Since Warren Buffett (Trades, Portfolio)’s annual letter came out and he followed up with a lengthy interview on CNBC where he talked about how much more Apple (AAPL, Financial) stock Berkshire now owned – and how he was the one who bought most of it – I have gotten a lot of email questions asking about his purchase.
This is not the first time I have received a slew of emails questioning the logic of one of Buffett’s investments. Since I have been writing articles about investing, he has made four investments that really got a reaction from value investors who doubted the logic of what he was doing. These include: Buffett’s initial purchase of railroad stocks and his subsequent purchase of all of Burlington Northern, his investment in IBM (IBM, Financial) despite him having said he does not invest in tech stocks, his investment in the four major U.S. airlines despite the fact he has said the airline industry is a terrible one for investors and now his investment in Apple.
Berkshire Hathaway's (BRK.A, Financial)(BRK.B, Financial) investment in Apple is far from the most controversial of these cases. A bunch of other value investors like the stock. It is a reasonably priced stock on an enterprise value basis – Apple has a lot of net cash, so its market cap exaggerates the valuation being put on the company. But, each of these investments by Buffett is an example of him moving into an area he had not previously touched. I am not sure Buffett ever invested in a railroad stock despite the fact that when he started his career – in the early 1950s – railroad stocks were a much bigger part of the investment landscape than they are today. Buffett may not have bought tech stocks before IBM – but it is, in most every other respect, the kind of stock Buffett would normally buy.
Also, Buffett previously said the reason he never owned Microsoft (MSFT, Financial) was because no matter whether it was true or not – people would assume the purchase was the result of inside information from his friend, Bill Gates (Trades, Portfolio). He also said, however, that at one point Microsoft stock got to a price – presumably, this is sometime after the 2008 financial crisis – that seemed low to him. Buffett rarely talks about whether the price of a stock seems low, high, etc. unless he understands something about that business and that industry. So, it is not unreasonable to think Buffett believes he understands some things about Microsoft. And those things might allow him to – within a very wide value range – know whether even a tech stock like Microsoft is cheap or not.
Now, let’s look at Apple. What does Buffett see in that stock? The number one thing that appeals to Buffett about Apple is something that should not matter at all to you. Buffett is attracted to Apple’s size. It is a huge stock. Buffett said on that same CNBC interview I mentioned that Berkshire was unlikely to take a bigger than 10% stake in a company because of the problems that presents. Berkshire has ended up with more than 10% of a company’s stock, but that has often been helped along by share repurchases on the part of the company itself.
Right now, Ted Weschler and Todd Combs are each running $10 billion portfolios at Berkshire. Those are the small portfolios. Buffett is investing at a whole order of magnitude more in size. But, let’s start with just the kind of ideas Weschler and Combs need to come up with.
Assume you are running a $10 billion portfolio that is fully invested in common stocks. Further assume you want to avoid buying more than 10% of a company’s stock. Now, assume you are a concentrated type investor the way Buffett is. As I write, my own portfolio is 65% invested in just two stocks: Frost (CFR, Financial) and BWX Technologies (BWXT, Financial). It is 85% invested in just three stocks. The third stock, however, is a micro-cap. Managers investing billions of dollars cannot even look at a micro-cap. The very smallest stocks they can possibly buy are things like Frost and BWX Technologies. So, how much of their portfolio could they put in those two stocks? Remember, I have 65% of my portfolio in those stocks.
Well, if you are managing $10 billion, and you are buying stock in a company with a market cap of about $6 billion (which is about the size of Frost and BWX), you can put just under $600 million into the company without crossing the 10% ownership threshold. So, say you have two good ideas that are each $6 billion companies – put them both together and you get just 12% of your portfolio in those stocks. Now, for me personally, I do not want to spend time worrying about a stock that is much less than 20% of my portfolio. Here, we are talking about stocks that are 6% of your portfolio if you buy absolutely as much of them as possible. You see the problem. And I have understated it.
Buffett is running about 10 times what Weschler and Combs are running individually. And neither Frost nor BWX Technologies is a small company. Within its niche of Texan banks, Frost is the biggest. And within its niche of nuclear work for governments rather than civilians, BWX Technologies is the biggest. So, Buffett cannot be looking for companies that have market caps of $6 billion. He wants companies with market caps of $60 billion or even $600 billion. Apple has a market cap of even more than $600 billion. So, here we have a company where instead of putting just 5% of your portfolio into the stock at the very most, you might get the chance to put 10%, 20% or even 50% of your portfolio into the stock. When Buffett was running his partnership, he liked to put 25% into his best idea. In the case of American Express (AXP, Financial), he even went beyond that. If we do a little math with the amount of money Buffett manages at Berkshire, we can see that ideas in the $100 billion to $700 billion market cap range are really, really useful to him because he can potentially deploy $10 billion to $70 billion (10% of the value of these kinds of companies) into such gigantic public companies.
