Archive for April, 2012

Market Madness

MF Global is the new poster child for why thoughtful financial regulation is needed more than ever. – Bart Chilton

Some excerpts from this speech given by CFTC Commissioner Bart Chilton last month (in the midst of “March Madness”):

FCIC
The Financial Crisis Inquiry Commission (FCIC) was established to look at what happened. It concluded the Troubled Asset Relief Program or TARP was needed due to two culprits to the calamity.

One culprit: regulators and regulation. You see, in 1999, Congress and the president deregulated banks. Banks were no longer bound by that pesky Depression-era Glass-Steagall Act that cramped their style and limited what they could do with the money in their institutions. With the repeal of Glass-Steagall, regulators got the message to let the free markets roll. And, roll they did—right over the American people.

The second culprit: The captains of Wall Street. FCIC concluded that since they were allowed to do so much more without those annoying rules and regulations, they devised all sorts of creative, exotic and complex financial products. Some of these things were so multifaceted hardly anyone knew what was going on or how to place a value upon them.

Credit Default Swaps (CDS)
CDSs were a significant component of creating this ginormously humongous dark market with no oversight by regulators. When I say ginormously humongous, that’s a technical term. You see, we at the CFTC currently oversee roughly $ 5 trillion in annualized trading on regulated exchanges, but the global over-the-counter (OTC) market is roughly—here it comes—$ 708 trillion. If you Google ginormously humongous, it should say, “See OTC markets.”

In the speech, Chilton goes through what he views as four of the most critical rule changes needed but have yet to be approved or implemented. Speculative position limits is one of the four. He argues that position limits have been needed for years and are now needed more than ever.

The Commission passed a final position limits rule in October but, according to Chilton, implementation has been delayed by a lawsuit and some other unfinished business with the SEC. More excerpts from the speech:

Speculation and “Massive Passives”
I know we need speculators. I know I know I know—there are no markets without them. Speculators are good. But like a lot of good things, too much can be problematic. Therefore, it is the excessive speculation that can cause problems, contort markets, and result in consumers and businesses paying unfair prices and negatively impacting our economy.

Chilton then describes what he calls “Massive Passives”:

Between 2005 and 2008 we saw over $ 200 billion come into futures markets from non-traditional investors. I call them “Massive Passives.” They are the likes of pension funds, index funds, hedge funds and mutual funds. These funds are very large—massive—and have a fairly price-insensitive, passive trading strategy. 

Then went on to say…

I’m not suggesting that the Massive Passives, or speculators in general, are actually driving prices. Let me be clear. I’m not proposing they were all in cahoots and decided to raise oil prices. What I am saying is that they contribute to price swings, and have a proportional impact in markets based upon their size as a whole, and certainly individual traders can push prices around if they have a large enough concentration. When prices are on the rise, like now, and the Massive Passives and others get into markets, they can push prices to levels that may be uneconomic—certainly not tied directly to supply and demand—and the prices may stay higher longer than they normally would.

The Speculative Premium
…you don’t have to take it from me, from Senators or U.S. Representatives, or from the President of the United States. In fact, you don’t have to take it at all. I know that many of you in this crowd won’t. Nonetheless, let me lay one more piece of research on you with regard to speculation. This one doesn’t come from some lefty activist group. It comes from one of the big Wall Street banks. Its researchers said that each million barrels of net speculative length adds as much as 10 cents to the price of a barrel of crude oil. The speculative length is a known quantity. With a little math, you can determine that the “speculative premium” on oil these days is around $ 23 a barrel—and that translates into about an extra 56 cents for a gallon of gas.

Considering the interests involved and the dollars at stake, I’m not surprised it has taken this long to address these kind of things. Still, we’d be smart to not wait too long. The most critical changes ought to be thoughtfully implemented well before the next financial crisis is upon us.

Not doing so is just asking for largely unnecessary self-inflicted economic pain at some unknowable point in the future.



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Thursday, April 19th, 2012 Investments No Comments

U.S. Bancorp’s 1st Quarter 2012 Results

From this post on the WSJ Deal Journal blog:

If U.S. Bancorp’s results were any more consistent, the bank might be able to stop reporting quarterly data.

