator – someone able to make bold, unconventional decisions (and own them), someone who in addition to everything else is able to inspire others to create what they may think is impossible. Yes, I am referring to the one and only Steve Jobs, he of the “reality distortion field.”
Here is an instance that comes to mind: Jobs asked his engineers to come up with a touchscreen computer – a tablet. They did. It looked like a bulky version of today’s iPad. Steve looked at and said “Let’s put the tablet on ice,” then refocused the company on miniaturizing that tablet and making a phone instead.
It is important to remember that at the time, though Apple was financially healthy, it was not swimming in cash the way it does today. Jobs made a benevolent dictator-like decision: He diverted engineers who were working on the MacOS to work on what would become the iPhone OS, causing the late release of some Mac products. And only years later, after the iPhone was a raging success, Apple brought the iPad back to life. That was Jobs’ Apple.
Now let’s visit Tim Cook’s Apple. The New York Times ran an in-depth article unearthing why Apple has (so far) failed to come up with an electric self-driving car. These few sentences jumped out at me:
“But the car project ran into trouble, said the five people familiar with it, dogged by its size and by the lack of a clearly defined vision of what Apple wanted in a vehicle. Team members complained of shifting priorities and arbitrary or unrealistic deadlines.”
Nokia spent a lot on R&D too
Even Jobs admitted that Cook is not a “product man.” Cook doesn’t have “the vision,” and thus he doesn’t have the authority to be a benevolent dictator. Nor does he have the charisma to project and maintain a reality distortion field.
Today Apple spends almost $12 billion on R&D – double what it spent just a few years ago. But as outside observers, we really don’t know where this money is going. Or more importantly, how productively it is being spent. I vividly remember how Nokia was increasing its R&D spend every year during the last years of its dumb-phone dominance, but all that R&D did not bring forth new products that would have saved the company from its eventual demise. Apple is not facing Nokia-like collapse, but the R&D argument still stands: R&D spend doesn’t always equal great new products.
The NY Times article said that Apple curtailed its ambition to make a car and is now focusing solely on self-driving technology. In other words, Apple is basically pulling out of the electric car space (at least for now).
If Apple develops and licenses its self-driving technology, it will recover some of its losses on investments made to date. But it will not be able to take advantage of the significant competitive advantage that comes with its incredible brand, its distribution network – hundreds of stores (potential car dealerships) sprinkled all over the world – its know-how in battery management, its design prowess, and its i-ecosystem.
We still own a little bit of Apple stock but have sold most of what we owned at current prices. Maybe Apple’s augmented reality products will become a huge success, or maybe the company is working on a brand new category of products that we have not even imagined. It is all possible.
In making investment decisions you never have perfect information. Apple is no exception. At today’s valuation we are paying for genius – Apple’s ability to successfully create and dominate a new, large product category. While the company is run by very talented people who will do a great job getting us excited about the categories of products they are already in, the company’s genius died with Steve Jobs.
Last time I talked about Shostakovich I said, “His music tells stories. We just don’t know what those stories are. Each of his symphonies could have been turned into a Fantasia type of movie.” Well, my lovely wife and I were listening to the first movement of Piano Concerto Number 2, and she said “Isn’t that the part that was used in Fantasia, the part about the one-legged soldier?” Well, she was absolutely right: It was featured in Fantasia 2000. I implore you to listen to the first part of this concerto, then watch Fantasia, and then listen to it again. Note the change in your perception of this music.
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).