Apple Inc. A value-based approach for the Retail Investor.

Transcription

1 The Continued Case for Value Investing C. Tau Murapa January 5, 2016 Apple Inc. A value-based approach for the Retail Investor. In 1984, Warren E. Buffett penned an article entitled: The Superinvestors of Graham - and-doddsville making a simple but powerful case for the continued relevance of the value investing approach. More importantly, it was a homily to his mentors Benjamin Graham and David L. Dodd on the 50th anniversary celebration of their first print (1934) of the groundbreaking Security Analysis: Principles and Techniques which revolutionized how financial analysis would be practiced. In the spirit of that tradition I will be making the continued value case for several wellknown, large-cap companies as particularly suitable investments for the types of retail investor clients I serve everyday. In my practice, I have a fairly even split between regular brokerage accounts and retirement accounts, and the majority of my clients are not professional money managers. Many clients have both types of accounts. With all of them I take a longer term, value-based approach where we always talk about the intrinsic worth of the company we are buying shares in and, over time, the continued operational health of the company while we wait for the stock price to normalize. Sometimes I receive articles from clients when an analyst or television pundit has a negative view on one of our investments. This is particularly the case with Apple Inc. as so many people have an opinion on such a well-known name. My focus as a value investor is ALWAYS on what we would pay for the entire company, how long it would take us to recover our cost, what the current yield is on our investment (I will elaborate this ownership concept as it differs from the traditional fixed income calculations of current yield), and operational efficiency 1

2 measurements such as Return on Equity (ROE) and Free Cash Flow (FCF). In many ways my approach is rather quantitative and fully dependent on reported GAAP numbers and NOT projections of future earnings, future earning growth etc. Indeed, I am just not built to make predictions based on assumptions for the future. As I am making my evaluations on past performance, I have to seek out a considerably large margin of safety to compensate for unforeseen circumstances that are bound to happen. Put another way, and with hopefully more clarity, I am seeking out discounts in price that would almost seem laughable if it didn t concern money and especially other people s money As someone who started out his Wall Street career in the Fixed Income (Bond) Division at Goldman Sachs & Company in New York, I have a certain comfort with the idea of a security maturing at a known amount, par or 100 cents on the dollar, which may trade at either a discount or premium prior to maturity, and which pays back certain cash flows while we wait. What is paramount here, of course is the credit worthiness of the issuing company. As such, I am more concerned whether the company is healthy enough to stay in business and ultimately pay off its obligations than future predictions of growth conquering new markets and launching new products. Of course, if a company is able to do these wonderful things, it will remain healthy and be in an even better position to pay me (as the investor) back. However, given that I NEED a certain margin of safety, I have to seek out companies that if they were merely to maintain current levels of cash flow generation, an investment in them today would still represent great value. With that brief background on my value approach we will now proceed to Apple. Before addressing the Apple case, I think it s extremely useful to note, once more, the inscription at the beginning of Security Analysis (second edition, 1940), [that I purchased as a trainee Stock Broker/Financial Advisor in the Santa Monica office of Morgan Stanley & Co.] which states: Many shall be restored that now are fallen and many Shall fall that now are in honor. Horace Ars Poetica 2

3 How fitting and concise a summary of the value investor s approach to seeking out unfavored companies and waiting for fair value to be restored Mr. Buffett opens his article: The Superinvestors of Graham-and-Doddsville with this question: Is the Graham and Dodd look for values with a significant margin of safety relative to prices approach to security analysis out of date? Emphatically, I say not When considering Apple, Inc. as it trades today, the first question we have to ask is what would we pay for the whole company assuming that we could in fact buy it. Now, let s keep in mind that this type of analysis is geared for the retail investor and the tools they have available so I ll lay out some terms as clearly as possible. At the close of trading today, Jan 5, 2016, the last Apple trade was at $ which denotes a market capitalization of $ BN. Essentially, market capitalization is saying that this is the amount the US stock market values the total shares outstanding. To get to this amount we simply take the price of one share and multiply it by the total shares outstanding. You can find the total number of shares outstanding at the bottom of the balance sheet. In other words if you were to buy every share outstanding you would pay this market-cap. Now for the sake of math and always looking to add any margin of safety we ll say Apple s market-cap today is ~$600 BN. Now Apple has done a fantastic job in the past ten years of accumulating a significant cash horde so that in buying the company we would be taking this cash and settling the outstanding long-term debt. As of Apple s 2015 year-end (September 26, 2015), Apple had a cash position of ~$205 BN versus long-term debt of $ Thus, we conclude that they have a net cash position of ~$150 BN. Thus, to buy the company we would pay ~$450 BN (i.e. market-cap minus net cash). So the logical question we would ask now is how much money is Apple generating that would effectively pay for the purchase over the next years. Let s point out an area of difficulty here in that we re effectively looking back and then making the assumption that going forward the company can continue to operate well. But let s also use this first point of potential hesitation as a reinforcement of what we re about as value investors. The question we are always asking is 3