It just keeps posting solid growth that generally outpaces most other lenders.

Earnings jumped 27% as average total loans increased 6.4% amid a 17% jump in commercial borrowing and 26% surge in commercial and commercial-real-estate commitments.

Not many domestic banks performed like U.S. Bancorp (USB) during the financial crisis or are now positioned as well.

From the U.S Bancorp’s earnings release:

U.S. Bancorp Chairman, President and Chief Executive Officer Richard K. Davis said, “U.S. Bancorp’s first quarter 2012 financial results clearly demonstrate that the momentum the Company has established and built over the past several years is continuing to drive performance in 2012. The Company’s first quarter diluted earnings per common share of $ .67 were 28.8 percent higher than the prior year and the increase was driven by revenue growth and improving credit costs. Our key performance ratios of return on average assets, return on average common equity and efficiency were 1.60 percent, 16.2 percent and 51.9 percent, respectively, in the first quarter. All of these performance ratios are among the best in the industry and at the top of our peer group.

“Average total loans and deposits were higher in the first quarter, posting year-over-year growth of 6.4 percent and 11.7 percent, respectively, as all of our balance sheet businesses benefited from growth initiatives and continued to capitalize on the flight to quality.”

That kind of loan growth or source of inexpensive funds has the potential to drive healthy future profit growth as long as U.S. Bancorp continues, as it has historically, to intelligently underwrite the loans.

Like most good banks, their above average returns on capital seems to begin with having sound practices and culture that’s reinforced by capable management.

It certainly shows up in the numbers.

Relative to many peers, U.S. Bancorp has exceptional net interest margins (at 3.6 percent, it doesn’t match the 3.91% of Wells Fargo: WFC, but handily beats most others) and the capacity for fee generation.*

As one of the stronger domestic banks going into the financial crisis, U.S. Bancorp was in a position to acquire some fine assets while weaker ones could not.

That certainly also hasn’t hurt their current results and future prospects.

Adam

Established a long position in USB at much lower than the recent market prices


* Payments processing, credit/debit cards, trust/investment management, mortgage banking, loan syndication and bond underwriting among other things.



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Wednesday, April 18th, 2012 Investments No Comments

Buffett on Commodity Businesses – Part II

A follow-up to this post on Berkshire Hathaway’s (BRKa) textile business. From the 1985 shareholder letter:

For an understanding of how the to-invest-or-not-to-invest
dilemma plays out in a commodity business, it is instructive to
look at Burlington Industries, by far the largest U.S. textile
company both 21 years ago and now. In 1964 Burlington had sales
of $ 1.2 billion against our $ 50 million. It had strengths in
both distribution and production that we could never hope to
match and also, of course, had an earnings record far superior to
ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business,
and in 1985 had sales of about $ 2.8 billion. During the 1964-85
period, the company made capital expenditures of about $ 3
billion, far more than any other U.S. textile company and more
than $ 200-per-share on that $ 60 stock. A very large part of the
expenditures, I am sure, was devoted to cost improvement and
expansion. Given Burlington’s basic commitment to stay in
textiles, I would also surmise that the company’s capital
decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real
dollars and has far lower returns on sales and equity now than 20
years ago. Split 2-for-1 in 1965, the stock now sells at 34 —
on an adjusted basis, just a little over its $ 60 price in 1964.
Meanwhile, the CPI has more than tripled. Therefore, each share
commands about one-third the purchasing power it did at the end
of 1964. Regular dividends have been paid but they, too, have
shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what
can happen when much brain power and energy are applied to a
faulty premise. The situation is suggestive of Samuel Johnson’s
horse: “A horse that can count to ten is a remarkable horse – not
a remarkable mathematician.” Likewise, a textile company that
allocates capital brilliantly within its industry is a remarkable
textile company – but not a remarkable business.

My conclusion from my own experiences and from much
observation of other businesses is that a good managerial record
(measured by economic returns) is far more a function of what
business boat you get into than it is of how effectively you row…

Then later in the letter Buffett added…

Should you find
yourself in a chronically-leaking boat, energy devoted to
changing vessels is likely to be more productive than energy
devoted to patching leaks.



Since businesses with commodity-like economic characteristics have little or no pricing power, a sustainable cost advantage ends up being the crucial factor for investors.

