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Grahamites
Grahamites
Articles (302) 

What Apple and IBM Have in Common

Why they offer higher margin of safety than Amazon

June 04, 2018 | About:

A few weeks ago I attended an event where we discussed our thoughts and observations from attending the 2018 Berkshire annual meeting. I read the detailed meeting notes and the after-meeting CNBC interview transcripts while preparing for the meeting. Somehow it dawned on me one similarity between IBM (NYSE:IBM) and Apple (NASDAQ:AAPL), or maybe more relevant to the discussion, one significant difference between the two tech giants and the other tech giants such as Amazon (NASDAQ:AMZN) and Alphabet (GOOGL): Apple and IBM have both been purchasing shares while Amazon and Alphabet have been net share issuers. Thanks to GuruFocus’ awesome interactive chart feature, we can visualize the 10-year trend of diluted average shares outstanding below.

I can imagine someone calling me an idiot right now because everybody already knows that. But before you do that, let me explain.

It’s not the fact that IBM (NYSE:IBM) and Apple (NASDAQ:AAPL) have been repurchasing shares on a mass scale that is worth this article. It’s understanding this fact from a margin of safety point of view that made me write this article.

We all know that tech companies are not Buffett and Munger’s strong suits given their experiences and how they built their circles of competence over time. So naturally they are competing in a field where they may not necessarily have the information edge they had in other fields such as banking.

Buying tech companies who are repurchasing a lot of shares makes sense for Buffett from the margin of safety point of view (this may not be a big factor in Ted Weschler or Todd Combs' decisions though).

Let’s just do some simple math:

As of the end of the first quarter, Apple had 4.915 billion shares outstanding. Berkshire owned roughly 4.87% of Apple, or almost 240 million shares.

Apple earned $61.3 billion operating profit last year and analysts' estimate for the current year’s operating profit is $69 billion (I’m using analysts' estimate because I don’t follow Apple closely).

Let’s simplify things again and let’s say Berkshire’s ownership percentage remains the same throughout the year. Let’s also say that Apple spends the announced $100 billion buyback money at an average cost of $200 per share in the next five years, in which case Apple will have bought back 500 million shares in five years. Berkshire, without spending another dime, would own 5.436% of Apple in five years.

What does this mean? In five years, Berkshire’s share of Apple’s operating profit can still be the same even if Apple’s operating profit falls from the current $69 billion. In fact, Apple only needs to earn $61.8 billion operating profit in five years for Berkshire to “break even” from an owners’ point of view. This means Apple’s operating profit can go down by more than 10% in five years and Berkshire won’t lose money! Anything above negative 10% growth or $100 billion share repurchase is upside.

Let’s compare this to the alternative scenario -- if Apple were to issue more shares like Amazon has in the next five years. Amazon has been issuing shares at a CAGR of about 1.62% for the past 10 years. If Apple were to issue shares at 1.62% a year for the next five years, Apple would have had 5.326 billion shares outstanding at the end of the five-year period and Berkshire’s ownership percentage would have been diluted to 4.5%.

What does this mean? Well, under this scenario, Apple would have to earn $74.67 billion, or 8% more in operating profit, in five years for Berkshire to have the same owners' earning.

The difference? Almost $13 billion in operating profit, or almost 19% (13 divided by 69).

I would be far more comfortable with the first scenario than the second scenario.

Granted, Amazon may have a much better growth rate than Apple in the next five years but from a margin of safety perspective with an owner’s mindset, Apple offers a better margin of safety.

Of course, in reality, if Apple’s earnings for the next five years fall far below Berkshire’s expectations like IBM did, it’s a different story. IBM did buy back a lot of shares but IBM’s operating profit in 2017 was probably way below what Buffett had thought back in 2011. Calculating owners' earnings is less meaningful if you have to sell the business in five years.

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

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