At the 2012 Berkshire Hathaway (BRK.A)(BRK.B) shareholder meeting, Warren Buffett (Trades, Portfolio) was asked why he decided to invest in IBM (IBM) and whether he would consider investing in other technology companies like Alphabet (GOOG)(GOOGL) or Apple (AAPL). Here was his reply:
“Well, those are extraordinary companies, obviously. They make lots of money. They earn fantastic returns on capital. They look very tough to dislodge, where they have their strengths. I would not be at all surprised to see them be worth a lot more money 10 years from now, but I wouldn’t want to buy either one of them. I do not get to the level of conviction that would cause me to buy them … We wouldn’t have predicted what would happen with Apple 10 years ago. And it’s very hard for me to predict what will happen in the next 10 years. They’ve come up with brilliant products. But there’s other people trying to come up with brilliant products. I just don’t know how to evaluate the people that are out there working, either in big companies or in garages, that are trying to think of something that will change the world the way they have changed it in recent years.”
Five years later, during an interview with CNBC, Buffett disclosed that he had purchased 123 million shares of Apple stock for Berkshire’s account (at that time, the stake was worth roughly $17 billion). Fast forward to today: As of its most recent 13-F filing, Berkshire owned nearly 250 million shares of Apple. At $223 per share, the position is currently worth $56 billion. A stock that Buffett said he wouldn’t be willing to own in 2012 now accounts for roughly 25% of Berkshire’s equities portfolio.
What changed in the minds of Buffett and Munger that led them to bet so heavily on Apple?
We can get a sense by looking at what they have said publicly since the investment was disclosed. Let’s start with some of Buffett's comments at the 2017 shareholder meeting:
“I think Apple is much more of a consumer products business, in terms of analyzing the moat around it, and consumer behavior, and all that sort of thing. It’s obviously a product with all kinds of tech built into it. But in terms of laying out what their prospective customers will do in the future, as opposed to, say, IBM’s customers, it’s a different sort of analysis.”
Buffett and Munger both expanded on these thoughts at the 2018 Berkshire Hathaway shareholder meeting, particular as it related to Apple’s capital allocation policies:
“I think it’s extremely hard to find acquisitions that would be accretive to Apple that would be in the $50 billion, $100 billion, or $200 billion range. They do a lot of small acquisitions. And, I’m delighted to see them repurchasing shares. We own 250 million or so shares. They have, I think, 4.9 billion shares. We own 5% of it. But I figure with the passage of a little time we may own 6% or 7% simply because they repurchase shares. And I find that if you’ve got an extraordinary product and ecosystem, I love the idea of having our 5%, or whatever it may be grow to - 6% or 7% - without us laying out a dime. I mean, it’s worked for us in many other situations. But you have to have some very, very, very special product, which has an enormously widespread ecosystem, and the product’s extremely sticky, and all of that sort of thing. And they’re not going to find $50 billion or $100 billion dollar acquisitions that they can make at remotely a sensible price that really become additive to that … As I look around the horizon, I don’t see anything that would make a lot of sense for them in terms of what they’d have to pay and what they would get. Whereas I do see a business that they know everything about, and where they may or may not be able to buy it at an attractive price when they repurchase their shares. That remains to be seen … From our standpoint, we would love to see Apple go down in price … So, we very much approve of them repurchasing shares.”
Charlie Munger (Trades, Portfolio) added the following:
“I think that a great many places have nothing better to do than to buy in their own stock, and nothing as advantageous to do as buying in their own stock. So, I think we know pretty damn well what’s going to happen to Apple. They’d be very lucky if there was something available at a low price that they could buy. I don’t think the world’s that easy. I think that the reason these companies are buying their stock is that they’re smart enough to know that it’s better for them than anything else.”
The commentary from those two meetings points us in the right direction.
The investment was based on two things: the sustainability of Apple’s ecosystem, and its ability to effectively own more of that ecosystem (for shareholders) through large share repurchases at sensible prices. And while it is still somewhat early, I think the bet has worked on both fronts to date.
Let’s start with the ecosystem. As noted on Apple’s fiscal third-quarter conference call held on July 30, the installed base continues to grow in each of the company’s five geographic segments and across all major product categories. At the end of calendar 2018, the iPhone active installed base was in excess of 900 million devices – a roughly 9% increase over the previous 12 months (with the company’s total active installed base across all devices growing at a comparable rate). As shown below, the iPhone active installed base has grown consistently over the past few years (data from JPMorgan):
The growth in the installed base is a major contributor to Services growth. The company now has more than 420 million paid subscriptions across its ecosystem, a number that has more than doubled over the past two years. This is flowing through to the income statement: Services revenues increased 13% in the third quarter to a run rate of $46 billion. In summary, Apple has done a good job adding additional users to a large base and keeping them engaged with their product offerings.
On capital allocation, Apple has lived up to any reasonable expectations as well, from my view.
In the year that Apple showed up in Berkshire’s annual report (2016), it generated more than $50 billion in free cash flow and held roughly $160 billion in net cash. That compared to a market cap at the time of roughly $650 billion. It’s not hard to see why, if you assumed that a large acquisition was unlikely (as Munger discussed), that repurchases at Apple would have a meaningful impact on Berkshire’s stake in the company over five years. (That’s especially true when the starting valuation when they were buying the stock was some low double-digit multiple of free cash flow.)
Fast forward to today: At the end of the third quarter, there were 4.6 billion diluted shares. That’s good for a cumulative decline of 16% since the end of 2016. In addition, management has committed to a “net cash neutral position” on the balance sheet in a reasonable amount of time (at the end of the third quarter, net cash was still more than $100 billion, or roughly $22 per share). To the extent they live up to these expectations in a reasonable period of time, this will meaningfully contribute to a significant reduction in Apple’s diluted share count over the next few years.
Conclusion
After a few years, it seems Berkshire’s investment in Apple is largely working as expected. (To be clear, I mean that in terms of the results delivered by the business.) The company continues to grow its active user base and has become more aggressive with its capital returns to shareholders.
And while the stock price has been volatile over this period, it looks like Mr. Market has largely rewarded long-term investors for these successes. As Buffett noted during an interview with CNBC in February 2019, his average cost on the stock is around $140 per share. At $223 per share, that’s good for an unrealized gain of about 60% for Berkshire (before dividends). Not a bad start.
Disclosure: Long Berkshire Hathaway B-shares.Ă‚
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