Think about what kinds of companies you have in the $100 billion to $700 billion range. It is pretty limited. Buffett likes focused companies. He likes brands. A great idea for Buffett is something like Coca-Cola (KO, Financial), American Express, Wells Fargo (WFC, Financial), Moody’s (MCO, Financial), or Gillette. Those were great ideas because they were not just big companies. They did very few things in a very big way. Buffett’s stake in Gillette got swapped into Procter & Gamble (PG) stock. He eventually did a deal to get out of P&G by taking control of Duracell. Duracell is a big brand like Gillette. P&G is an even bigger company, but only a few of its brands are huge in a way that is useful to Buffett. P&G as a whole is more diversified into things that are not really as good as Gillette is on a standalone basis.
Not only is Apple a huge company, it is a hugely focused company, which is attractive to Buffett. Apple’s fortunes are now tied to one brand (as they really always have been) and largely to one product (the iPhone). When you listen to what Buffett said about Apple, you realize how important this is. Buffett said he likes Apple. He said he sees how integral the iPhone is to the lives of people – especially young people – who now have it. And he says that he sees – at places like the Nebraska Furniture Mart stores he owns – that people upgrade from one iPhone to another instead of considering competing brands. So, the investment thesis is surprisingly focused for a giant company. It really has to do with one brand and one product, the iPhone. That is it. Buffett can evaluate the stickiness of one consumer product and one brand. That makes Apple easier to understand than Procter & Gamble or Disney (DIS) or other giant consumer-oriented businesses that are actually much more diversified. Apple is not diversified. That is the potential attraction.
Moving on, Buffett thinks Apple, like IBM, is not going to do a lot of big acquisitions. He thinks the company is going to buy back a lot of its own stock. This is a very common theme in a lot of his investments. One of the surest signs you can find for a “catalyst” that might change his thinking about a company is that company turning inward and focusing on the things it does best while dedicating its free cash flow toward reducing its share count year after year instead of expanding into other areas.
Buffett is not an activist investor, but if you look at those areas where he has been most vocal – either while on a board, in the way he abstained from a vote or what he said to the press – it is almost always a capital allocation decision. It is usually related to the issuance of company stock. Sometimes it is related to overpaying. Nonetheless, he is constantly urging the management of the companies he invests in to focus on widening their moat, doing what they do best and investing in themselves at a reasonable price (by buying back their own stock) rather than investing in somebody else by overpaying.
The only times I can think of Buffett having any complaints about Coca-Cola had to do with an acquisition the company wanted to do (at too high a price) or with giving stock to top executives. The stock grants to executives incident at Coke was reported in the press as Buffett complaining about executives being overpaid. I think the reason he abstained on that vote had more to do with the fact the company would be permitted to cause a lot of dilution if it used the program to the full extent it was asking shareholder approval for. So, it was probably more about Buffett wanting Coca-Cola to shrink its share count rather than grow it.
When Buffett was asked on CNBC about the growth prospects of both IBM and Apple, he answered by talking about share buybacks. Before Buffett bought it, IBM had one of the longest and most aggressive histories of buying back its own stock you can find at any public company. A lot of Berkshire’s investments have this feature. Look at how much American Express has shrunk its share count since Buffett bought that position. Or look at how much Coca-Cola has bought back of its own stock. In both cases, I’m pretty sure Berkshire’s investments are worth at least 33% more than they otherwise would be because these companies have shrunk their share count by more than 25% while Berkshire owned them. Buffett mentioned in the CNBC interview that Apple had bought back almost 5% of its stock in a year. That is unlikely to be a one-time thing. Apple will have problems with where its cash is located – it will end up with a lot of cash that would be taxed if brought back to the U.S. – but it does not need cash to grow, it cannot grow that fast anymore organically and it does not do big acquisitions.
For a tech company its size, Apple has historically been especially averse to acquisitions. A company as profitable as Apple that does not use money on high-priced, transformative acquisitions is eventually going to have to use that cash to buy back its own stock. There just are not any other realistic options. It could pay dividends; and because of Berkshire’s own tax status, Buffett would benefit at least as much from dividends as from (fairly or overpriced) buybacks. He does not mind dividends, and he certainly does not mind buybacks at stocks he chose in the first place.
What about Apple’s lack of future growth? I think this actually attracts Buffett. That sounds counterintuitive. But, let me explain. Apple is a tech stock and a consumer product company. The most dangerous time to invest in tech stocks and consumer product stocks is when they sell a high-priced product to a small pool of customers. The reason for this is that it allows market entry at the low end. If you are selling $1,000 watches or $10,000 computers, someone can come in selling a cheaper and more basic version of the product to a large group of people who have never owned the product. All sorts of market leaders run into this problem. They have the biggest dollar share of the industry, but economies of scale – and certainly gains in experience – are driven in large by the unit volume you do. The leader is in an awkward position because trying to expand the market cuts into their profitability on a per-customer basis.
If you are selling computers to corporate customers – you are not dreaming of the day when every living room in America can have a cheap, basic desktop. That future is potentially bad for you in several ways. One, it teaches whoever you are competing with a lot about many of the things you do. Two, it cheapens the image of what you are selling. Three, it changes the way you will have to sell what you are selling. Almost all technology, especially any sort of consumer tech, follows this pattern. It can be very tough for investors because it leads to a two-stage adoption of the technology.
