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If It's Undervalued, Why's It So Cheap?

November 07, 2012 | About:
The Science of Hitting

The Science of Hitting

231 followers
I wrote an article about Apple (AAPL) a few weeks back, which is something I rarely do – I tend to try and avoid discussing investments that evoke emotional responses from what seems like all investors, particularly when I have little to offer in terms of new thinking about the long-term viability of the business (as I noted at that time, I didn't have – and still don’t have – any special insight into what the future looks like for Apple); with that disclaimer, let me be clear that I’m simply using Apple as an example in this article because it perfectly encapsulates what I’m trying to say.

In a 1994 letter to investors entitled “Random Thoughts on the Identification of Investment Opportunities,” Howard Marks said the following:

"An investment that 'everyone' knows to be undervalued is an oxymoron. If everyone knows it's undervalued, why haven't they bought it and driven up its price? And if they have bought, how can the price still be low?

Yogi Berra said, 'Nobody goes to that restaurant; it's too popular.' The equally oxy-moronic investment version is 'Everybody likes that security because it's so cheap.'”

I think this is particularly relevant to Apple; in the past few days, I’ve read a slew of articles that present the investment thesis for AAPL by more or less saying the following: “In the past few years, Apple has grown earnings at a rate of [insert astronomical number here]; when I insert this rate into a DCF model – or even a figure HALF that rate – I derive an intrinsic value of [insert number well above the current stock price]. Therefore, Apple is a screaming buy.”

Let me be clear: These articles end right there; not one has proclaimed Tim Cook the leader of the next generation at Apple, or the recent "promotion" of Jony Ivey as the change needed to once again push this company ahead of the competition (arguments that could potentially be made). They simply assume that the historic growth rate is at least a decent proxy for future growth, and thus conclude that the stock is a no-brainer.

I think investors that have fallen back on this rationale are failing to consider that this is one of, if not the most widely followed stock in the world at this point in time. Suffice it to say that the astounding rise in Apple’s sales, earnings and stock price hasn’t gone undetected.

As noted by Mr. Marks, this line of logic is simply oxymoronic; if anybody is going to make this argument, one would assume that they’d address the critical question of how Apple will maintain such outsized growth. Yet, as of this writing, I’ve never seen such an article.

As I noted in my Apple article, I think the reason might be because there is serious concern about whether or not they will be able to. If the company isn’t able to develop groundbreaking innovation the way they did over the past decade, the risk isn’t that they won’t grow – it’s that sales and earnings could begin a precipitous decline as competitors enter markets and continually commoditize what at first were truly breathtaking product innovations.

The point is that you must maintain a sense of skepticism about your investments. Regardless of how well they have done, you must always keep an eye on the risks that can potentially result in a permanent impairment of capital. Throwing historic growth rates into a discounted cash flow model without any further analysis is simply inadequate. A few months ago, I wrote an article about Guru (and former Morningstar Manager of the Decade) Bruce Berkowitz, who has said the following about his investment approach:

“…We try to kill the company. We think of all the ways the company can die, whether it’s stupid management or overleveraged balance sheets. If we can’t figure out a way to kill the company, and its generating good cash even in difficult times, then you have the beginning of a good investment.”

I think many investors would have difficulty saying they’ve tried to “kill” Apple; on the contrary, I think the majority of them spend their time defending the company at all costs, only further cementing their belief that this is a great investment and that Apple is different from the precedent set by their (at times) uncrowned competitors, including HTC, Nokia (NOK), and Motorola (GOOG).

As I noted in the opening, this article isn’t solely applicable to Apple. Next time you find yourself salivating over a well-known investment where the thesis seems so incredibly clear (likely with some help from the blogosphere or a talking head on CNBC), remember that the rest of the market has likely glanced at it too; and if it continues to look like a steal, be able to answer this question before you take the plunge: “If everyone knows it's undervalued, why haven't they bought it and driven up its price?”

