Tuesday, April 23, 2013

Apple, Samsung and Google

            Most discussions of the swoon in Apple stock focus on competition from Samsung, but that overlooks the fact that Apple is as much of a software company as it is a hardware company.  What makes Apple devices so attractive and easy to use is the seamless integration of hardware and software, not either one alone.  Of the two components, it is the software that is more difficult to copy and, therefore, provides the barriers to entry that allow value creation for shareholders.  For that reason, the real threat to Apple and its stock price is not Samsung, but Google.  Profit margins on pure hardware look to be headed toward PC levels, while margins on creative software remain largely intact.

            What makes the Google threat particularly dangerous for Apple is that Google appears to be innovating at a much higher rate.  Hardly a month goes by in which there is not an announcement from Google of one type of new product or another.  Meanwhile, Apple remains hidden behind its curtain of secrecy.

            If Google can overcome the difficulties of providing software across a variety of manufacturers, as they appear to be doing with Android, and if that software is as good as Apple’s, the reason for paying a premium for Apple products may disappear.  That poses the greatest risk for Apple investors.

Sunday, April 21, 2013

GDP, Earnings and Stock Prices

            Earnings are the fundamental source of the value of common stock.  Although short-term market movements are unpredictable, in the long-run the market capitalization of companies cannot grow faster than their earnings.  On an economy wide basis, furthermore, earnings cannot grow faster than GDP unless the fraction of earnings to GDP continues to rise, which makes no sense economically or politically.

            The foregoing implies that to understand the recent behavior of the stock market, it is useful to take a look at the behavior of the earnings to GDP ratio.  Based on data from the Federal Reserve, the chart below plots the ratio of total corporate profits to GDP.

          As the basic theory predicts, the ratio is trendless.  Because earnings are more volatile, the ratio rises during good times and falls during bad times, but it always tends to revert to its mean value.  The most notable feature of the chart is the recent behavior of the ratio.  It reached its maximum in 2007, dove close to all-time lows in 2009, and then recovered to near record levels by the end of 2012, mimicking closely the behavior of the market.

            The chart appears to serve as a warning.  The ratio has risen to near record levels.  If it reverts as usual will stock prices fall?  The answer is they should not because the mean reverting behavior of the ratio is well documented and, therefore, should be reflected in market prices.  But there is a caveat with the foregoing should.  Research by John Campbell and Robert Shiller indicates that the market fails to fully account for the tendency of the ratio to revert.  If that is the case again, the chart does suggest that the rapid run-up in stock prices is likely coming to an end.

Friday, April 19, 2013

Apple and Buybacks

            One recommendation that Warren Buffett gave Steve Jobs is that if he thought Apple’s stock price was “cheap” there was no better use of Apple’s cash than buying back its own stock.  Mr. Buffett not only gives this advice, he follows it.  Stating that he believes Berkshire is worth at least 1.2 times its book value, he stands ready to buy Berkshire stock below that level.

            Research in financial economics suggests another reason why Apple should be paying attention to Mr. Buffett’s advice today.  Stock prices serve as signals, not only for investors, but consumers as well.  A collapsing stock price and a meager P/E ratio says that the market has little faith in the company’s future.  As a consumer, do you want to buy a product from a company whose future is bleak?  How comfortable do you feel buying a Dell computer today?  Such a collapse in consumer confidence is no minor problem.  As consumer confidence declines, prices fall and margins compress leading to a vicious cycle.

            To make matters worse, if Apple management does not begin a buyback it serves as another signal – namely that they do not think the price is “cheap.”  That rightly exacerbates both investor and consumer concerns, particularly in light of how cheap the stock appears to be.  Previously, I noted that the ratio of the value of business operations to earnings for Apple was only about half that of Microsoft.  Perhaps even more surprisingly it is significantly less than the same ratio for Dell!  The market clearly is saying that Apple’s future is bleak.  If Apple management does not see this as a value enhancing  buying opportunity, that speaks volumes as well.

            Management may choose to be secretive about Apple’s future products for strategic reasons, but there is no reason to be secretive about their confidence in the future of the company.  If they are confident, then it is hard to believe they will fail to conclude that the stock is cheap at less than $400 per share.  If they reach that conclusion, they should say so publicly and act accordingly.

Wednesday, April 17, 2013

Apple versus Microsoft

            I keep hearing that the PC is dead.  The future is tablets, phones, glasses, watches and the like.  Microsoft is toast.  Apple is the future.  Well not so fast – at least as far as the stock market is concerned.  It turns out that the market is a significantly more bullish on Microsoft than Apple (though it is bearish on both).  If that surprises you, let’s do the numbers.  What we really need to compare are the values of the competing business operations.  The table presents the calculation of those values.

