Apple: What You Can't Know, What You Can Know

I had an interesting debate recently with a Portfolio123 user who was big on combining stock screening with a subjective company-by-company analysis focusing on things like whether the company's business is understandable, whether it has a durable competitive advantage, whether it has a talented management team, and so forth. (If this strikes you as a Warren Buffett-esque approach, you're right; Buffett's name often came up in the discussion.)

In playing devil's advocate, I asked how confident he could plausibly be in his ability to accurately assess such issues. I'm concerned that well-meaning investors armed with books that present an overly idealized view of what you can learn by studying a business overestimate how much they know and, hence, wind up making bad decisions.

A Case Study: Apple

Let's focus on Apple (AAPL), which ought, one would think, be easy to decipher given how widely talked and written about it is.

Consider iPad, which is likely to pay a big role, for better or worse, in Apple's ongoing profit trends and stock price. Many of us have seen it; some of us own it; most of us believe it's either a game-changing milestone or an over-priced toy, and, it seems, everyone has an opinion on how well or poorly it will do.

The Art, Science And/Or Voodoo Of Forecasting

Unfortunately for forecasters, nobody can really predict what's going to happen. The forecasts you see depend, by necessity, on a chain of assumptions many of which are themselves highly uncertain.

Prognosticators can start with plausible assumptions about population and the percent of people who own laptops, iPods and/or iPhones. From there, however, we shift to guesswork. What percent may add iPad to their existing repertoire of gadgets? How many may take this as a first such gadget? How many more might buy it if or when prices get cut? How far will prices have to fall to boost demand? Might Apple introduce super higher-priced adaptations? What new apps might come out that persuade detractors to switch gears and jump on the iPad bandwagon? What will the pattern of growth look like, meaning how fast will market penetration ramp up from zero to a "normal" level beyond which general economic factors will play a bigger role (as may now be the case with iPod)?

If you haven't got a headache by now, consider that iPhone 4. We need to engage in similar exercise for that. We also have to make assumptions about how competitive efforts from Research In Motion (RIMM) and the Android consortium developing between Google (GOOG), Verizon (VZ) and Motorola (MOT) and potentially others. Speaking of competition, we have to assume a slew of iPad killers will be launched and wonder if any will rise above the crowd.

Bad News, Worse News, Good News

This looks bad. We don't really know as much about Apple as we might have thought we did.

Now, for some good news. Investors can live with the uncertainties described here because there are, actually, a lot of other highly relevant things you can know about Apple that will help you make a thoughtful yes-or-no decision about the stock.

The solution is to be found in the numbers, things we can know. If we can learn to move beyond the "past performance is no guarantee . . . " mantra foisted upon investors by lawyers and regulators, we'll find a wealth of information that can help us develop very reasonable assumptions about the future.

Growth Rates


Let's consider Sales and EPS growth rates for Apple, which are shown in Table 1. As you review the numbers, bear in mind that the original iPod debuted in late-2001 and the original iPhone came out in mid-2007.

Table 1 - Annual % Growth Rates

	2002	2003	2004	2005	2006	2007	2008	2009
Sales	7.1	8.1	33.4	68.3	38.6	27.2	52.5	14.4
EPS	267.8	4.1	267.0	351.4	46.3	73.4	72.6	33.9

When iPod was born, consumers didn't quite know what to make of it or iTunes and we see a slow build in sales. As to the mega-percent gains we see in early-decade EPS, brush them aside. I haven't dug deeply yet but pending further review, I'll assume those reflect unusual gains or charges, not recurring business trends. Starting in 2004, though, it looks like iPod began to pick up serious traction, helped probably by consumer familiarity, increasing comfort with and credibility for iTunes, and new iPod variations. This isn't an idle history recitation: notice how those developments translated into numbers.

By 2007, though, we saw some deceleration since by then, many owned iPods and felt no need to buy new versions. We also see the upward jolt resulting from iPhone's debut. Notice, too, the quick deceleration in 2009. Note the pattern: an initial ramp-up, as market penetration went from zero to something, followed by a leveling off.

Hold these thoughts. Let's now move on to something else.

Valuation

Table 2 shows some basic valuation metrics.

Table 2 - Annual % Growth Rates

	AAPL	Industry Median
PE (using estimated EPS)	20.17	17.57
Projected LT EPS Growth Rate	17.5%	15.0%
PEG Ratio	1.15	1.17

That should give pause to those who say Apple is overpriced. The valuation might actually be OK. It all depends on the reasonableness of the earnings projections.

