Responsible Investing Hypocrisy

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Socially responsible investing (SRI) continues to gather momentum in the investment industry, and is becoming increasingly popular amongst private investors. The idea is that investors allocate their capital to socially responsible businesses. There is some subjectivity as to what constitutes social responsibility, though ESG scoring (environmental, social, governance) is one widely accepted approach. Consideration can also be given to broad themes such as investing in renewable energy or electric cars for example, or not investing in certain industries such as tobacco, oil & gas, defense, etc.

Since we manage individual portfolios, we engage with our clients individually in this regard, whilst taking an overarching view on the long-term viability of any specific business that we invest in. This is fairly straightforward and for us it makes more sense than taking a one-size-fits-all approach.

But underlying this SRI movement is an incredible hypocrisy. We have an industry that for decades has peddled opaque, complicated, unnecessarily expensive products, riddled with conflicts of interest, now preaching social responsibility to its clients. Many in the investment industry even see SRI as a marketing hook to sell more of the same products:

Fee pressure behind ‘push on ESG’ – FT Adviser (8 Jun 2020)

Firms see embrace of ESG as way to garner more fees – P&I (24 Feb 2020)

There’s also the issue of ESG window dressing to consider – a topic for another day perhaps.

 

At Bellwood, responsible investing starts at home with the way we treat our clients. There are three major areas where we differentiate ourselves from the rest of the industry: Transparency, cost-effectiveness and alignment of interests. Unless the rest of the industry addresses these issues properly, SRI will be just another marketing smokescreen.

Let’s examine each of these areas and provide practical examples of how they apply in day-to-day business:

Transparency: How many layers are there between you and your money?

For a South African, a typical foreign investment starts with your financial advisor placing your funds on a local platform that invests in a global feeder fund that invests in an offshore fund, very often a fund-of-funds, which invests in several other offshore funds, which finally invest in various stocks, bonds, etc. That puts four or five layers between you and your underlying investments. There are variations on this often featuring asset swaps, endowments, wrappers and other financial products. The result is complexity, lack of transparency, inflexibility, limited access to your funds, and excessive costs.

Here are some questions to ponder: Do you know what your underlying investments are? Do you understand the underlying investment strategy? Does your adviser? Can you speak to the person who actually makes investment decisions? Are you able to access all of your funds anywhere at any time? Do you know what fees you’re paying through all the layers, or do you just see the top layer? Is it necessary to have all these layers between you and your money? Do they add value?

More often than not, many of these layers are sold with only the supposed benefits in mind, and with no consideration of the added costs – call it cost-benefit analysis. When you apply cost-benefit analysis more layers always make sense. It figures.

So how do we do things differently?

For starters we do proper cost-benefit analysis for every potential layer between you and your underlying investments. As a result, we’ve generally found that fewer layers are better. For example: Does it make sense for a private investor to work through a local platform to make a global investment? It limits your investment options significantly, it means that you can only access your funds from South Africa, the platform charges an extra fee, and it automatically adds another layer for the global feeder fund. On the ‘upside’, it means you don’t have to go through the minimal admin of moving your funds offshore, and it provides your adviser with a convenience in terms of reporting, switching funds, charging fees, etc. It really makes more sense for the adviser than the client.

At Bellwood, our clients have their own direct offshore accounts. They can login and view detailed statements of exactly what their underlying holdings are, what transactions/trades have occurred, and so on. They can pick up the phone and speak to or send an email directly to the person who manages their portfolio, who can explain our process in detail (which is also part of our client take-on process), the rationale behind specific investments and transactions, etc. Our clients control access to their own funds without restriction. Our clients pay a management fee to Bellwood, and negligible trading costs to the underlying broker. Simple, transparent, flexible and cost-effective.

 Cost-Effectiveness: Do you know what fees you’re actually paying?