Now, it’s one thing to understand the importance of owning shares in a lowest cost producer (or, at the very least, among the lowest), but figuring out who that actually is and why the advantage they have is sustainable isn’t usually all that easy.

Adam



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Monday, April 16th, 2012 Investments No Comments

Wells Fargo Reports Earnings

From the Wells Fargo (WFC) quarterly earnings release:

Wells Fargo & Company (NYSE: WFC) reported record net income of $ 4.2 billion, or $ 0.75 per diluted common share, for first quarter 2012, compared with $ 3.8 billion, or $ 0.67 per share, for first quarter 2011…

Net interest income after provision for credit losses did grow to $ 8.89 billion from $ 8.44 in 1st quarter of 2011 but was basically flat compared to 4th quarter of 2011.

The key driver of earnings growth was noninterest income:

Noninterest Income
Noninterest income was $ 10.7 billion, up from $ 9.7 billion in fourth quarter 2011. The $ 1.0 billion increase was driven by increases of $ 506 million in mortgage banking, $ 458 million in market sensitive revenue, and $ 181 million in trust and investment fees.

In the 1st quarter of 2011, noninterest income was just under $ 9.7 billion.

Wells Fargo will likely earn roughly $ 3.20/share this year. That compares to peak earnings prior to the financial crisis of $ 2.49/share (a nearly 29% increase). The fact that they are already displaying relatively strong earnings power in a still somewhat fragile economic environment would seem to imply they’ll do just fine as conditions improve.

Yesterday’s closing price was within 2% of a 52-week high yet, using the $ 3.20/share estimate, the stock currently sells for under 11x earnings.

Adam

Established a long position in WFC at much lower than recent market prices



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Saturday, April 14th, 2012 Investments No Comments

Yacktman on PepsiCo

In this recent GuruFocus article, Donald Yacktman had the following to say about PepsiCo (PEP):

PepsiCo has a diverse group of food and beverage businesses that offer a high degree of predictability and have solid growth potential over time. The long-term growth potential comes in large part from continued international expansion and product innovation. Management has a mixed track record with its “Good for You” strategy and its recent acquisitions. We believe the company will need to show improved results from several of the key areas of strategic focus or there may be a new management team in place in the near future. The potential for the stock is less about the growth, which we think is mid-to high single-digit per year, and more about the combination of valuation and quality of business. – Donald Yacktman

Donald Yacktman has liked PepsiCo for some time but that seems a slightly less favorable assessment compared to previous ones by him and his team.

PepsiCo has some high quality businesses, but the execution on some fronts lately has been somewhat disappointing.

Earnings is expected to be down this year compared to last year. Using this year’s number, PepsiCo is selling for nearly 16x earnings.

So, while not expensive (especially if an investor believes those earnings will begin to bounce back next year), it hardly seems like a bargain near the current valuation considering some of their recent difficulties.

A larger discount until they prove some things to shareholders seems warranted.

Check out the full article. In it, the co-managers at Yacktman Funds respond to readers’ questions.

Adam

Established a long position in PepsiCo at less than recent market prices



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Friday, April 13th, 2012 Investments No Comments

Investing in Precious Metals: What to Consider

Investing in gold and other precious metals has become a very popular investment over the past several years. People who are looking to invest in this area, however, should take some precautions. Historically, investing in commodities like precious metals has always been considered a high-risk investment.
Before investing your money in precious metals, take some time to think about the following questions.

1. How much of your portfolio will you invest?

As a general rule, you should try to spread your money out among a variety of investments. While the exact allocation or distribution of your assets will be dependent on factors such as your age, age at which you want to retire, net income, total amount of money you currently have invested, and your risk tolerance, it is important to make sure that you do not have all or most of your assets heavily concentrated in one area.

Because of all of the advantages and risks to investing in these commodities, financial advisors usually recommend that potential investors keep a maximum of twenty percent of their total portfolio invested in gold, silver, and other similar metals. Investing more than this portion of a portfolio is usually thought of as being too risky for most individual investors.

Unfortunately, many people tend to ignore this rule and invest everything they have into commodities. This can lead to you losing your life savings if there is a sudden downturn or dip in the precious metals market. If you’re considering this investment, be sure to keep the majority of your money in other investments.

