Tuesday, October 20, 2009

Apple's Soar Means Future Sores

Once again, Apple (AAPL) impressed investors with results that handily beat analyst expectations. The company continued to move iPods en masse, and sold a record number of Mac computers and iPhones, staunchly defying the drag on consumer spending that has been the bane of this economy.

There can be little doubt that Apple is a well-run, exceedingly competent company. That much can be determined with a quick look at the company's financial statements, where equity returns of around 25% are commonplace. What makes those returns even more impressive is the fact that no leverage is employed in garnering these exceptional returns: Apple has no debt!

While this means the company itself operates with very little risk, that does not automatically translate into a low risk investment. That's because it's important for investors to be able to separate a great company (which Apple clearly is) from a great stock. What makes a stock great is a price that allows investors to buy the business at a significant discount to its intrinsic value.

Is Apple a great stock? That will depend on the value of its business. For a company that grows sales and profits as quickly as Apple does, the value of its business is very difficult to determine with any degree of precision. There will be wide-ranging opinions on what earnings will be next quarter, let alone next year or the year after, making predictions of Apple's business value a difficult venture to say the least.

But what is clear is that as the stock price soars in reaction to near-term profit expectations (e.g. upcoming product launches, or increased distribution of existing products) or the expectation that near-term upward price momentum will continue, downside risks for the investor increase. Twice in 2008 (once in January, and once in the fall), Apple's stock fell by 40%. This was not an indictment of the company, but rather it highlights the risks of owning a company (no matter how great it is) at a price that makes it difficult to determine whether it is indeed under- or overvalued.

Large, institutional investment firms often have no choice: there are a limited number of large companies from which to choose, and often investments are made when it is far from certain that there is value to be had. For individual investors, however, there are far better investments available (from a value point of view), where downside risk is minimal and upside potential is strong.

There are many smaller companies out there that trade at discounts to their inventories, discounts to their receivables, or discounts to their land holdings. There are even more companies out there that trade at discounts to their earnings despite the fact that they are market leaders in their categories.

Apple's stock holds a special place in the heart of many individual investor accounts, not only due to the well-loved consumer products the company produces, but also due to the fact that it is a superior company that continues to defy expectations. But investors must keep in mind the fact that price and value are two different things: just because Apple's business value is high, does not mean one should be willing to pay anything for the stock. Investors are encouraged to put a business value on Apple, and if they cannot assert that they are buying the stock at a discount to that value, they should avoid the downside risk that may be present in the stock price by considering companies that appear to trade at discounts to their intrinsic values.

1 comment:

the_obtuse_investor said...

Excellent post Barel.

I just want to add that since the post rightfully implies that Apple stock is overbought-- it does not mean that it is an invitation to short it. That is dangerous because it adds the ticking clock aspect that works against the patient investor.

Markets can stay overbought far longer than one can remain solvent.