Although I’m going to use the specifics of Apple to discuss some investing specifics, my intent is that you’ll see the broad contours of how I evaluate investor psychology and the growth potential of mega-caps that operate in nearly every country and have cumulative revenues in the billions of dollars.
Number One: The margin of safety principle really works. Does BHP Billiton have business results that merit it beating the S&P 500 from 20% to 2% since April 7, 2016? No. It’s just that the expectations got so low that reversion to the mean was inevitable. Does Conoco’s business performance suggest that it ought to be up 40% compared to the S&P 500’s 13% gain since February 10th, 2016? No. But while the dividend was being cut, the expectations for Conoco got so low that reversion to the mean was bound to propel it upward.
You should be very hesitant before paying a higher than usual P/E ratio for a well-established, non-cyclical large cap. I do cover some exceptions to this rule such as Nike, but the test for making an exception is that: (1) the odds of future double-digit earnings growth must be very high, and (2) the starting valuation must still bear some tie-in with reality.
Otherwise, you focus on beaten-up out-of-favor stocks like Ebay. No one likes EBAY right now because it is not Amazon. But it doesn’t need to be Amazon to deliver excellent returns. It is repurchasing 6% of its stock per year, growing in the 3-5% range, and has a P/E ratio around 10 on a normalized basis. It will eventually outperform even though it doesn’t “feel good.”
The reason why you don’t want to overpay is that, as soon as earnings indicate that there will be a slower than expected gain, you must not only deal with that lowered expectation but you must also subject yourself to the P/E compression that accompanies it.
At the start of 2015, the analyst consensus called for Apple to grow earnings per share at a rate of 11%. Well, for the 2015-2016 period, earnings are basically flat. What happened? The P/E ratio compressed from 14.5x earnings to 10.3x earnings. Apple’s 30% decline over the past year is not related to profits declining by 30%; it is the result of investor perception driving the valuation down 30%.
This is why I don’t join in the hype about Facebook (FB). People don’t realize how dangerous it is for a $320+ billion company to have a valuation of 70x earnings. The 20% annual growth has been coming, and so the stock price hasn’t fallen to the $50s or $60s. But what happens if you get a year or two of 7% earnings growth?
Number Two: I love Warren Buffett’s analogy about how families that buy hamburger by the pound don’t get excited when prices go up and melancholic when prices go down. In nearly every area of life except the stock market, we enjoy the prospect of getting more for less.
People are letting price dictate their analysis. There were people who couldn’t get enough Apple in the $130s last year that are now muttering things about slow Chinese growth and saturated phone markets. That is the wrong way to behave. Apple is far, far more interesting now at 10x earnings than it was at 14x earnings.
Number Three: If you look at Apple’s profits of $50 billion, there is intuitive sense in wondering: “How does this thing double? Does it need profits of $100 billion five years from now to turn my investment of X into 2X?” No. In addition to dividends, shareholders in mega-cap stocks almost find it necessary to engage in buybacks.
A lot of people who own Exxon, Walmart, and the like get disappointed whenever dividends barely creep up during times of difficult market conditions. I don’t join in that hand-wringing. Once you reach a certain size, it is necessary to manage a lowish dividend payout ratio because the future growth of the investment requires stock repurchases to boost earnings per share.
Wal-Mart was making $12.1 billion in profits back in 2006. It is making $12.7 billion in profits this year. It is so huge and massive that the needle is hard to move. They are responsible for the sale of almost half a trillion in goods per year–where do you go from there? The answer is stock buybacks. Wal-Mart keeps its dividend payout ratio in the 30% and 40% range so that it can retire large blocks of stocks. The share count has declined from 4.1 billion to 3.1 billion in the past decade. One out of every four shares of Wal-Mart stock that existed back in 2006 don’t exist today. That’s why earnings have grown from $2.92 in 2006 to $4.10 today. It’s not that Wal-Mart is doing more and more; it’s that Wal-Mart has lots of cash flow available to make other shareholders get bought out so that the remaining pie is able to get divided into fewer pieces.
The same thing happens at Exxon. It keeps its dividend at around a third of earnings, and it has reduced its share count from 5.7 billion to 4.1 billion over the past ten years. Just like Wal-Mart, about one out of every four shares that existed in 2006 no longer exist today so that the remaining shareholders have a higher ownership percentage in the firm. When oil was in the $80s and $90s per barrel, Exxon made $7 per share in 2006. If oil gets back up there, Exxon will make around $9 this time around because of the reduced share count.
When a company’s strategy requires constant share repurchases, it makes sense to enjoy the moment of lower stock prices because it means that more shares will get retired and the amount of earnings you can claim from the business will increase (this is also a risk of owning these types of companies, as extended overvaluation could make capital allocation decisions more difficult).
If you look at Apple specifically, it is spending $11 billion in buybacks that goes toward actually reducing the share count (the actual buyback amount is higher and goes toward mopping up the dilutive effects of executive compensation). Apple traded at $132 last year. That means 83 million shares get retired under the plan.