2. How will you come up with the money for the investment?

Deciding what money to invest is as important as deciding where to invest it. Some people choose to invest in precious metals within their retirement plans at work. This means that they are using the money they would have otherwise put into other investments in the precious metals market. Because it is inside of their retirement account, however, they will need to plan on keeping the investment for a long time.

Other people decide to invest the cash they have or take on unsecured debt, such as a credit card, to get the money to invest. If you choose to do this, make sure that you are investing money that you can afford to lose. Remember that the market can vary a lot, making it a less than ideal place to put money that you may need access to right away.

Taking out a loan in order to invest in precious metals is very risky. In addition to having to pay back the principal, you also have to make sure that the investments nets enough to pay back the loan and make a profit. Take out a loan only if you are very experienced with the commodities market.

3. How long do you plan on holding on to your investment?

While holding onto precious metals for the long term (that is, more than five years) has historically turned a profit for most investors, it is entirely possible to lose a significant portion of your principal by investing in precious metals. While the fact that gold and silver have never traded at zero on the market is touted as proof that this is a safe investment, the truth is that it only means that an investor will probably be able to hold out during a price drop and wait for the price of their investment to come back up.

Nonetheless, investing in the precious market over the short term can be very risky. It is next to impossible to predict what will happen to the price of gold or silver from day to day. Be sure to carefully consider your overall financial situation before making the decision to invest in precious metals. Also, be sure to research the investment thoroughly before buying.



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Wednesday, April 11th, 2012 Investments No Comments

The Illusion of Skill

This article is an adaption of the book “Thinking, Fast and Slow” by Daniel Kahneman (emeritus professor of psychology at Princeton) that was published last year.

The 2nd half of the article focuses on the results found in studies of active traders, professional fund managers, and advisers.

The Princeton professor is known for research on how quirks in human behavior lead to illogical investor decision-making and outcomes. In reality, his contributions are proving to be much broader.

Some excerpts:

Active Traders, Take a Nap*
On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year, in addition to the significant costs of executing the trades. Some individuals did much better, others did much worse, but the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas.

Inactivity Wins**
…on average, the most active traders had the poorest results, while those who traded the least earned the highest returns.

While professionals may have (or at least seem to have) an advantage over amateurs…

Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.

Now, what about wealth advisors? Kahneman looked at data for some anonymous wealth advisers to figure out whether the same advisers consistently achieved better returns for clients and display more skill than others. Once again…

The results resembled what you would expect from a dice-rolling contest, not a game of skill.

The Illusion of Skill
What we told the directors of the firm was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign that they disbelieved us. How could they? After all, we had analyzed their own results, and they were certainly sophisticated enough to appreciate their implications, which we politely refrained from spelling out. We all went on calmly with our dinner, and I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions — and thereby threaten people’s livelihood and self-esteem — are simply not absorbed.

Kahneman closed with the following…

…overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.

In the 1970s, the work of Kahneman (in collaboration with Amos Tversky) challenged the flawed but once prevailing wisdom in social science that people generally acted rationally and selfishly (in some ways still alive and well even if to a lesser extent). First, they showed that mental shortcuts (heuristics) are useful but “lead to severe and systematic errors.” Later, their prospect theory exposed flaws in the dominant models in economics at the time. The basic assumption that people will always act rationally and in their own interests was wrong.

For Kahneman and Tversky, it was obvious that people are not fully rational nor selfish.

In 2002, Kahneman won the Nobel in economic science. What’s at least notable about winning such an award is that Kahneman is a psychologist.

I am currently reading Kahneman’s “Thinking, Fast and Slow”. The book looks at the many forms of cognitive bias and at the flawed manner that traditional economic models assume people behave among many other things. I’ve found it insightful and useful for investing and beyond. It is a comprehensive (and, though accessible, I mean comprehensive!) look at the sources of human irrationality.

To me, Kahneman seems most interested in allowing the implications of the better ideas in his field to speak for themselves, while recognizing their limitations, and noting some of the key disagreements among colleagues, where applicable.

He seems a humble expert.

Refreshing.

It has been well worth reading so far.