In phase one, one leader establishes their dominance in the “pro” market and the stock looks great. But, in phase two, another – and usually different – leader establishes their dominance in the “consumer” market. Then that stock looks great at the expense of the first leader. We could be talking about computers or cell phones here. But if you go back further in history, TVs and radios followed the same pattern too. These things are always invented long, long before you remember them being invented, but were not adopted quickly. People tend to remember when they started seeing cell phones everywhere, when they started using the internet in their own home and so on. Those years have nothing to do with when these products were first invented, commercialized and so forth. Often, there was a company you have completely forgotten about that made and lost a fortune before the time period you even think of the new consumer tech as being suddenly important to society.
What does this have to do with Apple? It is part of a broader question. Just how “moaty” are consumer technology companies? At least on one side of the economic value equation, companies like Apple, Facebook (FB) and Alphabet's Google (GOOG)(GOOGL) depend entirely on the mass appeal of their product. We call them technology companies. Internally, I am sure they seem very technical to those inside the organization. But how much does technology drive the economic returns at these companies? And, at this point, how easy is it to attack any of these business models on some technical difference between your product and theirs? How much of what makes the iPhone successful is the Apple brand, the fact a customer already owns an iPhone and is used to using it, the fact a customer’s friends, family and peers already own an iPhone and, as a consequence, the fact other entrepreneurs and organizations have invested time money and effort in trying to reach people by designing products to be used on an iPhone?
In other words, has the iPhone become the default choice for customers because the Apple brand is good enough, the status quo is good enough, people are not all going to jump on another bandwagon together and the suppliers are going to be where the demand is? Is the iPhone always going to be the easiest choice? This is exactly the same question for Facebook and Google. A very long time ago, I wrote that while I did not own Google stock and did not know how the organization would develop over time as a company, I did know that understanding anything technical about a search engine no longer mattered. Google does not need to be the world’s best search engine to be the world’s most popular search engine. The advantages it has are too entrenched and the differences between one set of search results and another are so small – Google does not really have to compete on quality anymore. Google is enough of a brand and search is enough of a commodity that it does not matter.
The things that got Apple to the position it is now in are not necessarily the things that will keep it there. A lot of readers emailed me asking about Apple’s brand and whether it would last. The answer to that is yes and no. It will be a recognizable brand that is seen as good enough in a decade or two. I would be very surprised if that changed. On the other hand, I would be surprised if the Apple brand was seen as being particularly innovative or standing for very specific design choices or anything like that in a decade or two. Coca-Cola is a great brand, but it is not a very specific brand. It cannot be anymore. When people think cola they think Coca-Cola. And when people think phone – they think Apple. But, Apple will not need to convince anyone to try a smartphone for the first time anymore. They do not really even have to convince anyone to try an Apple product for the first time anymore.
Apple has very high returns on the money it actually ties up in its business. The numbers look lower because they have excess cash. Likewise, the stock looks more expensive than it is because it has a lot of excess cash. If Apple’s sales grow somewhere between nominal GDP and the rate of inflation in the countries where it operates in and the company dedicates every cent it makes – or more, since Apple already has net cash – to buying back its own shares, it will still be a “growth” stock on an EPS basis. For an example of this, see BWX Technologies. It is not really a growth company at all in terms of what it does. It does not gain new customers (outside of the U.S. Navy). It does not win totally new projects (outside of the carriers and subs it has long provided reactors for). And it does not even get many more orders for a higher build rate for the number of those ships now than it did in the recent past. Despite all that, the company just put out a press release saying it expected a “low double-digit” EPS growth rate for the next three to five years. That is a growth stock, but it is one because it is doing something very, very profitable on a return on capital basis. It is retaining all the business it already has and growing the business it retains a tiny but consistent bit, and then it is taking all the money it makes and buying back its own stock. When a super high-quality business buys back its own stock, it is not impossible to turn an underlying 5% type growth rate in how much more your customers actually want into more like a 10% growth rate in the earnings you report per share.
IBM is another good example of that. In the 10 years before Buffett bought the stock, it was not very good at company-wide revenue growth. Over the last decade, IBM had close to 9% annual EPS growth at the same time it had close to zero percent revenue growth. A lot of that is accomplished simply by not growing the assets you tie up in the business at all (IBM’s net tangible assets actually shrank over the last decade) and then taking all your free cash flow and – instead of growing assets like most companies do – use it to reduce your share count.
What Warren Buffett (Trades, Portfolio) sees in Apple is probably a slow growth, wide moat consumer brand that can use all its free cash flow to buy back its own stock and thereby be a high-growth stock in terms of EPS, even while it is slow growth in terms of additional units sold. Apple may not be a growth company anymore, but that does not mean it cannot be a growth stock. All Buffett cares about is the growth in earnings per share. So, he is not necessarily betting Apple can sell a lot more iPhones over the next five to 10 years. What Buffett’s betting on is Apple’s ability to report a lot more in earnings per share over the next five to 10 years.
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