 Transparency and cost-effectiveness go hand-in-hand. Where there are more layers between you and your money, you will be paying more fees, and often you won’t know about them beyond the top layer because the underlying fees are simply lumped into the daily unit trust prices. With the platform-feeder fund setup described above, it’s common-place to pay anything between 3% and 5% per year once you add the fees for each layer, whereas a more transparent solution should result in fees of around 1% p.a. for a reasonably sized investment. These differences in fees are not insignificant! The following graph shows what $1m dollars invested in the S&P 500 20 years ago would be worth now depending on the fee being charged:

So how do investors wind up paying such exorbitant fees? Often it’s just that the numbers sound small – “0.5% p.a. here, 1% there, 2% for the fund, oh the platform only takes 0.25%” – so nobody really thinks about the impact that these fees make over long periods of time. Often investors don’t know – their advisor charges 50-100bps and they think that’s it.

Sometimes it’s a deliberate marketing strategy, usually in the area of supposed tax benefits (or deferral). This is a trap that catches so many investors and advisors alike because they don’t do the math properly! The tax numbers are big (often overstated) and applied once-off, or simply deferred more often than not. The costs are usually smaller numbers compounded over time, and because they’re small they’re often only mentioned in the paperwork. The headline numbers make for an easy sale. The reality is that in most cases, any supposed tax benefits are far outweighed by the additional costs involved, and they usually come with the added bonus of complexity, limited investment options and restricted access to your money.

We’re not saying there isn’t a place for these types of products, but that all too often these products are sold to investors that don’t need them.

At Bellwood, we do the math. Most of the time the math says the costs outweigh the benefits. But this is something we can assess properly on a case-by-case basis, with due consideration for other benefits and drawbacks, rather than touting some convenient headline numbers to sell a product.

Alignment of Interests: Make sure you’re not being sold!

“Show me the incentive and I will show you the outcome.” – Charlie Munger

The reason there is so little transparency and so much unnecessary expense is because the investment industry is riddled with conflicts of interest. The grotesque reality is that wealthy investors are a huge cash cow around which an enormous industry has been built to collectively milk it. So how do you guard against this? Understand the incentives of the people you appoint to manage your investments.

Here are three common practices to avoid:

1) Commission-based advice: Trusted advisers are the gatekeepers of their clients’ wealth. This puts them in a potentially lucrative position, especially when they have different ways to earn additional fees. Many advisers make their money through upfront and referral fees. If they were government officials it would be called bribery, but in the investment management industry it is fully disclosed and therefor legal and accepted practice. Many product providers will pay advisers large upfront or ongoing commissions (taken from their clients’ investments no less, and disclosed – it’s all above-board) for bringing clients their way. Others will add a small fee on top of their own fee to pay the adviser for the referral. Is this of ‘advice’ independent? Is it any wonder that advisers are all for selling more products and putting more layers between clients and their money?

2) The broker-manager: Stockbrokers generally make their money from brokerage and management fees. They are often given discretion to manage client portfolios as they see fit, and they charge a management fee for that, but they also make money every time they trade for the account. While all will profess to be honest and most probably are, the reality is that such a perverse incentive naturally makes honest people see more opportunities to trade than would otherwise be the case. More trading means more brokerage, which is more cost to the client, but more money for the broker. The number that gets put on the white board at the end of each day is brokerage generated – that’s the target. Portfolio performance is secondary. This arrangement is not in the best interests of the client.

3) Performance fees: Asset managers often tout performance fees as a way of aligning their interests with their clients’. The reality is very different. Performance fees are first and foremost an additional way to make more money – an added fee. Second, because they are generally asymmetrical (if we win we make way more money, if we lose we still make our normal fees anyway) they create an incentive for asset managers to take greater risks that have potential for huge payoffs, but also greater risk of loss. This creates a conflict of interest, not alignment.

 

What makes us different?

So how to we deal with these institutionalized conflicts of interest at Bellwood? We only charge a management fee and nothing else. We don’t accept referral fees, commissions, upfront fees, brokerage fees or charge performance fees. If you make more money, we make more money. If you make less money, we make less money. This incentivizes us to look for cost-effective solutions for our clients that maximize their wealth instead of looking for product providers that give us the best ‘rebate’. It also incentivizes us to focus on our investment process and generate real returns for our clients. We also invest substantial portions of our own wealth alongside our clients.