Adam

* Terrance Odean, finance professor at the University of California, Berkeley
** Terrance Odean and Brad Barber in the paper “Trading Is Hazardous To Your Wealth”.



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Monday, April 9th, 2012 Investments No Comments

Buffett on Berkshire’s Earnings Mix: Operating Earnings Versus Gains from the Sale of Securities

Analyzing Berkshire Hathaway’s (BRKa) earnings isn’t always straightforward.

The year 1985 wasn’t especially confusing compared to other years but serves as a useful example. The Shareholder Letter from that year shows that Berkshire’s pre-tax earnings grew substantially year over year from $ 200.5 million to $ 613.4 million.

On the surface a great year but, unfortunately, that bottom line number doesn’t reveal much about what Berkshire’s true earnings power was at the time.

It was, in fact, a very good year but not nearly as good as the tripling would indicate.

The reason? Much of the increase came from the sale of marketable securities. Here’s how the picture looked that year with gains from the sale of securities separated from the earnings (in millions) from Berkshire’s operating businesses:*

                                                              1984              1985
Operating earnings                       $ 87.7          $ 125.4
Gain from Sale of Securities    $ 104.7         $ 468.9
Other                                                  $    8.1           $  19.0
Total Earnings                                $ 200.5        $ 613.4

Here’s how Buffett explained the year over year performance in the 1985 Shareholder Letter:

Our 1985 results include unusually large earnings from the sale of securities. This fact, in itself, does not mean that we had a particularly good year (though, of course, we did). Security profits in a given year bear similarities to a college
graduation ceremony in which the knowledge gained over four years is recognized on a day when nothing further is learned. We may
hold a stock for a decade or more, and during that period it may grow quite consistently in both business and market value. In
the year in which we finally sell it there may be no increase in value, or there may even be a decrease. But all growth in value
since purchase will be reflected in the accounting earnings of the year of sale. (If the stock owned is in our insurance subsidiaries, however, any gain or loss in market value will be reflected in net worth annually.) Thus, reported capital gains or
losses in any given year are meaningless as a measure of how well we have done in the current year.

The bulk of that gain from sale of securities was the result of selling General Foods.

Now, Berkshire had bought General Foods at what they viewed to be a substantial discount to per share business value back in 1980. Also, the business had fine underlying economics and, according to Buffett, a management that was focused on increasing that business value.

Shares bought cheap compared to 1980 value and, as a result of attractive underlying economics along with sound management, intrinsic value grew substantially over the five years or so.

None of the above led to a reported gain while the next thing that happened did. Phillip Morris came along and made a nice premium buyout offer for the shares of General Foods. More from the letter:

We thus benefited from four factors: a bargain purchase price, a business with fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value. While that last factor is the only one that produces reported earnings, we consider identification of the first three to be the key to building value for Berkshire shareholders. In selecting common stocks, we devote our attention to attractive purchases, not to the
possibility of attractive sales.

So value was enhanced over many years but the gains had to be recognized all at once as accounting earnings in that one year.

Adam

* Earnings do not include the amortization of Goodwill. From the letter: …amortization of Goodwill is not charged against the specific businesses but, for reasons outlined in the Appendix to my letter in the 1983 annual report, is aggregated as a separate item. The reason comes down to the difference between economic and accounting Goodwill. The Appendix in the 1983 letter does a nice job of explaining this.



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Sunday, April 8th, 2012 Investments No Comments

Jamie Dimon’s 2011 Annual Shareholder Letter

In his latest letter to the shareholders of Berkshire Hathaway (BRKa), Warren Buffett had this to say about the CEO of J.P. Morgan ((JPM), Jamie Dimon:

One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.

He also added some additional thoughts on Jamie Dimon and J.P. Morgan recently on CNBC.

Well, Jamie Dimon’s 2011 letter to J.P. Morgan shareholders was just released and it is a very good one.

Some excerpts from the latest letter:

$ 1.8 Trillion of Capital and Credit
During 2011, the firm raised capital and provided credit of over $ 1.8 trillion for our commercial and consumer clients, up 18% from the prior year.