Now, Apple trades at $95 per share. At this going rate, 116 million shares get repurchased under the plan. This year alone, the difference between an average purchase price of $132 and $95 means the difference between the company earning $9.20 per share in profits and $9.26 in profits even if everything else is the same. And, of course, this decision has a compounding effect throughout the rest of Apple’s corporate life as those additional $0.06 for each additional share go on to compound.
Number Four: Intuitively, you would expect stocks conducting massive stock repurchases to be less volatile because the company itself is always placing a “buy order” for the stock regardless of the price. Throughout 2016, Apple places a market order to purchase $50 million on every day in which the stock market is open. You would think that would make it harder for stock prices to go from $132 to $95, or Exxon to go from the $100s to the $70s, or Wal-Mart from the $90s to the $60s, but yet it happens because there is still a greater force of institutional market participants haggling over the proper price compared to the mindless buy orders of companies auto-purchasing stock and index funds doing the same.
Number Five: Stock buybacks really do add to the bottom line. Last year, Apple made $53 billion. This year, it is going to make around $50 billion. You’d expect earnings to come down 5% to 6%. And yet, last year’s report of $9.22 in earnings ought to be compared to earnings of around $9.15 to $9.25 this year as Apple reduces it share count by over 100 million this year. This is when the effects of stock repurchases are the most stark: earnings are down, and yet earnings per share are up.
Number Six: The politics of repatriated earnings has been on a slow burn the past five years, never quite taking the center stage of the tax debate. That is because multinational U.S. companies are able to borrow at extremely lucrative rates in the 2% to 3% range to come up with the cash to actually ship out to shareholders while the corporate coffers remain locked overshores to avoid the 35% tax associated with bringing those profits back.
The nice thing about dividends is that they can’t be faked–there actually must be in account in Apple’s name on it that is sitting on $12 billion in cash that will be mailed out to all of the stockholders collectively. But paying a dividend is burdensome when the cash profits exist but are not readily transferable. It is no coincidence that Apple went from no debt in 2012 before it paid a dividend to over $62 billion in debt today as it has begun paying the dividend.
The discussions of the $100+ billion cash hoard at Apple is overstated to the extent that it cannot be immediately accessed without having 35% of it chopped off. Apple has $38 billion in U.S. cash that is currently being used for buybacks and dividend payments, and the $62 billion in debt taken on since 2012 has been Apple’s way of paying past dividends and funding buybacks without turning a $100 billion cash pile into $65 billion upon return to the United States.
This stopgap measure works without notice so long as interest rates remain low. If multinationals need to borrow at 5% rather than 2% to 3%, then you will see U.S. companies move overseas under tax inversion deals with a heightened intensity, or in the alternative, the spinning off of foreign subsidiaries so that they can access the cash and make dividend payments to U.S. shareholders without paying a repatriation tax in addition to the dividend and capital gains taxes that the shareholders themselves would have to pay. The politics of these actions have been subdued on account of lower interest rates, but will roar when the status quo changes.
Conclusion: I have no idea what Apple will do over the next 20+ years because the super long-term product demand for phones manufactured by Apple is very hard to predict. Less than a decade ago, Blackberry appeared to have the upper hand on this market and phones are not like the soda market where you can have third-ranked firms like Dr. Pepper still thriving and enriching shareholders even while having a subordinate position to competitors.
The success of Apple, more so than the typical company I cover, is tied to the competence of management. Coca-Cola doesn’t need brilliant management to give shareholders mid single digit returns. Look at the history of Nabisco after Adolphus Green died in 1917. The management skated by on his legacy for half a century, selling the same biscuits, using the same factories, and offering no innovation. And yet, shareholders still got 7.8% annual returns. A $10,000 Nabisco investment increased ten-fold over three decades without any notable innovation or implementation of strategy after Green died. Now, Nabisco is part of Mondelez and still churning out millions of dollars in dividends for shareholders because people like to eat the same baked snacks over and over again throughout their lives.
Apple is not the kind of company where you can get away with that. Management always has to be looking over its shoulder, warding off the next threat. And if the threat does materialize, the earnings engine of Apple can be impaired, perhaps substantially and quickly. Most companies I cover have a negative mandate–don’t screw up this cash cow. But Apple is one of the few with an affirmative mandate–you must execute a strategy that keeps you at the top. The terms for investment success are different and the duty required of Apple executives is higher.
Also, none of this is to advocate market timing. Many too people fret over stock prices that drop shortly after they make an initial purchase. Just as you can’t take skill credit when a stock quickly rises after your purchase, don’t beat yourself up when a stock goes down immediately after your purchase. Over the course of your investing life, the short-term performance of your investment in the immediate year aftermath will most likely be a wash.
Don’t worry about that. The question is: Did you act intelligently purchasing Asset X at Price Y? In this case, we are talking about the purchase of Apple at 14x earnings at the $132 high. There was nothing stupid about that decision, even though the immediate results were not enticing. If you logically agree that the stock market is a voting machine in the short run and a weighing machine in the long run, then don’t let an emotion convince you to take the voting machine seriously when you put your actual capital at stake. Let the dividends rack up, the earnings per share grow, and see where things are years from now. In the meantime, focus on creating a new surplus so that you can increase your household’s cash-generating power. It’s the only intelligent way to behave.
Originally posted 2016-06-21 22:27:01.