Simple, transparent, cost-effective and as aligned as it is possible to be with our clients’ interests – these principles should form the foundation of any credible responsible investing initiative.

Our clients and regular readers will recognize that we’ve invested a great deal into our investment process. We trust that you will recognize that as highly as we prize our professional capabilities, we esteem the value of our reputation and integrity even more highly.

“Lose money for the firm, and I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless.” – Warren Buffett

Difficult Investments

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NetEnt and Evolution Gaming have been two of our most successful investments to date. Both are Swedish companies operating in the online gaming industry (i.e. casino/betting systems). Since we acquired them through 2018/19, they have returned 120% and 370% respectively. As of March however, the performance of these two stocks couldn’t have been more divergent. Evolution held up well through the first quarter. Even at its lowest point in March it had nearly tripled since our original acquisition. NetEnt on the other hand lost nearly 40% during the first quarter, reaching a new low in March, down more than 50% from where we’d bought it.

Despite the dismal share price performance of NetEnt up to March, our process indicated that the stock was priced for better long-term returns than before. We continued to buy shares through the first quarter (though not quite at the low), making it our second largest holding by the end of March. In the three months between 19 March and 23 June, NetEnt rallied more than 250%. (It became apparent to the market that their US expansion strategy was starting to bear fruit). By May, NetEnt had become the largest position we’ve ever held in our portfolios. As we didn’t deem it expensive we decided to maintain our full exposure.

On 24 June, Evolution Gaming announced an all-stock deal to acquire NetEnt. The deal priced NetEnt at a sizeable premium and sent the shares 30% higher on the day. Because of the large position size, NetEnt has made a significant contribution to our performance during the quarter. NetEnt is a good reminder of how quickly things can change in financial markets. We need to be patient when things don’t immediately go our way, and ready to respond when rapid changes do occur.

Difficult investments require discipline

There are some valuable lessons to be learned from NetEnt about how successful investments can play out over time. On the one hand you can have a company like Evolution. Evolution moved sideways for a little while after we bought it, and then just climbed higher and higher. Evolution has been an ‘easy’ investment in the sense that we’ve only ever experienced success from the get-go.

NetEnt on the other hand has been a difficult investment. After two years of investing more and more into the stock, we found ourselves 50% down. Three months later we’re up 120%. Successful equity investments seldom deliver nice consistent return streams like Evolution. Most successful investments involve long periods of volatility – like NetEnt.

What is interesting about these difficult investments is that we often make more money out of them than the easy ones. We may have ‘only’ made 120% on NetEnt (vs 370% for Evolution), but we actually made more money out of NetEnt than Evolution. How? We kept adding to our position as the price came down and prospective returns increased. To do so required emotional detachment and discipline.

Why is discipline so important? Because without a disciplined investment process, our judgement can easily be clouded by emotion. Emotional investment decisions generally lead investors to buy when stock prices are high, and to sell when stock prices are low.

Ownership leads to emotional bias

An investor’s emotional perception of a stock depends on two things: 1) What the share price has done, and more importantly 2) whether or not he owns it. Take NetEnt as an example. In the two years before we bought it, the share price had dropped by more than 50%. We were excited by the opportunity to buy a good business cheaply. We didn’t feel those losses. But then two years later, we were down 50% on our investment – and we weren’t happy about it. The fundamentals hadn’t really changed, but our emotional perception of them had. Why? Because we owned it. If we’d been driven purely by emotions we might have resisted buying more shares, or worse, thrown in the towel and sold out.