On Buybacks and Dividends
We also bought back $ 9 billion of stock and recently received permission to buy back an additional $ 15 billion of stock during the remainder of 2012 and the first quarter of 2013. We reinstated our annual dividend to $ 1.00 a share in April 2011 and recently announced that we are increasing it to $ 1.20 a share in April 2012.

J.P Morgan’s Stock
Normally, we don’t comment on the stock price. However, we make an exception in Section VIII of this letter because we are buying back a substantial amount of stock and because there are many concerns about investing in bank stocks.

It Could Have Been Much Better
Recently, we have begun to achieve modest economic growth around the globe, somewhat held back by certain natural disasters such as the tsunami in Japan. But I have no doubt that our own actions – from the debt ceiling fiasco to bad and uncoordinated policy, including the somewhat dramatic restraining of bank leverage in the United States and Europe at precisely the wrong time – made the recovery worse than it otherwise would have been. You cannot prove this in real time, but when economists 20 years from now write the book on the recovery, it may well be entitled, It Could Have Been Much Better.

A Stronger System
There also should be recognition that the whole system is stronger. Accounting and disclosure are better, most off-balance sheet vehicles are gone, underwriting standards are higher, there is much less leverage in the system, many of the bad actors are gone and, last but not least, each remaining bank is individually stronger.

Best and Highest Use of Capital
Our best and highest use of capital (after the dividend) is always to build our business organically – particularly where we have significant competitive advantages and good returns. We already have described many of those opportunities in this letter, and I won’t repeat them here. The second-highest use would be great acquisitions, but, as I also have indicated, it is unlikely that we will do one that requires substantial amounts of capital.

More on Buybacks
If you like
our businesses, buying back stock at tangible book value is a very good deal. So you can assume that we are a buyer in size around tangible book value. Unfortunately, we were restricted from buying back more stock when it was cheap – below tangible book value – and we did not get permission to buy back stock until it was selling at $ 45 a share.

Our appetite for buying back stock is not as great (of course) at higher prices.

Dimon does also say that they plan to buy back the amount of stock that
we issue every year for employee compensation because “we think this is just good discipline”.  I find that to be a bit disappointing but the statement that follows provides some reassurance they won’t do that kind of thing at any price:

Rest assured, the Board will continuously reevaluate our capital plans and make
changes as appropriate but will authorize a
buyback of stock only when we think it is a
great deal for you, our shareholders.

The statements “our appetite for buying back stock is not as great” and “will authorize a buyback of stock only when we think it is a great deal” should be the norm among CEOs but that kind of discipline is far from a given.

Adam



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Friday, April 6th, 2012 Investments No Comments

Is a $ 1 Trillion Market Cap in Apple’s Future?

There have been some recent headlines made by analysts who are predicting that Apple (AAPL) stock will hit $ 1,000/share.

Brian White of Topeka Capital Markets said he expected it to happen within 12 months while Gene Munster of Piper Jaffrey said it would be more like by 2014.

Apple May Be World’s First Trillion Dollar Company

Are these predictions at all similar to the kind of price targets that happened during the tech bubble?

Well, I doubt we are there yet but I readily admit to not being a fan of the whole price target game. Never have been and never will be but I also realize the price target folly that goes on is not going away anytime soon.

So I’ll leave the guessing what a stock will do over a shorter time frame like 2 or 3 years to others.

To me, it has always made more sense to to buy what I understand at a discount to a conservative estimate of hopefully well-judged worth, then let it compound for years to come.

Other than that, just monitor the strength of the core franchise and sell only if something fundamental materially breaks (and occasionally, if reluctantly, when the capital is needed for a clearly superior alternative).

Well, that’s true for most investments I’ve made but, as I’ll get to later in this post, it’s not easy to do with something like Apple (at least not easy for me).

So will Apple soon be intrinsically worth $ 1 trillion? More importantly, will it be able sustain and grow that value for a long time?

Let’s look, somewhat simplistically, at the kind of assumptions that are needed to get Apple to a $ 1 trillion valuation.

Assumptions
15% earnings growth in 2013 and 2014 (I think many are expecting more than that)
Dividends and buyback plan is executed as announced
15x enterprise value/earnings
Shares outstanding remain roughly the same (per Apple’s recent announcement, buybacks are to neutralize share dilution)

With 15% growth in earnings through 2014, by my math Apple will have over $ 200 billion in cash after paying the dividends and executing the buyback. That 15% level of growth suggests Apple will be earning roughly $ 55 billion in 2014.