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.2/5 (39 votes)

Comments

batbeer2
Batbeer2 premium member - 1 year ago
Hi SoH,

Thanks for another interesting read.

>> An investment that 'everyone' knows to be undervalued is an oxymoron

I disagree with mr. Marks.

Take Vodafone. Most investors I know agree that the stock is cheap. Still, they will find reasons not to own it:

- The stock has always been cheap and it always will be.

- The Verizon stake is not "in play".

- All telecom stocks are cheap.

- The company is too big

- The stock doesn't move at all

- The payout ratio is too high

etc. etc. etc.

Inevitably such stocks are owned by a group of market participants who are able to sit on a portfolio of stocks with no discernible catalyst. A rare breed.

In short, most investors I know look for stocks with a specific catalyst. This leaves many stocks out there that are universally regarded as cheap but "uninteresting".

vgm
Vgm - 1 year ago
SoH,

Thanks for the article. In some ways, I feel you're writing on a rather superficial level, however. For example, you say:

"They simply assume that the historic growth rate is at least a decent proxy for future growth, and thus conclude that the stock is a no-brainer."

Whether it's a real example or not, this does not represent the mental process of any serious investor worth his or her salt, and we/you should not be reading such nonsense. In terms of Apple, I think of Steve Mandel who has held it for years as it has made its meteoric rise. As one of the topmost stock analysts out there, he has been carefully evaluating it as it evolved and decided it still represented 'value' - even when others were bailing on the assumption that it "must" be overvalued after it had risen so much. He was right because his ongoing analyses were rigorous and correct, not because of historic performance - and it's been hugely profitable for Lone Pine.

Today, Apple may or not represent good value with a margin of safety, but credible investors like Julian Robertson still think it's cheap. We should be stimulated by people of the caliber of Robertson, but never listen to the average talking heads on CNBC (Fast Money comes to mind) as you suggest some are doing.

The word "everyone" may be dangerous in the context of your article. On the one hand it can of course never actually be accurate, and on the other in its common usage it encompasses the full spectrum of investor abilities. That's quite a range. It's like saying 'everyone can play baseball'. Well, yes and no!

Thanks again for the stimulation.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Batbeer,

Thanks for the kind words; I would simply point that, as you note, Vodafone (as you describe it) is only attractive to market participants who don't mind waiting - and I think that's a much, much smaller number than "everyone".

Vgm,

Thanks for the comment; the reason I added the intro was for a comment like yours. I understand what you're saying, and I'm not doubting it - Apple may very well be a fantastic investment, particularly when one considers the caliber of money managers who hold it among their top positions (Einhorn, the people you mentioned, etc); when I said "everyone", I meant everyone who had wrote articles using the rationale I presented, without any further explaining as to why they felt this was sustainable over time (there are a few that fit this description on SeekingAlpha). The point is that these people (the one's writing such articles) are pointing to something that everyone, even the bears, know to be true - this is the type of mental block I think Mr. Marks is talking about. Thanks again for the comment!

sapporosteve
Sapporosteve premium member - 1 year ago
For me, Apple is an interesting case study.

Firstly, it appears that Apple can do no wrong by a lot of people/analysts. I like Eihorn, but when he says that it can be a trillion dollar company, then I start to think that some are drinking too much "Apple juice". Going from 1 to 10 is easy, going from $600 billion to 1 trillion is another thing. I get a feeling of a Halo Effect around the stock.

It is interesting to see what part of a company's success is a direct result of their efforts and what aspects are due to external factors.

1. Porter/McGahan have done studies that show that what industry you are in is a major contributor to success. Apple is no doubt in a "hot" sector at the moment and has been for the past 5 or 10 years. So Apple being in High Tech sector is a partial reason for their success. Like being in Australian mining services over the past 5 years.

2. Fama/French 1999 show that profits mean revert. As does Montier.

3. Chan/Karceski/Lakonishok 2001 show that high growth rates dont persist.

4. Wiggens 1997 finds that while some companies do exhibit superior economic performance, only a small minority do so and they are not sustainable over the long term.