Our natural emotional perception of a stock is highly dependent on whether or not we own it, yet this has no impact on the future of the business. These perceptions shouldn’t enter the equation. Let’s imagine for a moment that we held off buying NetEnt two years ago, and we didn’t own the stock in March. We’d probably have been just as excited, if not more excited about the prospects of this investment than we were two years before. We’d be emotionally detached from the losses suffered by NetEnt investors over the preceding four years. That’s how we needed to think about NetEnt in March, even though we did own it and had suffered through some of those losses.

No investment process can stop us from feeling these emotional biases, but a great investment process needs to override them in our decision making and enforce discipline. We need to make decisions as though we don’t own the stocks. We need to ignore the emotional impact that ownership brings to the table. Every time we look at a stock that we already own, we need to look at it through the same emotionally detached eyes that we had before we bought it. That’s what our process does for us.

Red Flags Analysis: Wirecard, Alibaba

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At Bellwood, we follow a quantitative process that ignores popular narratives and makes decisions based on underlying fundamentals like profitability, financial strength and valuation. One of the things that differentiates us from other quants-oriented asset managers is that we subject our portfolios to a more qualitative ‘red flags analysis’ before implementation. So the numbers always tell us why we should buy something. We never buy something for qualitative reasons where the numbers don’t stack up. But while we never buy something that the numbers don’t support, we will at times not buy something that the numbers say we should because of qualitative red flags. For us, the biggest red flags are serious questions around a company’s accounting practices, from credible sources.

Wirecard

We saw a very clear example of this play out in the last quarter. We’ve had Wirecard AG (a German internet payments company) on our watchlist for some time, based purely on the numbers. In May it came onto our shortlist and we discussed Wirecard’s merits: It was profitable, had high growth, a decent valuation, strong cash flows and modest debt – the numbers looked good. So we decided to put it through our red flags analysis. Even a cursory glance through their news history reveals that there have been serious questions around their accounting practices, from credible sources, for some time. As a result, we didn’t invest – an easy decision.

In June, Wirecard announced a $2 billion hole in their accounts. The stock price has since fallen 98%. This type of qualitative red flags analysis is simple and we believe it adds significant value to our process. It’s by no means a guaranteed system, but it does a good job of managing the risk associated with fraud, among other things.

Alibaba

To be clear, we didn’t predict the Wirecard fraud, nor did we know that it would play out so quickly after our discussion. But we did see the potential and we avoided it. There are other examples where there is good reason to be suspicious of a company’s accounting where so far nothing has happened. A good example would be Alibaba. Alibaba has been under a cloud of suspicion since its listing in 2014, though it is making new highs as we speak.

We recognized the ‘numbers’ return potential for Alibaba in 2016, but decided not to invest because of their accounting practices. We would make the same decision today. Time will tell if there is substance to these allegations or not. It’s worth noting that between 2009 and 2018, Wirecard’s share price had increased 50x – but now the price is lower than in 2009.

We sleep easier knowing that the companies we hold aren’t under a cloud of fraud suspicion that might implode at any time. We trust that our clients do too.

Keep Doing the Basics Well

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What a quarter it has been. COVID-19 has abruptly reminded us of the many frailties in our global society. The world seems almost paralyzed by the shock. As bad as the reaction in financial markets has been, it pales in comparison to the magnitude of the real economic pain this virus is causing across the globe, not to mention the widespread fear and the impact felt by those who are directly affected by the illness.

Remember that the world is, and always has been, a scary place. This is not the first time something bad has happened, though every crisis has its nuances. It won’t be the last time either. The nature of the risks we face may change over time, but “do not let us begin by exaggerating the novelty of our situation.” – CS Lewis.

 

We entered the first quarter well-positioned for a pullback in the market (generally speaking – we certainly didn’t foresee the COVID-19 crisis) with ~20% in cash and strong balance sheets across our portfolios. These are the two things you want going into a bear market. We are ready to deploy cash as we see the right opportunities to do so.

