I will never sell Apple (AAPL). I first purchased it in September of 2015. It was my first investment. The one that made me into a man. It has taught me a lot since those days, when I look back it was fate for me to be paired with Apple since the beginning. They have shown me so far that great companies will reward you in the long run. I will remind you that when I bought Apple they then went into a funk for about a full year. Touching as low as $92 a share. I looked at that and said to myself there is no way they are worth that.
I have shown you how the Oracle of Omaha selects his investments. In a way, I have tried to resemble him in my investments. I mean honestly, how could you argue that he doesn’t know what he is doing. The way I see it, it’s like Michael Jordan teaching you how to play basketball. Why in the world would you look another way? I wouldn’t.
I am going to walk you through each one of the companies in my portfolio. Each one of the Fab 5 has a special place in my heart, not because I am emotionally attached but because they were opportunities of investment that I could not pass up. I would ride or die with these 5 companies. I will use some of the business tenets that were taught to me and I will select a few of them to show you how I used them to help with my decision. Let’s get into it.
Tenet) Simple and Understandable
A business needs to simple and understandable to be a good investment for me. At most times the best businesses are simple because there is less that can go wrong they are easy to run. Warren Buffett says he likes businesses that can be run by a ham sandwich. Now, I do not think Apple can be run by a ham sandwich I do believe that it is very simple and understandable.
The business is simple; they sell consumer electronics that improve your life. It started with the Mac computer then the iPod and now the iPhone. When they were preaching the iPod the slogan was simple, a thousand songs in your pocket. It has always been about simplicity for Apple. Their products are extremely easy to use and work in a way of elegance. My grandparents are old timers. They were really bad with technology and then we gave them an iPad. They were able to navigate and work the technology like they have done it their entire life. The simplicity of the product has been made so even technologically adverse people can quickly pick up and iPhone and work it.
They have made their products simple and the business is just like that, at the end of the day the business comes down to selling more iPhones, Macs, and iPads. That is what the business does and will continue to do.
Tenet) Consistent Operating History
Apple has been public since of December 12, 1980. They meet the criteria of being operational for a long period of time. They are no longer a startup. That might seem pretty obvious. Over the past 30 years, they have created some pretty incredible statistics. The revenue has grown from 4 billion in 1988 to almost 230 billion in 2017. What intrigues me is that I am willing to bet that back into 1988 they were probably having the same conversation we are having now, how much bigger can they get? Since 1988 the market cap has grown from 5 Billion to over 800 Billion. (If you want to see there market cap now check Yahoo Finance). These numbers are incredible. They have performed year in and year out since 1988 and that was 30 years ago. Their performance history is without a doubt consistent. Yes, here and there they have a down year but that is common. Every business can not put out record numbers every year. With investing you should look to measure success with the performance from decade to decade. In that category, Apple pretty much goes unmatched.
Tenet) Favorable Long-Term Prospects
Like I said before they were probably talking about how big could this company possibly get back in 1988. The same conversation a lot of analysts are having now. The trouble is Apple’s long-term prospects will continue to flourish with the growth of American and the amount of population. They have created a moat around their business and are the go-to brand for consumer electronics.
The three main products specifically the iPhone will benefit from the growth in America overall. If you think about it the more people on this earth, the more people with hands that can be filled with Apple products. There are over 400,000 iPhones sold every day and they will continue to fill the hands of those who do not already have them. The consumer electronics market has quite a bit of barrier to entry with it. I can not just go out and make a cell phone.
Apple’s iPhone’s make up about 12% of the total phone market telling us there is still room for growth. Honestly, this number makes me happy, it keeps the words Apple and monopoly out of the mouths of officials. Healthy competition is a good thing, but everyone that owns phones understands that the gold standard is iPhones. There will be nay-sayers and the people that vow to never buy apple products but these people are minor.
Another thing that makes them favorable in the long term is just the demand and pricing power. The great thing I like about Apple is they can pretty much price the new versions of products at whatever they seem acceptable and people will buy them. They have a product that is desired by many and with that much demand, they have pricing power. A brand with pricing power is a great business to own.
Overall they have a moat with crocodiles and piranhas in it. They have a demand for products that is rivaled by few and with the growth of America in general Apple should continue to flourish. The key to investing is being invested in a business who will have earnings that virtually guaranteed to be higher in 20-30 years. With Apple, I have very high confidence that the likelihood of that is high.