4 simply this: Right now what would we pay for this company and does this amount represent a bargain? In terms of operations, Apple had an incredible year - again In 2015, Revenues increased from $ BN to $ BN, an increase of 27.88% More important is the return to the bottom line (or profits/earnings) which in 2015 were increased from $ BN to $ BN or 35.14%. But when considering that we re looking to buy the company we re actually going to look at the actual cash that s being generated by the company. After all, it s from that cash that the company pays taxes, dividends and even its own shares in the open market. So a number we really want to know about is Free Cash Flow (FCF) which is basically the cash generated from normal operational activities minus the cash it needs to spend (capital expenditure or capex) to maintain these operations. For 2015, Apple s FCF increased from $49.9 BN to $69.9 BN or an increase of 40.01%. We ll evaluate these numbers more a little later. Now that we ve assessed what we d have to pay for the company and the cash-flow from operations that will effectively pay for the purchase, we ll use a few metrics to ascertain whether this company is indeed a bargain. It is very useful to note here that when Mr Graham first set about evaluating the intrinsic net worth of company he started from a position of assessing the book (or liquidation) value. If the market capitalization of the company was below the book value then, by definition, the purchaser was getting a bargain. Obviously, he would then look further and assess whether he d indeed found a potentially profitable buying opportunity. With the growth of the equity markets, companies have tended to trade at higher multiples of book value especially in technology or if they have heavy debt loads. As such, other methods have been employed to basically look past the fact that most companies are not trading at a discount to book value, with the notable exception of some financial services firms. Borrowing liberally from Mr Buffett and other notable value investors such as Joel Greenblatt, we will now apply some techniques to get a sense of whether we re really getting a bargain when we buy Apple today (today s market cap - net cash). To recap, the last trade for Apple was done at $ for a market-cap of $587 BN which adding a bit of safety is ~$600 4

5 BN. They have ~150 BN of net cash so our true purchase price is really ~$450 BN or $80.66 per share (implying $22.05 a share in cash). Now, I took a little time a bit earlier to mention the free cash flow that is generated by Apple which was ~$70 BN in 2015 (or $12.55 a share). Often, my first assessment will be a quick back of the envelope calculation where I take the Free cash flow (FCF) and discount it at 6% (risk free rate I d expect to receive from a long-term treasury bond). We can go into this calculation more at a later time. However, when doing this calculation for Apple, using BN shares outstanding, I get fair value of $ a share based on the $70 BN of FCF in Interestingly, when I do the same calculation on Microsoft s $ BN of FCF in 2015, I get fair value of $48.04 a share. Microsoft closed at $55.05 today so it wouldn t be a deeply discounted stock to me. What is crucial in the analysis of Apple is the question of how reliable are these cash flows in what is a very competitive industry but on first glance it would indeed appear to be sufficiently discounted. However, we do want to provide that margin of safety. As such, we have to be a a little skeptical of the $209 intrinsic value just on principal Once again, we must have a significant margin of safety in any investment. So the first question I have to ask myself is: How likely is it that Apple can maintain these cash flows? One year ago (2104), Apple had just achieved a then corporate record $49.9 BN in FCF. Just to get some context, the combined 2014 free cash flows from Microsoft, Walmart and Exxon Mobile combined was ~$53 BN. I also mentioned earlier that as a previous bond guy I am pretty comfortable with the idea of little to no growth if the company can at least maintain its current cash flows. So what I d rather do is take a number between $50 BN and $70 BN, say $60 BN, and use that in my free cash flow valuation of the company. The other way I can add to the margin of safety is effectively ignore the fact that Apple is being extremely aggressive in buying back its own stock. Indeed, in 2015, Apple bought almost 300 million of its own shares but if I assume that the share count will stay where it is then I ll arrive at an intrinsic value of $ with a high margin of error. Put in other words, I just need them to come in at $60 BN in FCF and maintain their current share repurchase rate then this ~$180 a share number is quite reasonable. 5