It’s at times like these that we need to remind ourselves of the basics and keep doing them well. We’ve highlighted 4 principles that we think are especially relevant to a crisis like this:

Basic Principle #1: Be proactive about asset allocation

To the extent that it is possible, keep enough cash aside to meet near-term liabilities and contingent liabilities. You don’t want to be forced to liquidate large portions of your stock portfolio or other assets in the middle of a liquidity crisis. A focus on asset allocation also reduces the urge to engage in speculations about which way the market will head next, which are seldom profitable.

Basic Principle #2: Beware of leverage

The sustainable return of businesses across the board is going to take a knock during this economic crisis, with a few exceptions. A major factor that will determine which of those recover and which don’t is leverage. A strong balance sheet is the most valuable asset a business can have during a crisis. Overleveraged companies are likely to become distressed and may be forced to raise capital at the worst possible time, permanently impairing the equity of existing shareholders. Financially sound businesses are more likely to ride out the storm and recover.

This has always been a major focus in our investment process. Our portfolios are well-positioned in this regard.

Basic Principle #3: Diversify

This crisis has affected the travel industry more than any other, and it seems unlikely that this will recover in a hurry. Grocery production, medical, pharmaceutical and certain technology companies have been relatively unaffected. Some countries have also suffered worse outcomes than others. Geographic and industry diversification remains a cornerstone of financial risk management.

It is important, however, not to buy overvalued or low-quality businesses for the sake of diversification. Diversify within the constraints of quality and valuation.

Our portfolios are well-diversified on both an industry and geographic basis.

Basic Principle #4: Keep your discipline

The reality is that it’s probably too late to address the first 3 points. They needed to be in place before the crisis hit us. Without a doubt the most important thing to do through the crisis is to keep your discipline. Emotional decisions are seldom good decisions, yet emotion drives markets more than anything else in times like these. Stick to your financial plan. We are sticking to our investment process.

Remember that the shares you own are not merely pieces of paper and numbers on a screen. These shares represent ownership of very real businesses providing very real goods and services. These businesses are more substantial and secure than most of our own private businesses, yet because we are made aware of their market value on a tick-by-tick basis, and because we are detached from their reality, we are more inclined to worry about them and react impulsively.

Traditional economics assumes that we are all rational thinkers, therefore more information makes us better decision makers, but this simply isn’t true. Because we are not always rational, more information can feed our irrationality and make us worse decision makers. This is especially true of financial markets where we are constantly bombarded with information and live prices. Perhaps this even applies to the situation we find ourselves in with COVID-19. Don’t let the deluge of negative information distract you from doing the basics well.

When patience doesn’t pay

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Last quarter we wrote about active share and how our portfolios are very different from the index. The strength (both relative and absolute) that we saw in September continued through the end of the year, as our portfolios rose 13.1% in aggregate during the last quarter, bringing our total net USD return for 2019 to 23.5%, while holding roughly 15% in cash.

If in the previous quarter we were reminded of the importance of active share, then this quarter we were reminded of something equally important: Equity returns don’t come smoothly! As of end-August our year-to-date return was only 3.5%.

It’s very easy to lose patience with a stock, an investment strategy or even the whole stock market when returns don’t quickly materialize. So how do we counter this? Is it simply a matter of being patient in every instance? Turns out there’s more to it than that.

Lesson #1: Patience doesn’t pay when you invest in a bad business.

Let’s consider a tale of two stocks – Johnson & Johnson (JNJ) and Ford – two American heavyweights. Between 2002 and 2012, JNJ’s share price changed by… 0%. A decade of no real return. The same was true for Ford. Since 2012 JNJ’s share price has more than doubled, while Ford’s has languished for almost another decade. Following those 10 years of no return, how could an investor distinguish between these two companies? The answer is to break down those returns into their components: Sustainable return and revaluation. Sustainable return is a persistent source of return, while revaluation tends to cancel itself out over long periods of time.

Between 2002 and 2012, JNJ’s real sustainable return was 165%, while its valuation had dropped 60%. Ford on the other hand had delivered negative sustainable return, and its valuation had more than doubled over the same period. To an investor looking back at 10 year total returns in 2012, these two stocks would have looked the same. To an investor looking at sustainable returns and valuations, these two stocks couldn’t have been more different. JNJ is a high quality business with a proven track record of profitability and a healthy balance sheet, both of which drive strong sustainable return. Ford has always been the opposite.

