Investment Case: Apple
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.
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.
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.
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).
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.