Tenet) Rational Management
I want management that understands one of their main goals, to create as much value for shareholders in the long run as possible. We, partial owners of the company, need to be taken care of at all times. If management doesn’t understand this simple fact it is not a company I want to be invested in.
The main job of management is to allocate capital, by going through these moves with a fine tooth comb we are able to see whether they have been acting rationally or not. The business cycle is usually the main time frame used to see where the total earnings should go because I would not consider Apple a silicon valley startup anymore. They currently (As of 09-2017) have a 74 billion cash pile. This pile has been accumulating for some time. What management has done with this cash has shown us they are rational.
Since 2012 they have paid a dividend that has increased every year. The plans have been to not increase a dividend unless they expect to be able to pay that dividend well into the future. They are aware that they cannot achieve the same returns on the capital that they once did when they were in the growth stages of the business. The decision to pay a dividend was one that was recognized as “Hey, we don’t need the money for growth now so let’s pay our owners their share.” To me, this was a rational decision.
Since this crossroads, they have been making the correct rational decisions. They have bought back their stock and has been increasing the dividend. Now, I know stock buybacks can be a gray area so I will simplify why I think this is a good decision. As of right now, the intrinsic value I have calculated for Apple is above the current market price. Buying back shares at this level to me is acceptable. They think the same thing I do, the company is undervalued in the long term. I will never sell apple because the management is extremely rational and has proved it.
Tenet) Management Candor
I look for management that operates like myself. When there are mistakes or downfalls you don’t hide from it. You apologize or discuss the downfall then move to fix it. I have no problem with a company taking a little bit of a hit or bad publicity if one thing happens, management comes out and apologizes and openly addresses the topic.
Apple’s management is just like that, especially the CEO Tim Cook. He has never been known for hiding from problems. When faced with adversity he told the post this:
“The classic big-company mistake is to not admit their mistake. They double down on them. Their pride or ego is so large that they can’t say we did something wrong. And I think the faster you do that, the better — change gears to something else. If you’re honest, people will give you the benefit of the doubt.”
I could not ask for a better response from the CEO of a company I partially own. If you don’t believe him, I refer you to the success of Apple. The proof is in the pudding. We have all seen companies that do some shady things. Think of Solomon Brothers or the Enron scandal. But since the beginning of his time as CEO of Apple Tim Cook has been nothing but candid with shareholders or anyone.
Tenet) Return on Equity
Instead of EPS, intelligent investors look at return on equity. It is a great way to see how management did what they said they would and then see if they put their deployments of capital to use. A solid return on equity can show us that they are deploying capital in areas where they will be good investments. I read somewhere that Buffett looks for companies that have an average of about 15% ROE. I don’t know how true that is but I will say, the 15% mark is a good place to start. We are looking for companies that can compound themselves and grow even bigger year after year.
A 15% ROE is higher than the average return of the market. Do we want companies that can grow at rates commonly over the return of the market, the reasoning? If the value of the business increases at rates larger than the average return of the market, then at some point when Mr. Market prices a company accurately you will have beaten the market. This is all my opinion not a set in stone rule, we all know that in investing anything can really happen. That is the logic I follow through.
When we turn to look at Apple’s ROE, the average ROE over 10 years is a little above 30%. An exceptional ROE. This is a great sign for Apple investors. The capital that has been deployed was used efficiently. With a 10-year average being double the acceptable ROE, the strong track record speaks for itself.
Because the EPS for companies can easily be altered they can sometimes be a smoke screen to the underlying business. The best way to see beyond the smoke is to look at the quarterly ROE numbers. With this, we can get an idea of how effectively the capital was used during the quarter. As long as the company is continuing to have a solid ROE on a quarterly basis then I wouldn’t pay much attention to the quarterly EPS. For the most recent quarter (reported 09-2017) Apple had an ROE of around 35%. Satisfying the track record.
Along with the ROE with a company we look at the amount of leverage is being used. Leverage is debt and debt can get a bad wrap. I believe that the amount of debt a company has needs to be compared to their ability to service the debt. Yes, a company can have a lot of debt on its balance sheet but if they are able to service it and have a steady track record of doing so then debt is okay. It all depends on the company.
I like companies that can operate with little debt. Apple does not have a lot of debt. They have a track record of low debt levels (being under 1 on the debt to equity ratio). Their financial leverage and interest coverage ratios are well above acceptable so there is really no need to worry about the debt levels of Apple. In fact, they have current assets that outweigh the total debt so if they wanted to they could completely pay off all their debt quickly. This is absolute emergency scenario though. Overall though, the debt levels are low and acceptable.