Lesson #2: Patience doesn’t pay when you overpay, even for a good business.

So now we know we must invest in good businesses. But 10 years is a very long time to earn nothing from a good business like JNJ. So how can we avoid waiting 10 years to earn a positive return? Don’t overpay! In 2002, JNJ was on a 32x PE ratio. In 2012 it was 13.7x. Once you’ve determined that something is a good business, you still need to pay a good price for it to ensure good returns.

There are countless examples of high quality businesses that have delivered fantastic sustainable returns since 2000, but have only recently reached breakeven for their investors that were paying ridiculous prices during the tech bubble. It took 15 years for Microsoft investors (who paid 70x PE in 2000) to breakeven, despite the business delivering 430% real sustainable return over the same period.

Interestingly, Ford has traded on a single-digit PE for most of the last 20 years. Valuation on its own isn’t enough – you still need to buy a good business – remember lesson #1.

 

But what about the medium term? In 2010, JNJ traded on a 14x PE. It was cheap, it was a good business, but two years later it had delivered no return. This is when patience is required. This is when patience pays.

 

How can we apply these lessons today?

So let’s come back to 2020 and see how things are set up: The US stock market continues to make new highs. Over the last 10 years the S&P 500 has returned 256%. Why not simply buy the S&P 500 today and be patient?

If we adjust for the abnormally low margins of 2009/10 the S&P 500 traded at a PE of 13.5x a decade ago, vs 22x today. Roughly half of the total return of the last decade has come from revaluation from historical lows to the highest PE since the tech bubble – a non-persistent source of return. If valuations revert to anything near their long-term averages, and sustainable returns remain roughly the same for the next decade, this implies low-single-digit real returns from the S&P 500. Furthermore, these returns aren’t likely to come smoothly! Don’t expect the last decade to repeat itself. Remember lesson #2.

We’re far more comfortable holding a globally diversified portfolio of high quality businesses trading at historically low valuations, with 95% active share relative to the global benchmark index.

Investment Case: Apple

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We sold out of our position in Apple in the 4th quarter of 2019. We bought most of our shares in 2016 between $90 and $120 for a total return of roughly 140% in just over 3 years. While Apple has been a phenomenal investment for us, and it remains an excellent business by our estimation, we think the valuation has raced ahead of the underlying business fundamentals.

In this Investment Case post we put Apple through our process and demonstrate why we bought in 2016, and why we sold at the end of 2019.1

The Causality of Return

While many investments are made on the basis of predictions, narratives, or statistical correlations, our process is based on the causality of return, which is defined by the following mathematical identity:

Return = Yield + Growth + Revaluation = Sustainable Return + Revaluation

This identity forms the foundation of our investment philosophy and process, so we’ve written about it on several occasions here, here, here and here.

Sustainable Return

The iPhone has been one of the most successful and profitable consumer products in history. Over the last 20 years Apple has delivered real sustainable returns of >20% p.a. driven primarily by rapid growth in revenues, but as the company has matured sustainable return has become less growth oriented and increasingly driven by return of capital to shareholders.

This form of sustainable return is constrained by a combination of profitability and valuation. At current prices Apple yields 1%, but repurchases about 5% of their shares each year. We think it is unlikely that Apple will be able to sustain this rate of share buybacks for very long at the current price.

Our future expectations for overall sustainable return are ~9% in real terms – still very healthy.

In 2016 we had a slightly more conservative sustainable return assumption at ~8%, owing mostly to lower Growth assumptions.

Revaluation

Since we’re measuring Sustainable Return in terms of revenues, we need to do the same with Revaluation. To this end we need to determine a “fair” Price/Sales ratio and compare it to the current multiple.

Price/Sales = Net Margin x Price/Earnings

According to Bloomberg, analysts expect Apple’s net margins to be around 19%. We think this is a reasonable base-case assumption.