Analysts are looking, on average, for a 49% EPS gain in 2010.

Does that make sense? Go back to Table 1 and look at how the catching on of iPod and the ramp-up of iPhone impacted results. We can't expect the current new products to match because they will not be as large a proportion of Apple's total business as the old pioneers were. But the gain analysts expect in 2010 is well below what we see associated with prior new launches. So analysts are leaving room, quite a bit of room, for the new products being smaller portions of the total business and for potentially slow initial consumer adoption. Bear in mind, also, that estimated 2010 results reflect two major product launches, iPad and iPhone 4, in contrast to the past, when major launches occurred one at a time. There's a lot that can go wrong that can cause Apple to miss the target, but that's always the case in Corporate America. Based on what we're seeing here and now, I'm inclined to accept the projected 49% 2010 EPS gain. That means the 20.17 forward PE presented in Table 2 is legitimate.

Now, look at the projected long-term (assume three to five years) 17.5% EPS growth rate and notice how modest it is compared to what Apple has achieved in recent years. While nobody knows if iPad or iPhone 4 will take over the world, it seems clear that such a level of success is not necessary for the company to hit the 17.5% growth projection. All that's needed is for the iPod to not fall off a cliff (or if it does, to at least have the fall cushioned by increased iTunes sales based on a larger customer base) and for the new products to have at least moderate success. Anyone comfortable with these unspectacular assumptions should be willing to accept the 17.5% growth-rate target, which would make the 1.15 PEG ratio legitimate.

What We Now Know

This is just a sample of the analytic process, so there's a lot more that can be done with Apple's financials. That said, even this gives investors a lot to go on than they get by watching or participating in the endless and often virulent debates between Apple fans and Apple haters.

We still don't know the future, but we have learned some important and relevant things: (1) while numbers that depict past performance guarantee nothing, they can teach us a lot about the dynamics of a business, and (2) it won't take nearly as much success as many assume in order to justify Apple's current stock price.

Subjective issues like durable competitive advantage, etc. are fun to contemplate, but if you really want to make thoughtful decisions about stocks, you really need to work with the numbers.

It's Different This Time - Yes, Really

The stock market has not been a fun place to be since 4/23/10, and with 2008 still looming so large in our memories, we have to wonder whether we're again heading for something really ugly. At present, I don't think that's in the cards.

Differences

For normal people, the ultimate obscenity is known as a " four-letter word." For investors, the ultimate obscenity may be a four-word sentence: "It's different this time."

That underscores the trepidation I feel as I point out some important differences between now and late 2008.

For starters, the current downturn did not begin at anything even remotely resembling a peak price level, as we can see from Figure 1, a Yahoo! Finance S&P 500 price chart.

Figure 1

Actually, considering the vigor and persistence of the bounce of the early-2009 bottom, it's easy to argue that the market was due for a rest and would have found a reason, any reason, had Greece, Spain, et. al. not served one up so readily in the spring to start the ball rolling.

Stateside, there's a huge difference in expectations. Before the 2008 meltdown, many still though sub-prime lending and the accompanying approach to derivatives was a good thing. Now, we know better, much better. Going into 2007-2008, the financial system still had a lot of junk that needed to be cleaned up. It may not be pristine now, but it seems plausible to argue that we're a heck of lot cleaner than we were back then.

Finally, there's the nature of the stock selling itself. What happened in 2008 was not an ordinary bear market, or even a severe bear market. It was a completely different animal.

Figure 2 shows the number of S&P 500 stocks which fell 5% or more in one week at various points in time.

Figure 2

It's pretty bad so see how often a large number of blue-chip stocks fell so much so quickly, and it's interesting to note that we've been seeing some of that in the very recent past. Let's use that to get a general feel for how market weakness plays out in the real world.

Next, look at Figure 3, which raises the ante by charting the number of S&P 500 stocks that fell more than 10% in a week.

Figure 3

Now, we're starting to see some distinctions. The 2008 melt-down was different from most other bad periods in recent memory. The only other thing that came close was the post 9/11 selloff.

Finally consider Figure 4, which shows the number of S&P stocks falling more than 15% in a week.

Figure 4

Imagine a 15%-or-more stock price decline in one week. It's by no means unprecedented. We've seen situations like that when bad news comes out, often something very disappointing on the earnings front. But such events are usually scattered occurrences.

