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 (“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?”