Apple currently trades at 27x earnings, a high multiple that requires healthy growth to be justified. Over the last decade Apple’s median PE has been 15.5x, though we’re happy to work on an exit PE of 18.5x as reasonable.

18.5 PE x 19% Margin = 3.5 Price/Sales which is 34% below Apple’s current 5.3x revenue multiple. If we annualize this over 7 years, our Revaluation assumption becomes -6.4% p.a.2

In 2016 our fair Price/Sales estimate was 3.1x, primarily owing to a more conservative exit PE multiple. This compared favourably to the prevailing multiple of 2.4x at the time, implying Revaluation of +3.8% p.a. annualized over 7 years.

Total Return

The following graph shows how Apple’s Sustainable Return (blue) and Total Return (green) have developed over time. The dotted blue line shows where Sustainable Return would go at a rate 9% p.a. (real) for 7 years:

The yellow circle indicates where we originally bought Apple, while the red indicates where we sold.

Total Return = Sustainable Return + Revaluation

In 2016, our conservative Total Return expectation was 8% + 3.8% = 11.8% p.a. in real terms (~14% p.a. in nominal USD terms).

Actual Sustainable Return was slightly higher than our expectations (9.5% p.a. vs 8% in real terms). Revaluation, on the other hand, completely overshot, as is often the case since valuations are so volatile and unpredictable in the short-term. This provided us with an opportunity to earn what we would have been satisfied to earn over 7 years, in just more than 3.

Today, our base-case Total Return expectation is 9% – 6.4% = 2.6% p.a. in real terms (~4.8% p.a. in nominal USD terms).

Good Quality

Apple remains a high quality business. It is consistently profitable, and though it has raised some debt in recent years it still has very strong financials and cash flows.

Profitability is a most important driver of sustainable return over time – it determines the trajectory. A profit can be returned to shareholders in the form of Yield or reinvested in the business for organic per-share Growth. Yield and Growth are the two constituents of Sustainable Return. Absent consistent profits, few businesses can deliver high Sustainable Return over long periods of time. No problems here for Apple.

Financial Strength is the second most important driver of Sustainable Return over time. It doesn’t say much about the trajectory, but it says a lot about the riskiness of the business and the probability of a sudden, steep decline in Sustainable Return should the business run into financial difficulty.

Apple has raised $100bn in debt since 2012 when it had none. This represents <10% of the market cap of Apple and doesn’t present much risk at this stage.

What is more of an issue is that the valuation of Apple at 27x earnings places a constraint on the sustainability of Apple’s share repurchase program. Apple’s balance sheet will come under pressure if buybacks continue at a rate of 5% p.a. at these valuations. This wasn’t an issue in 2016 when the stock traded at 12x PE. This means less Sustainable Return potential from Yield.

Probabilities vs Possibilities

In 2016 Apple traded on a 12x PE. It subsequently returned 140%, well beyond our expectations and trades on a PE of 27x. This valuation is expensive in absolute terms and relative to Apple’s own history. This valuation also constrains Apple’s ability to generate Sustainable Return through return of capital to shareholders, making future returns heavily dependent on Growth.

While higher returns are obviously possible for Apple, we believe our inputs to be a reasonable base-case. Anything is possible, and there is a range of likely outcomes rather than one specific outcome set in stone. But investors should be concerned with probabilities, not possibilities. In the case of Apple, the probabilities favour low returns over the next 5 to 10 years.

As always, the way to think about this is not to try and predict the future for this one stock, but to ask whether you would invest in a portfolio of 50 stocks with the same preconditions. If the answer is no for the 50, it should be no for the one too.

 

1 Note that this is just a high-level overview of a more thorough analysis.

2 Technically, Return = Growth + Yield + Revaluation x (1 + Growth), but since the Growth interaction with the Revaluation term is usually quite small, we just group it into Revaluation for the sake of simplicity. Our calculations always factor this interaction in though.