6 To recall, the current purchase price net cash is $80.66 and fair value is $ which would be a % gain from this true purchase price. Looked another way, Apple is currently trading at a 55% discount of fair price or 45 cents on the dollar. If it even takes four years for Apple to trade at this fair value based on these free cash flows, we would have received an 18% compounded annualized return which would still substantially outperform the S&P 500. Another way a great value investor like Warren Buffett assesses whether a company is a reasonable purchase (and let s remember he actually buys whole companies) is by asking how long it will take pre-tax earnings (earnings before interest and tax or EBIT) to effectively cover the purchase price. Thus, if the real purchase price is ~$450 BN and Apple generated EBIT of $ BN, Apple s EBIT/Purchase Price coverage would be: EBIT/Real Purchase Price = /450 = 16.11% Another way of looking at it is to say that Apple would take 6.21 years to cover the purchase price (450/72.515)yrs. As a general rule of thumb, we like to reach a 10% threshold (or 10-year time horizon) to cover the purchase so Apple is very strong here. Another very useful way of assessing the margin of safety is to analyze the operating efficiencies of the company. One way of doing this with a prospective purchase is to analyze the Return on Equity (or book value) to get a sense of how well the company uses its capital to generate pre-tax cash flows. The ROE calculation would be as follows: ROE = EBIT/Book Value = / = 60.76% Just to understand, a return on equity of approximately 60% is phenomenal. A general rule of thumb for a Mr. Buffett purchase is a ROE of over 25%. By comparison, Microsoft had a ROE of 23.10% for its year ending 2015 so Apple is operating with exceptional efficiency. 6

7 A final way I like to ascertain whether an investment represents great value to a buyer is to get a sense of the current yield it generates for the owner. I am after all a bond guy at heart. But it is important to remember that we re not fixed income (bond) investors. In the bond world we would be looking at total rate of returns or how much money is returned to in terms of interest payments and any capital appreciation (if any) when the bond is sold or matures. Another measure in bond world is current yield which is basically a measurement of what kind of return the interest payment you receive represents as a percentage of your actual purchase price. The current yield on a bond would be: Current Yield = Annual Interest/Purchase Price of the bond Thus, if you pay 90 for a bond ($900) and receive 9% interest, your current yield would be 10%. However, when I look at current yield as relates to our purchase of Apple, we look at the total returns that were effectively paid back to us as share holders/business owners in Thus, we re looking at: Current yield = Earnings Per Share/Net Cash Purchase Price = 9.22/80.66 = 11.43% For a investment grade bond yield this would be a very satisfactory and would indicate that company would pay for itself in approximately eight and a half years. Ever in search of margin of safety, I d like to note here that value investor Joel Greenblatt, who s magic formula methodology I admire greatly, likes to use an EBIT/Enterprise Value calculation when calculating Earnings Yield which can also be useful. This is seen as a better measurement than Return on Equity. Mr. Greenblatt, who was the first outside investor in contemporary value investor Dr. Michael Burry s Scion Capital, also uses a Return on Tangible Capital calculation measured as EBIT/(Net Working Capital+Net Fixed Assets) as part of his 7

8 magic formula which he believes is a better measurement than Return on Assets. These calculations could definitely help us if further analysis is required. Once again, I d like to emphasize that the raison d être of the value investor is that we have a mindset that we re effectively purchasing entire businesses when we buy stock; and that we want to make sure we re getting a good return in the shortest amount of time possible. The various methodologies I have used supports the idea that value investors often have differing methods of assessing value but, at the end of the day, we re extremely focused on the concept that we re viewing the worth of the entire company and are looking for a bargain based on healthy yields (Earnings/Purchase Price) and companies that the market is undervaluing greatly. Conclusion: When considering the case of Apple, Inc., which closed at $ implying a market capitalization of $ BN, and based on its 2015 pre-tax earnings of $ BN from revenues of $ BN (31% pre-tax operating margins), and with a net cash position worth $22.05 a share, Apple is an extremely healthy company. The $69.9 BN in free cash flow is a record for any company, anywhere ever Yet despite this 40% increase in free cash flow from 2014 (114.33% since 2012), Apple s stock is trading 6% lower than it traded one year ago Indeed, based on the average free cash flow from the past couple of years, and using a discount rate of 6%, Apple should be trading at approximately $180 a share instead of $ (or $80.66 a share ex-cash). The current health of the company and the significant discount the current share price represents, definitely makes Apple Inc. the type of value with a significant margin of safety relative to prices investment Mr. Buffett discussed in his article: The Superinvestors of Graham-and-Doddsville. Apple would definitely be considered a fantastically well-run company with a highly competent management team and a very high sense of responsibility to shareholders as evidenced by the dividend that was reinstated in August of 2012 after a hiatus of 17 years. Furthermore, Apple is definitely trading at a very deep discount to its actual worth providing the necessary margin of safety this value investor requires. Tally Ho and Happy Hunting - CTM 8

9 Mr. Murapa is the founder of Murapa Investments, Inc. which is a Registered Investment Advisor based in Los Angeles, CA. Mr. Murapa graduated with a BA with Distinction and Honors in Political Science and a MA in Medieval History from Stanford University. Previously, Mr. Murapa was a Financial Analyst in High Yield Credit Derivatives and a Business Analyst in the Global Credit Derivatives Group at Goldman Sachs & Company in New York and a Financial Advisor at Morgan Stanley & Company in Santa Monica, CA. Mr. Murapa is also the Principal of Murapa Capital Partners, LLC which is a merchant banking holding company. 9

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