Is Buffett Really Bearish?!

So, with Buffett dumping airlines, JPM and not jumping into the markets in March, is he really all that bearish? His cash keeps piling up to the frustration of long time Buffett fans.

March Decline

First, I would have to say that the March decline was pretty quick. It crashed, and the market bounced back pretty quickly. Plus, what crashed are the stocks that are going to have a lot of problems. What rallied are beneficiaries. I would have loved to buy MSFT, GOOG, AMZN or whatever, but those didn't really tank all that much. 

 

Plus, for a company like BRK, you would want to take advantage of any distress to get involved, but as Buffett said, with the stimulus package, the phone wasn't ringing all that much. There may be opportunities within each of the private holdings too, and we know there is a lot of pain in just about every wholly owned business at BRK.

 

Buffett Bearish? 

A while back, I argued that this increase in cash does not necessarily reflect a bearish view on Buffett's part. OK, maybe it's not super-bullish. But it's not outright bearish, either. 

 

First, I said the accumulated cash pretty much corresponds to the rise in float; since the mid-1990s, cash and fixed income investments always approximated the amount of float. Also, just because Buffett doesn't buy stocks doesn't mean BRK is not fully exposed; some of his former stock holdings are now wholly-owned subsidiaries. Just because they are no longer publicly listed equities doesn't mean we can't participate in intrinsic value growth of the business. We still own the equity. Same with outright purchases of other listed and unlisted businesses.

 

To show this, a while ago I posted how BRK is fully exposed despite the high cash balance. First, I added up the stock holdings, and then to that, I added the net worth of our subsidiaries; the railroads, utilities, and manufacturing, services and retail, and it all added up the the full value of BRK's shareholders' equity.

 

I showed that the high cash holdings of BRK is not a drag on future potential returns as it would be in a mutual fund. If a mutual fund had a high cash holding, yes, then it would lag in a bull market. Not so BRK. 

 

Since manufacturing, services and retail is no longer itemized on the balance sheet, I can't do this, but if you net out the cash, cash equivalents and fixed income securities with float, you will see that what you have left is still equity ownership in the various businesses; the cash is not necessarily a drag on returns on this basis. Of course, if the cash was invested in higher returning securities, future returns would be higher.

 

But it's still fair to say BRK has 100% equity exposure.

 

Here are a couple of tables to illustrate this. 

Liquid Assets = Float

First, check out the liquid assets (cash and cash equivalents plus fixed income investments) against float. This is just an approximation of float using the 2 or 3 items shown on the consolidated balance sheet so may not match what Buffett calls float, but it is close enough.

This ratio is on the far right of the below table labelled, "Liquid / float". Since 1999 or so, it's been remarkably stable at around 1. Someone asked about this at a recent annual meeting and Buffett said there is no relationship. It is a head-scratcher because it seems to match perfectly over time.

By the way, the cash and cash equivalents include only what is at the top of the balance sheet and excludes cash held in railroad / utilities (for simplicity, and most cash is in the insurance segment anyway).

 

Stocks to Total Shareholders Equity

Some insurance companies like MKL and Y use their equity portfolio to shareholders' equity ratio to show how much stock market exposure they have. This, for BRK, is in the column labelled "Stocks to sheq". It is amazing to think it was above 100% before the Gen Re merger. BRK back then was a leveraged play on Buffett's stock-picking skills, and any investment in bonds offered free incremental points on ROE above all that. No wonder why returns were so high back then. 

 

Since then, the stock portfolio (including equity method investments) has averaged 52% of BRK's total shareholders equity.  Despite the huge cash holdings, note that the year-end figure was 62%, and at the end of the 2Q2020, it was 56% despite the portfolio taking a big hit this year. This is higher than the 52% average since 1998. I use the average since 1998 because the beast was a different animal pre-Gen Re. 

So, this piece of evidence doesn't really show any bearishness on Buffett's part, or at least compared to the last 20+ years.

 

BRK Balance Sheet Stuff

 

This next table shows some other ratios. Investment leverage is used by insurance companies too, total investments versus total shareholders equity. This is not really all that relevant for BRK because insurance is only one part of the business. 

 

Investment Portfolio

But let's look at the portfolio in a conventional way. We will add the cash, cash equivalents and stock portfolio and see how that breaks down. 

 

The column labelled "equity %" shows how many percent of total investments was invested in stocks (including equity method). 

 

And, check it out! This also averaged 52% since 1998, and at year-end 2019, this was 65%, and was 58% at the end of 2Q2020.  

Buffett bearish? Well, according to this piece of evidence, not really. Or, at least, not all that much more than in the past 20 years.

Maybe this is a little tautological but liquid assets as a percent of total investments is also below historicals, and also liquid assets vs. total shareholders equity is also lower: 51% average since 1998, but 34% and 41% at year-end 2019 and 2Q2020, respectively.