15x that amount of earnings results in an enterprise value/earnings of $ 825 billion.

Add in the $ 200 billion of cash and you get a $ 1 trillion market cap.

For those willing to buy the above assumptions the stock may not seem expensive now. Yet, while I own shares of Apple (disclosure: purchased at less than 1/3 yesterday’s closing price), the risk/reward of buying near what it sells at now is far less comfortable for me.

It’s not that the stock is expensive compared to current earnings. Certainly not.

It’s that, unlike most other things I own, it’s difficult to judge what Apple’s normalized earnings are likely to be longer term. There is a wide range of outcomes (seemingly now more on the upside than downside these days, but that’s often the time to start being skeptical) and the safety margin is smaller.

I can see why others will likely still see the stock as still a good opportunity and they may turn out to be right. Apple’s near term prospects are hard to argue with and, considering their track record, will probably even continue to surprise on the upside.

I just have no idea and I’m not willing to risk additional capital based upon the assumption that $ 50 billion plus in earnings will be a sustainable number that can be built upon for years to come (they very well may prove it is more than sustainable, but no one gets to invest in retrospect).

What’s the normalized earnings for a company like Apple that has seen its recent earnings explode higher?

Maybe still a lot higher but who knows in an industry as dynamic as the one Apple competes in. Among other scenarios, it’s also possible this is a temporary explosive spike in earnings that, as competition pressures margins somewhat, eventually settles in at a lower level and then Apple grows from there. Apple would remain a terrific business if that happened, but the stock would seem a whole lot less cheap.
(Of course, this was also a possibility a few years back. Just consider that Apple’s earnings have gone from $ 5 billion/year to $ 40 billion/year in only five years. So while, with the benefit of hindsight, this concern may prove to be too early some caution seems at least warranted.)

When the earnings picture changes this quickly, it is important to at least consider the various probable outcomes instead of blindly extrapolating into what seems a blissful future.

I don’t doubt the stock could go up from here but eventually an investment gets to the point where it’s not clear to the owner (me) what the longer run downside risk is (again, even if it turns out to be a wrong judgment after the fact).

So, while I may not be selling the shares I already own anytime soon, what seemed a clear margin of safety when I initially purchased Apple’s stock has, to me, mostly disappeared.

Can Apple can become worth $ 1 trillion and make it stick longer term? As good as Apple is, that’s still too hard to figure out. I mean, the durability of any company that resides in a dynamic industry is difficult to figure out but, of course, Apple is not just any company.

Over the next five years or so, Apple’s upside is or at least seems just fine compared to just about any large cap. I don’t doubt they may get to $ 1 trillion or more in market value. They may even seem worth it for a while (or end up actually being worth it).

The math required to get there isn’t aggressive.

Having said that, I know of some great (if far more boring) business franchises in less dynamic industries that, if bought at the right price, still have a far better long-term risk/reward for my money.

That’s my comfort zone.

Apple’s business is not.

Of course, none of them can probably match Apple’s potential near-term (and possibly even longer-term) term prospects. 

I have owned Apple’s stock the past two and a half years for the simple reason that the price became ludicrously low compared to its rapidly growing intrinsic value. The margin of safety seemed large and turned out to be even larger than could have been known at the time (at least by me). As always, the price paid relative to likely value dictates the risk one takes on an investment.

Eventually the price gets so low that something I normally would not like to own becomes attractive.

Apple’s business has a far wider range of outcomes than I usually like so it’s kept on a shorter leash than most other things I own. (In contrast, selling something like Coca-Cola  (KO) would never be a consideration just because it became somewhat expensive. Though if it ever became late 1990s expensive I would!)

The fact is, I never will be the best candidate to own Apple’s shares long-term (others are more qualified), but I wouldn’t want to be betting against their future prospects either.

Adam

I do not make stock recommendations as that comes down to individual circumstances. The site is for informational and educational use and opinions found here should not be treated as investment advice. 



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Wednesday, April 4th, 2012 Investments No Comments