To infinity and beyond
A recent report by Goldman Sachs describes Apple (AAPL) as a “Very Important Position” (top ten holding) for 47 hedge funds. Overlooked is that fact that it’s not a significant position for 93% of the hedge funds in the survey and represents only a 1-2% overall allocation, less than its weighting in the S&P 500. Further, three years ago it was in fact a top ten holding of 109 hedge funds, so more than half decided to cut back. What happened?
Perhaps the real question is, “how cheap is AAPL today?” Carl Icahn, who owns over $4 billion of shares, famously called Apple a “no brainer” – although in fairness he said this closer to the trough a year or two ago. Still, today Apple trades at 10x forward earnings – half the market multiple for one of the great businesses in American history. Earnings are forecast to grow at 10% per annum, the dividend yield is a healthy 2% plus, and stock buybacks continue apace. Given almost $140 billion in net cash, “rock solid” is an understatement for its balance sheet. With the stock down considerably over the past year, shouldn’t we see Warren Buffett, Seth Klarman and other legendary value investors on the shareholder list?
The issue is that value investors need a tether – intrinsic value – to determine whether something is “cheap.” (See our recent post on Is Warren Buffett a Value Investor?) What’s Apple worth today, they ask? Other than cash, its assets are almost entirely intangible. At 4x book value, it won’t show up on traditional value screens. Unlike a railroad or Coca Cola, three quarters of revenue today comes from products that didn’t exist ten years ago (the iPhone and iPad were launched in 2007 and 2010, respectively).
So how should we value it? A discounted cash flow model – the weapon of choice for modern value investors – ordinarily would be a good place to start. However, a DCF requires financial assumptions out to the end of time – remember the concept of a “growing perpetuity”? As a shortcut, most models instead go out only five years and include a lump sum at the end called a “terminal value.” In essence, you assume that the company is either sold or that it will trade at a certain multiple in the market. Given Apple’s $500 billion plus market cap, it’s not going private so you’re left with where it will trade.
But given that this exit price represents 70% or more of the value today, you can’t avoid making a call on what happens in years 6 through infinity – not easy in a world of rapid innovation and short business cycles. What if the “next big thing” is outside the Apple ecosystem?
As we know, the tech industry is frighteningly good at shooting the wounded – good luck predicting winners in the 2020s.
So what do Wall Street analysts do? They punt. As Daniel Kahneman noted in Thinking Fast and Slow, when asked a difficult question, humans are wired to ask an easier one and answer it instead. In lieu of a valuation, Wall Street analysts instead try to guess what someone else will be willing to pay in, say, a year or two. This approach naturally grates on value investors since it starts to look and feel like the greater fool theory of investing.
Over time, some of the most successful hedge fund investments are those where there is no natural investor base. Ironically, despite its popularity, Apple may be stuck in between two investor camps: growth investors who moved on as earnings momentum slowed, and value investors whose tools are ill equipped to evaluate technology companies with precarious longevity.