Tenet) Net Margins
A strong company will have larger than normal net margins. Currently, the S&P had a net margin of 9.44% for the year of 2017. Apple for the 2017 fiscal year, Apple reported a net margin of 21.09%. Sustainably higher than the average of the S&P. Before Taxes, Apple’s margin was 27.96%.
These are the margins of the great company. Look, one sale turn into net income after all the expenses. The best way too better net income is a combination of multiple things either raising sales or lowering expenses. Apple’s management has shown they know how to handle the expense structure by keeping the margins around the 20% level for 10 years. A level that is hard to achieve and they have done a great job of keeping it like that.
Tenet) Owners Earnings
In 2008, owner’s earnings were $5 Billion (net income + depreciation – capex). In the fiscal year of 2017, it was $46 Billion. With the actual numbers that are a 23.62% compounded annual growth rate. I don’t know about you but that is a rate of compounded growth that can double your money in about 3-4 years (using the simple rule of 72). I will take that any day.
Tenet) 1 Dollar Premise
At the end of the day, we like to keep it simple right? Well, that is what this test does. It’s a simple way to see if a company has done good things with the retained earnings and those good things have translated in the market value. We have to remember we are investors in the stock market, so it would be nice to have a return on our money.
If we take all the retained earnings from the past 5 years they add up to $98 Billion. The market cap has increased from $428 Billion to $790 in that time. For every dollar retained you are getting about $3.5 of market value. That is a pretty good bargain if you ask me.
The Market Tenets
I am currently writing this and back when I first bought Apple my knowledge about investing was very limited and some might say that this was beginners luck but I might argue differently. At one point my apple investment was in the red for a whole year. I didn’t make a single penny from my investment until about a year later. During that year I was consistently buying shares because at one point shares of Apple were below $100. To me with my novice knowledge thought this was a huge deal. I couldn’t put a number on it but I knew that Apple was worth more than $100 a share. I look back and laugh at how I thought I knew something. However, I did have the ability to assess the situation and spot value. Warren Buffett likes to think that if an investment doesn’t scream to you “Bargain” then you shouldn’t touch it. Even in my novice state, this price was screaming just that.
For the sake of the article, I will go back and calculate the numbers just to see how a deal could have been made and decided on the way back then. We will just assume I knew all of these techniques and applied them when I first bought into the company.
I bought Apple in August of 2015. The owner’s earnings for Apple during that time calculate out to $37 Billion. This would have been using the fiscal year of 2014 because the 2015 numbers would not have come out yet. To come up with the value of the business we have to discount the future owner’s earnings back to the future. Apple has a compounded rate of about 20%. Because investing involves a lot of things that are not for certain I used a much smaller growth rate simply because I would rather get a smaller number and be wrong than get a huge number and be wrong. This increases the margin of safety.
I took the owners earnings of $37 billion and used a growth rate of 5%, much less than the annual 10-year CAGR average. To get a present value we have to discount the total back using an appropriate discount rate, Buffett uses the long-term bond yield as his discount rate. In August of 2015, the rate was 2.5%. To add extra protection to my intrinsic value estimate I used a larger discount rate, 4%. With all these inputs the estimated intrinsic value of Apple would have been $972 Billion.
To add more margin of safety to the investment, we don’t buy at the full price of intrinsic value. I use the 25% discount on that number, like Buffett. An appropriate purchase price of Apple would have been around $729 Billion. When I purchased Apple the market cap was around $610 billion. Buying at an extreme discount to what I can see as a bargain price. Furthermore, increasing my margin of safety.
I want to make it very clear I did not go through these steps when I first purchased Apple. I had no idea about any type of analysis. Some can say its beginner’s luck and I would totally agree. I made my decision based on the stock price and a little idea of what I had about the company. Which, is a terrible way to invest. The reason I will never sell Apple is that of the reasons I have gone through above and if I have. If they ever get into a rut again and their price drops well below intrinsic value again I will be standing there happily waiting to catch their fall.
Apple is an amazing company. The brand, the management, the massive cash pile, the large returns on equity consistently….etc. Buffett says that a successful investment is buying a company who has earnings that are virtually guaranteed to be larger in 30 years than they are now. To me, this is one of those companies.
Peace and Love,
If you need a refresher on how I pick my companies to check this out: How to Pick Stocks Like Warren Buffett
I (Michael Kandolin) do personally own shares of Apple.
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