When Apple (AAPL) was at $702, professional investors couldn't love it enough. It was the most-held stock among the largest funds when they reported their holdings as of June 30, 2012.
And then, just like that, the sentiment began to change. The word on Wall Street and in the tech world was that Apple had lost its spark. It would also be very difficult for them to replicate the success they had with the iPhone and the iPad. And the stock price hit the skids.
We have been watching Apple for the past few years from the sidelines. Apple passed our first rule with their financially strong balance sheet, but the stock price never became attractive enough to be considered a value for our portfolio. That all changed on December 28, 2012.
When we first began doing research on Apple, we decided we would only be buyers of Apple if the stock price were less than $515 — which means we would be paying no more than 12x earnings. We added it to the portfolio when it traded below our trigger price on December 28, 2012.
The Apple story reminds us of when we added Microsoft to our portfolio four years ago. Its share price had fallen more than 25% and analysts had little interest in its plans was for the future.
In the face of an onslaught of negative sentiment, we added the stock to the value-oriented portfolio because the company passed our two tests: it had a financially sound balance sheet, and it was trading at a discounted price.
As it turned out, the most bearish projections made two years ago never played out, and Microsoft's business continued higher. And since we bought Microsoft in May, 2011 it has gained over 41%.
Similarly, in our view, at the current price, Mr. Market is not pricing in any growth for Apple. When Apple reported their second quarter results in April, analysts were focused on the drop in Apple's earnings compared to one year earlier, and its slowdown in sales.
Instead of focusing on expectations, we focused on what was knowable. Here's what we found in their latest results that made the stock price an even bigger bargain:
Apple sold $43.6 billion of products for the quarter—without any new products.
Increased dividend by 15%—for a yield of 3%–50% higher than the S&P 500 index.
Share buyback of $60 billion by the end of 2015. This will decrease the share count by 148 million shares or 15% of shares outstanding.
Cash and marketable securities of $144 billion on the balance sheet.
Profit margin before taxes of 31%.Backing out the $144 billion cash and marketable securities, Apple's shares are trading at only 7x trailing twelve-
month earnings. Mr. Market is not pricing any growth into the stock price.
We think Mr. Market missed the boat on pricing Apple. Just doing a back-of-the-envelope calculation, we don't see these growth drivers priced into the current stock price:
New products scheduled for fall 2013. There is talk of Apple coming out with a watch or TV. Any additional sales from new products would be gravy to shareholders.
A cheaper iPhone. About 70% of smartphone users around the world use prepaid phones. If Apple comes out with a cheaper version of the iPhone, they could potentially capture millions of new users who would enter Apple's echo system.
Acquisitions. With a war chest of hundreds of billions of dollars, and tens of billions flowing into the company each quarter, Apple could make an acquisition that would impact their long-term growth.
Lower margins. Apple is currently earning profit margins in the 30%+ range. If they wanted to sell more units and increase market share, all they would need to do is lower the prices on iPhones and iPads. They would still be making money and adding tens of millions of new Apple users.Keep in mind—we're talking about a market that industry estimates say will be growing by leaps and bounds over the next few years. According to the IDC, the smartphone market will double between 2012 and 2016.
Gartner estimates that the tablet market is growing even faster—from 125 million units in 2012 to a projected 375 million by 2016. Apple is not selling products to a buggy-whip market. If any one of these growth drivers materializes, the stock should see a multiple expansion and the share price should soar.
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