 

 

 

AAPL

By the way, for those who say Buffett has lost his touch, what do we call AAPL? At $470/share, the gain to BRK on this buy is $83 billion! This is not how much it's worth now, but how much BRK has gained on the position of around 250 million shares. That's as much as the total shareholders equity BRK had as recently as 2004, and also as much as the gains on all of the other holdings as of the end of 2019 (so before the recent decline in most of these holdings). 

This is the table from the annual report, excluding AAPL.

I admit I have been an AAPL naysayer for years. Part of this multiple expansion is probably due to a shift in the business model from a hardware, consumer electronics business to more services. I have no idea how this will pan out over the years, but I do notice more and more people living their lives in a very Apple-centric way.

Conclusion

People are frustrated that Buffett continues to accumulate cash. The cash just gets bigger and bigger and it makes Buffett seem more and more bearish. But as you can see from the above, the cash balance may grow, but so does BRK. So on a relative basis, the cash balance hasn't really been growing all that much. Judging from this analysis, you can't really conclude that Buffett is any more or less bearish than he has been in the last 20 years. But that won't stop people and the press from obsessing over this 'nominal' figure. Oh well... 

Cost Cutting, R&D etc.

This is going to be a wandering post, just thinking out loud about a few things that have been on my mind.  I've been posting about "outsider" CEO's and now about 3G Capital.  They of course have a lot in common, but one thing is that these acquisitive CEO's cut costs, and sometimes a lot.  And this obviously raises questions about the sustainability of the business model.

This also ties in with the current Valeant / Allergan drama which I haven't posted about yet.  The bearish view is that Valeant's business model is unsustainable.

Many say the same thing about other cost cutters.  Popular examples would be Sears Holdings and Hewlett Packard.  The consensus seems to be that Lampert cut investments so deeply that it has destroyed Sears Holdings, and Mark Hurd cut R&D so deeply at Hewlett Packard that he destroyed the business.

I'm sure there is some truth in both.  When I used to go to K-mart at Astor Place in NYC, the elevator would make a scary, grinding sound.  I only rode it when I had to and it only went from the first floor to the basement; I would not have ridden an elevator that sounded like that to a high floor.  (I actually love that K-mart.  Since we don't have a Walmart or Target in Manhattan, it's great for cheap things you might need.)

And every time I walk into a Sears it was really a sad sight.  I actually really liked the kid's clothes at Sears.  I thought it was good stuff for the really low prices.  But I could get the same sort of thing at Target, Old Navy, Children's Place and many other places (so why would I go all the way to Sears just for that?).

But on the other hand, I'm not too sure more capex to make the stores look nicer would have made much of a difference.  Sears seems to have clearly lost business in their respective categories to Home Depot / Lowes, Best Buy etc.  And K-mart is just losing out to Walmart, Target and now the dollar stores.  Capex doesn't seem to me (and never did) to be the answer, really.   A nicer look wouldn't make me want to go to Sears versus Lowes.  They are just suffering from a much deeper existential problem.

Hewlett Packard too may be undergoing similar pressures; they could have pumped more money into R&D, but to achieve what?

This got me curious about what many consider the most innovative company on the planet:

Apple (AAPL)
So, let's take a look at AAPL.  Just out of curiosity, I looked at AAPL's sales and R&D since 1992.   Steve Jobs came back to AAPL in 1997, the iPod was launched in 2001, the iPhone hit the market in 2007 and the iPad came out in 2010.

Surely, Jobs must have come back to AAPL and boosted R&D and spent billions (like other tech companies) to create such great products.

Let's take a look:

Apple R&D History

What is stunning here is that AAPL spent an average $610 million per year in R&D between 1992 - 1996.  Jobs came back in 1997, and between 1997 through 2001 when the iPod was launched, R&D averaged only $382 million, 40% less than previous management!  OK, so the iPhone is really what shook the world.  Between 1997 and 2007 when the iPhone came out, R&D averaged $486 million per year, still 20% less than the previous management.  In terms of percentage of sales, previous management spent 6.9% of sales on R&D, and Jobs spent 5.6% over the following ten years until the iPhone came out.

If you only looked at the numbers, you might have been horrified.  My gosh, you would say.  AAPL is so "has been" that they should be boosting R&D, not cutting it!  This is a disaster in the making!

At the time, one of the most innovative companies was Nokia, so let's just look at what their figures looked like around the peak.  In 2013, they sold the phone business to Microsoft so I left out 2013.

Nokia R&D History

So these guys, the most innovative company in the world at the time, were spending between four to six billion euros per year on R&D, and double digits as a percentage of sales.   Nokia was spending more than ten times as much on R&D as AAPL.