Imagine more than 300 simultaneous such situations within the S&P 500, the blue chips, the supposedly safest and most respectable part of the market!

That's powerful. That's also rare, enough so to even exceed the post-9/11 market drop. Making matters worse was the backdrop. Aside from the 2008 peak, unusually high levels continued to occur for several months.

Now, it's clear that late-2008 was a very special situation and that what we've been experiencing so far this spring has no resemblance at all to it (despite, even, the now-infamous flash crash).

It's definitely been rough out there. Figure 2 makes that clear, and so, to a lesser extent, does Figure 3. But we're not experiencing anything like the widespread and largely indiscriminate equity-dumping that occurred in late 2008.

Even so, we can't be complacent. Look again at Figure 3. We had nearly a year of persistently bad readings before the bottom fell eventually out of the market. We can even see a bit of that in Figure 4. Similarly high readings, albeit not as spectacularly high as late-'08, marked much of the early-decade bear market as well.

The most recent (spring of 2010) many-big-declines readings we see in Figures 3 and 4 are not cause for panic. But the trend bears watching. If it doesn't recede soon, we will want to fasten our seatbelts.

Why Investors Defy Critics And Use Leveraged ETFs

Leveraged ETFs are hated by many gurus and commentators but are loved by investors.

Critics fear misuse by investors who hold these newfangled securities too long. They are designed to double or triple the performance (or the inverse of the performance) of the target index when held for a day. But if held longer, all bets are off, as the zigs and zags of daily price action can cause leveraged ETFs to chart unexpected courses. (Depending on how long one holds such an ETF, and how erratic the index's path, it's actually possible to lose money on a leveraged short ETF even if one correctly assumed the index would fall.)

But judging by the volume of trading, these securities are loved by investors. Among the 100 ETFs that rank highest for 60-day average volume, 32 are leveraged, split evenly between leveraged long and leveraged short.

What gives? Are there really so many daytraders out there who are holding leveraged ETFs for a single day, and guessing right about market direction onften enough to stay solvent and continue coming back for more?

That's possible. There is, however, another possible expnalation. Maybe these ETFs can actually contribute in a ocnstructive way even to someone whose market timing is less than 100% perfcet and who, hevan forbid, actually does hold them for more than a day. Actually, I'm in this caegory.

I used StockScreen123.com to create a model for low-price stocks, those which trade below $3.00 and can be bought or sold with reasonable spreads through the window-trading platform of on-line broker FolioInvestong.com. I love this segment of the market. It usually offer much better returns than I can get even from other kinds of small-cap investing, and this segment offers opportunities to hit big-time investment home runs. However, risk, here, is real and substantial. Being exposed to stocks like these when the market is gyrating wildly can be a painful experience.

Obviously, I could go into and out of these stocks based on my assessment of market conditions, but even if my timing is reasonably accurate, the drain form dealing with even reasonable low-price-stock spreads can add up. So I decided to hold my stocks through thick and thin and when I'm worried about the market, add a leveraged ETF, specicifally, the Direxion Daily Small Cap Bear 3X ETF (TZA). On May 21st, I bought enough TZA to result in my having a 15% stake in it, and 85% in my regular low-price stock portfolio.

Figure 1 is the performance record of this account as presented on the FolioInvesting web site from 5/21/10 through 6/5/10. The dark blue line represents my portfolio, which was up 0.43% over this volatile period. The light blue line represents the Russell 2000, which was down 2.36%. As to TZA I bought it at 6.986 and on 6/5,it closed at 7.54 for a gain of 7.92%.

Figure 1


There's noting fancy happening here. My timing hasn't been perfect and my stake in TZA in the past couple of weeks hasn't always been beneficial, although it was so at the end of last week and still is as of this writing.

That's OK. I'm not trying to win a spot on TV as the next great daily forecaster or change the world or win a Nobel Prize. I only want to inject enough stability into a normally high-risk-high-reward stock portfolio to give me the fortitude to stay put and avoid allowing myself to get scared into selling a potentially great stock portfolio at the wrong time. Inb that respect, TZA is serving me well right now, as it has done in simiular contexts in the past.

This is one example of how one fundamentally-oritned non-daytrader uses leveraged ETFs. I can't speak for all the others who use these products, and judging by the volume, there are a lot of them. I suspect, however, that amopng that crowd, there are many other stories that while not identical to this one, are likely to be at least soemwhat similar.