Apple Stock: Why I Don’t Want a Slice

Today’s guest post, “Apple Stock: Why I Don’t Want a Slice” is by Value Indexer. VI writes about enjoying wealth at Simply Rich Life and index funds at Value Indexer.

A year ago I couldn’t think of anything that would replace gold as the dumbest non-scam investment. But it turns out I was wrong. Not about gold — it’s still a terrible investment — it’s just that something even worse has come along: Apple stock. I think Apple may soon become another legendary money-losing tech stock along the lines of Blackberry or a less-brutal Nortel.

What’s wrong with Apple? It’s a great company making great products. It’s not, however, a great stock. A few lucky investors made a TON of cash on Apple stock. But lately, the crowd has piled in to lose money. While this is only anecdotal, it seems a lot of people have bought Apple stock because they like the company’s products, e.g. the iPhone, or simply because of its “buzz”. Asset demand theory tells us that such superfluous factors can have a very real inflationary impact on stock price. These speculators aren’t doing a solid fundamental analysis to figure out whether their stock purchase is a good idea, which is a recipe for disaster.

Why We Buy Stocks

When you buy a stock you shouldn’t care about corporate revenues, market share, or how cool and innovative a company is. You are buying one thing and one thing only: a portion of the company’s future profits. Buying stocks of companies that don’t make a profit ends like the dotcom craze when everyone realizes there’s no value. But Apple does generate profit and lots of it. What’s so bad about that? The value of a stock is based on the profits that it will earn in the future. Most of the time, the easiest way to estimate those is by looking at the last year’s profits and projecting (guessing) how fast they’ll grow. If they increase quickly then the stock is worth more than if profits grow slowly. OK, so I still haven’t shown why Apple has a few worms. Here goes.

Competition Squeezes Everyone

Apple is already one of the largest companies in the world with massive profits (armchair economists should read this as “abnormal profits”), which has attracted increasingly vicious competition. As competitors innovate, most consumers won’t keep paying a premium for iPhones. There might always be a hardcore hipster jugend that’ll buy iPhones, but that’s not enough to sustain their current valuation (and predicting the tastes of such fickle demographics is a crapshoot in the long run). Consumers will move to companies that offer good products and services at cheaper prices. Apple will need to continue pouring money into marketing and R&D to maintain their position but, because of competition, they’ll reap fewer benefits (no matter how many lawsuits they might win against Android manufacturers). We can already see convergence in the smart phone market where products are increasingly un-differentiated. Smart phones will follow the same curve as radios, televisions, and computers: birthed as heavily branded products, they will morph into generic, mass-market, low-price goods. The same thing will occur in the tablet market. This is the process by which abnormal profits get wiped out in competitive markets.

You might point out that Apple has maintained its ability to “differentiate” its products in the PC and laptop markets, allowing them to sustainably reap oligopolist- or monopolist-style profit. You’re correct. But this market is only a small portion of Apple’s profits. Why? The market became un-differentiated. A small core of users continues to be willing to pay higher prices for worse specs, and allegedly superior software, but not as many as in the mid-2000s. Maybe Apple will strike gold again by successfully creating an entirely new market, just as the former shining stars — iPhone and iPad — become insufficient to sustain the company’s valuation. Maybe the new CEO will be the next Steve Jobs. Say, what’s his name again?

Do You Really Want a Slice?

Stock prices should be based on future profits but they are often driven by emotions. Last year, Apple stock was pushed to a high price by greed and the assumption the company could pull off another “market creator” move. It hasn’t happened yet. The stock’s high prices, and therefore its insane P/E ratios, were not based on fundamental valuation. If investors come to see Apple as a “has-been” dog they’ll beat down the price even more, with the same vociferous irrationality they inflated it with — similar to how RIM was pushed well below its intrinsic value simply because of fear.

The spreading meme of Apple’s fall-from-grace and subsequent stock plunge could happen even as the company continues to sell more iPhones and iPads — to move more volume into an already-saturated market, Apple will need to give up profits. Blackberry was on top just a few years ago and then its stock price fell 96% from peak-to-trough. Apple has been falling, but it might still have a long way to go. As much as stock market adages are trite, I think a classic one applies: never catch a falling knife.

I don’t want to discredit the things Apple has done. It was an ignored David in a world of computer Goliaths that managed to create entire new market categories. That took a lot of hard work and a bit of luck. But to keep growing at the same pace when it’s already one of the largest companies in the world would be even more improbable.

The Real Test For Stocks

Whatever stock you are thinking of buying, ask yourself: why will the company’s profits continue to grow over the next 10 years in spite of increased competition that such success will inevitably attract? If you aren’t confident about a company’s competitive moat, then stay away.