OK, so this is an exception you say.  These disruptive innovations are always like this and they are unpredictable.  Jobs is also a special case; a super-genius, so we can't use this as a standard for anything.

This is also true.   But this would reinforce my doubts about AAPL's long term future (I have no position, but my view hasn't changed since the series of posts I made about AAPL in the past). If Jobs was able to create so much and change the world with less than $500 million per year in R&D, what are they coming up with now spending ten times that amount every year?!  Does AAPL now have the big company disease?

Other Companies
Being curious, I took a look at a bunch of other companies considered innovative (and not), and some others that are known for spending a lot on R&D:

                             Sales         R&D      R&D%
MSFT                   $77.8        $10.4       13.4%
AAPL                 $170.9        $ 4.5         2.6%
Samsung             $201.1       $11.5          5.7%   (converted at 1000 KRS/$, 2012)

GOOG                  $55.5         $8.0        14.4%

IBM                      $99.8         $6.2          6.2%
HPQ                    $112.3        $3.1           2.8%
INTC                     $52.7      $10.6         20.1%
Sony                      $45.2        $4.7         10.3% (converted at 100 yen/$, sales exclude financials, film                                                                              and music)
Nintendo                 $5.7        $0.7         12.5%

BA                        $86.6        $3.1           3.6%
GM                     $155.4        $7.2           4.6%
Toyota                $256.9        $9.1           3.6%  (converted at 100 yen/$)
Honda                 $118.4        $6.3          5.4%  (converted at 100 yen/$)

So there are some surprises here.  MSFT is spending $10 billion per year on R&D, or 13.4% of sales.  You wonder where that money is going given their lack of innovation.  Sure, there is some stuff going on; incremental improvements etc.  But nothing really exciting.  And that's after spending $10 billion per year?  Again, maybe it's not fair but it's stunning what AAPL was able to achieve with less than $500 million per year.

Sony too spends $5 billion per year, and the iPod should have been their product.  GoPro too came out of nowhere and that's exactly the sort of product Sony would have come up with back in the 1970's and 1980's when Akio Morita was still running the place.

GOOG spends a lot, and who knows where that goes.  We know they are working on all sorts of things; Google Glass, driverless cars etc.

Owner-Operator Tangent
This AAPL and Sony talk gets me off on a tangent.  What's really interesting is that AAPL created the products that Morita would have no doubt created.  Why was Sony not able to?  There have been a bunch of books on the topic, but at the end of the day, I just think that true innovation is hard with non-founder-owners  (I use the term owner-operator, but I actually mean founder-owner).  Sony, like MSFT, had certain businesses to protect too; AV business that would have become obsolete due to digitization (which happened anyway!) etc...

(Which makes me wonder, how much of MSFT's $10 billion is actually spent on creating new things versus trying to protect the Windows business?  Imagine buggy manufacturers, upon seeing the automobile on the horizon,  investing massively in R&D for horse feed that might increase the speed of horses.  Is that what MSFT is doing?)

I read a few books written by Tadashi Yanai, the amazing CEO of Fast Retailing (which runs the Uniqlo stores).  At one point in 2002, he retired and handed off the CEO-ship to someone he thought was perfect for the part; he understood the culture and what drove Uniqlo's success, was smart, ambitious and hard-working.

But it didn't work out.  Why?  Yanai said that the new CEO set a modest growth target and got too comfortable.  He didn't want to take risk and make drastic actions to further the success of Uniqlo; he wanted to protect what was there and grow modestly with low risk.  This turned out to be a disaster for Uniqlo and Yanai had to come back.

Maybe it was a similar story with Howard Schultz and Starbucks.  He also retired once and had to come back.

This is what worries me about the generation directly after the founder/owner.  A founder/owner will take big risk and take bold actions because he can.  Employees can't complain.  He is the star.  Shareholders can't complain.  Suppliers, vendors and customers can't complain.   They are all there thanks to this one individual (well, OK, it's all teamwork.  But there is usually that one person that attracts the team).

But when a non-founder / non-owner takes over, they can't afford to upset people.  They can't take bold actions and take big risks because if they fail, it can be catastrophic.  They tend to work to maintain the status quo, or work for modest growth and improvement.

(This is something to think about too with Berkshire Hathaway, by the way.  Buffett can afford to take bold actions and goof up since he has so much goodwill (and cumulative performance) built up over the years that even a humongous blunder (unless it destroys BRK completely) will probably be forgiven.  Not so the next CEO.)

This, by the way, is why I think Samsung was able to give AAPL a run for it's money while Sony is nowhere on the map:  Samsung is still (or was until recently) founder-run and Sony is not.