So does Apple have a moat? Bruce Greenwald says no. Now of course he maybe wrong.....

The industry is highly competitive and for me it seems to be based on who has the latest technology. I think Apple may have had a first mover advantage but no longer does. Some one can tell me if I am wrong here, but I dont think Apple was the first one out with an Mini iPad? There are plenty of smartphones/iPad competitors now so I think Apple has lost that previous "wow" factor when it totally dominated markets. Just looking at Business Insider and they list the top 10 smartphones. Now I am not saying Business Insider are right but the point is there is plenty of competition out there.

I think there are a couple of other things. One, the fight over patents to my mind does not play out that well because it shows that they may be relying more on past efforts than future efforts. I freely admit this is a very subjective comment.

The maps fiasco was not a good show of strength.

Apple seems to be cheap on forward earnings and in my mind that makes it more like a growth stock than a value stock.

But like Howard Marks says

"What matters most is not what you invest in, but when and at what price".

So if you got in early good for you, but is Apple a great buy now?

Thanks for the post SoH

regards

buynhold
Buynhold - 1 year ago
Nice article, Science of Hitting!

>> "An investment that 'everyone' knows to be undervalued is an oxymoron. If everyone knows it's

>> undervalued, why haven't they bought it and driven up its price?"

It's a good question to ask why it's undervalued, but I wouldn't say well-known undervaluation is an oxymoron. There can be many reasons not to buy: short-term orientation of the masses, career risk, herd mentality, lack of a visible catalyst, poor past performance of stock etc etc ...

I believe Buffett claims that in 1973 when WPO was selling for $80mil, most analysts, brokers, and executives knew it was cheap (worth at least $400mil), but still nobody wanted to buy/recommend it.

By Howard Marks's logic, an investment everybody knows to be overvalued is also an oxymoron. During the dot-com bubble days, everyone agreed that well-known stocks like Microsoft, Cisco, Sun Micro were expensive. So everybody should have been selling them, no? Yet, people kept buying.
Alfastur
Alfastur - 1 year ago


It is an interesting theme here. It is hard to explain why but sometimes it seems that everybody agree that something is cheap but they don't buy. I remember an interview of Warren Buffett. I don't remember exactly but I think that it was with Charlie Rose. He was talking about how he bought his position in the Washington Post. The market capitalization was about $80 million, although the assets could be valued about $400 million. He bought big lots from a few sellers. He asked why they sold. They agreed that they were selling cheap, but they thought that the price of the stock was heading lower. And for a while they were right.

In this case there was a bear market. When other stocks get lower it seems logical that people and institutions could need to sell to cover loses in other stocks. However other times such price distortions can happen without a generalized bear market, and it seems that mass psychology by iftself is enough to cause opportunities.

When speaking before a Congress Committee Benjamin Graham said that he didn't know why in the long term stock get back to their fair value. Fortunately it seems it is possible to take advantage of Mr Market vagaries without needing to understand all that goes on backstage.

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Some great comments, with a good dose of different (and interesting) thoughts - thanks everybody!
summerbell
Summerbell premium member - 1 year ago
Can Berkshire Hathaway be viewed in a similar way ?

Buffett thinks it undervalued and is close to buying back stock. A great many commentators seem to feel the same, often looking at valuation in a variety of different ways. Indeed, I struggle to find any commentary that regards the price as high or overvalued.

The bear case seems to be limited to ...'no dividend, Buffett health, better opportunities elsewhere'.

So, if it is undervalued, why's it so cheap ?

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Summerbell,

That is what I'm addressing in this article - if you are not pointing to specific factors in your analysis for the bear case, then your work is far from complete; the points you note on Berkshire are relevant - the articles about Apple, on the other hand, fail to address the history of this industry, and simply assume that low P/E means screaming buy without addressing any of the relevant factors that might explain how such a "cheap" valuation can exist in a free market. Thanks for the comment!

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