(in billions) Apple Microsoft
Current Market Capitalization 378 241
 + Total debt 0 12
 - Cash and investments 140 70
 = Value of operations 238 183

2012 Earnings 41.7 17
Value of operations/2012 Earnings 5.71 10.76

Starting from the market capitalization, the value of operations is calculated by adding back any debt used to finance the company and subtracting out holdings of cash and investments that are not part of operations. 
            The calculation reveals that the operating values of the two companies are not that different  - $238 billion for Apple versus $183 billion for Microsoft.  But the earnings are vastly different.  Apple’s 2012 earnings of $41.7 billion were almost 2.5 times greater than Microsoft’s earnings of $17 billion.  Consequently, for the two values to be approximately equal the market must be placing a much greater operations multiple on Microsoft than Apple - the table shows it does.  Because the primary determinant of the multiple is future long-run growth, the analysis reveals that the market is much more pessimistic as regards Apple than Microsoft.  The market is saying that if Microsoft is dying, Apple is moribund.

Saturday, April 13, 2013

Computer Technology and Valuation

            I admit to being a tech junkie.  In the last twenty years I have not gone three months without buying a new computer, tablet or phone – until this year.  This is not for lack of desire.  I have the money in bank and am as anxious to buy as I have ever been.  I feel like a mini Warren Buffett.  My gun is loaded, but there is nothing to shoot at.

            Last fall I did buy three new devices – an iPhone 5, an iPad mini, and a Microsoft Surface RT.  The RT made it two weeks before I donated it to Caltech.  Windows 8 on my PCs suffered the same fate.  I went to the trouble to install it on a couple of machines and then spent a weekend going back to 7.  The same was true of Office 365.  I bought it, installed it, and then spent a day going back to 2010.  This is the first time I have ever gone backward with office, but I hated the sliding cursor in Excel and the program seemed generally slower.

            The last new computers I bought were two retina display MacBooks.  The displays are beautiful and I still love the machines, but the computers are almost a year old - ancient by my standards.  Ironically, I run Windows 7 on both of them because I find it to be more flexible than OSX which also needs major innovation.

            TVs have even been worse.  I keep wanting a new one but hate 3D.  I can’t tell the difference between the Sony panel I bought two years ago and current models.

            Worst of all there is nothing I am dying for that is coming out soon.  Well Apple TV maybe, but that has been coming for years now.  I feel like Lucy, Charlie Brown and the football on that one.  I will buy the new iPad and mini iPad when Apple updates them, but I am not pining for either.  Unless the iPhone 5s is a meaningful upgrade from the 5, I may have to pass on that one. 

            So that’s the problem.  I am sucker for any new technology.  I have the money.  I want to buy, but the shelves are bare.  The point of all this is what does it mean for the valuation of computer and technology device companies?  If one the world’s easiest mark isn’t buying, what about people who are not such suckers?

Tuesday, April 9, 2013

The Stock Market Rally and the Fed

A common refrain in the financial press is that we are experiencing a “Fed induced rally in the stock market.”  According to this popular account, the Fed is drowning the market in liquidity resulting in low interest rates that have driven up stock prices.  Does that make sense?  The question cannot be answered in the abstract – it requires a model for evaluating the level of stock prices.  Whereas valuing individual stocks is particularly tricky, it is less difficult to value the market as a whole because the constant growth assumption is much more applicable to the entire market than to individual stocks.

The constant growth model implies that the level of stock prices is given by the equation,

 Stock price level = Next year’s expected earnings / (k-g). 

The Fed’s impact on the stock market comes into play via the denominator, (k-g), so let’s take that apart.  The g is the easier part.  It is the rate at which earnings are expected to grow.  As such, it includes two components.  The real growth rate in earnings plus expected inflation.  The discount rate, k, is the sum of three components - the real rate of return on long-term Treasury bonds, plus expected inflation, plus a premium for the risk of investing in common stock versus Treasury bonds.

            Notice first that when calculating (k-g) expected inflation disappears because it is included in both k and g.  In addition, there is no apparent reason why a loose Federal Reserve policy would alter the risk of investing in common stock compared to Treasury bonds, so let’s set that term aside.  Putting the pieces together, for the Fed to decrease (k-g), and, therefore, increase stock prices, it must either drive down the long-term real rate of interest or increase long-term expected real growth in earnings.

            First, as to real interest they are definitely low by historical standards.  Currently, the real yield on a ten-year Treasury TIP (an inflation protected bond) is -0.69% (yes, it is negative, that is not a typo), well below its long-run average of more than 1.50% prior to the financial crisis and the change in Fed policy.  However, despite all the Fed’s effort future real growth in earnings is also depressed relative to the time before the crisis.  The question is by how much?  It is hard to believe that expected real earnings growth has dropped more than a percentage point.  Assuming that the Fed is responsible for the substantial drop in real interest rates, then yes it looks like at least part of the current stock rally is Fed induced.  That should serve as a warning to investors.  Watch the ten-year TIP in conjunction with Fed policy.  If the Fed begins to tighten and the ten-year TIP starts to rise, it could be bad news.