A really great book written by a founder is:  Creativity, Inc: Overcoming the Unseen Forces That Stand in the Way of True Inspiration.   Catmull is really honest and discloses a surprising amount of stuff about Pixar in the book.  I guess only Catmull or one of the other co-founders would be allowed to disclose so much.  But reading this book, it makes you realize how hard it is to create and maintain a culture even when the founders are still there.  This makes it feel like it will be very hard to keep up the winning streak without Catmull, Lasseter, Stanton etc.


Other Innovative Companies
We can look at Facebook, Twitter, GoPro and many others; they were created with very little capital. But it's not fair to say that the cost of creating Facebook was a laptop, an internet connection and a college student.  For every Facebook, there are many others who try to follow in the footsteps of Michael Dell, Bill Gates, Steve Jobs, and most fail.  So the actual cost of creating a Facebook is much higher than that.

I suppose we can argue that that is the case with the recent AAPL too, that Steve Jobs is a special case.  Very few people change the world multiple times.   So Jobs can work wonders with $500 million and most others can't.  But does that mean they can with $5 billion?   If they can't do something with $500 million, why should we think they can do it with $5 billion?

Valeant, Allergan, Yahoo
So it makes me wonder, maybe Michael Pearson is right.  He has been in the business a long time and has seen a broad view of the pharmaceutical industry as a consultant so probably really understands the waste that goes on in R&D.   And his idea is to just spend R&D where it matters; go for the high probability bets like line extensions or alternative uses and forget about the shotgun approach that seems to be common in the industry (not sure if that's still the case but I think it used to be; just do everything and see what sticks).

And perhaps purchasing products via M&A is more efficient than spending a ton on R&D.

Which reminds me that Yahoo's best investments have been Yahoo Japan and Alibaba.  I suppose they could have spent the same money in R&D or marketing.

Masayoshi Son of Softbank is like that too; he has made some great bets over the years.  I've never owned Softbank or any of his entities only because he is just too far out for me.  He told Charlie Rose not too long ago that his stock price went down 99% but bounced back quite a bit.

Well, I tell people don't worry about stock price volatility and who cares what happens to the stock price as long as intrinsic value is growing.  But a 99% decline, however temporary, even for me, is too much.  We all have our limits, I suppose.

Does R&D Have to be Constant? 
Back to the subject of R&D.  I wonder if R&D has to be constant.  Ackman pointed out that Allergan actually pays the CEO to spend money on R&D. I think that is to deter a CEO from slashing R&D dramatically to boost profits to collect a bonus.  So it makes sense at some level.  But it also reduces the incentive to make R&D more efficient.  It's sort of the opposite of zero-based budgeting; they know R&D will not be cut regardless, because it can't be cut by contract.  Is that really the way to run a business?

What would happen if all of the R&D in every company was subject to zero-based budgeting?  Every year, you would have to justify every dollar of expense in R&D; why it is needed, the probability of success and potential return etc.

Unfortunately, for competitive reasons we shareholders really can't demand details on R&D spending.  But I guess we can demand more disclosure as to how efficient or useful the R&D actually is.  What the heck is MSFT spending $10 billion on?!  NASA (actually, a panel that includes NASA) says that they can get people to Mars with $80-100 billion in 20 years.  That's $4-5 billion per year to get a manned mission to Mars!   What's MSFT gonna do with twice that?!

In a lot of companies, particularly high margin companies, it may be that they spend on R&D because they can.  Their margins are high enough that even if they spend a ton on R&D, their margins would still be higher than anyone else, so why not spend and see what will come out of it?

Other Costs
So I looked at R&D and innovation (well, not really;  I just looked at some raw numbers), but the same argument applies to all other costs.  Just because you cut cost doesn't mean you are hurting the business, and just because you spend more doesn't mean you are improving the business.  It all depends on what the costs are for.  Is the cost really essential, or is it there because the business can afford it?  In companies, people constantly need to be promoted so organizations tend to get bigger and bigger.

The guys at 3G Capital have been doing this sort of thing for years (as have, for example, the folks at Danaher) so they understand this very well and obviously have a good grasp of what sort of costs can be cut and which can't.

Even though I have no proof, I tend to believe that more businesses go out of business or suffer due to lack of cost controls (complacency) rather than too much cost cutting (which no doubt occurs too).

Conclusion
Well, there's really no conclusion in this post.  Just more questions.  I've worked in a big company and understand the resistance to change.  Whenever we are asked to cut costs, all hell breaks loose and people fear that all sorts of bad things will happen.

Well, I did experience one bad cost-cutting drive.  A company I worked for hired an efficiency expert and all hell did break loose.  Suddenly there were no more paper towels, toilet paper or soap in the bathrooms and the hallways went dark as there were no more light bulbs.  A bunch of other problems popped up, and it turns out that this efficiency expert was paid a percentage of total costs saved.  Duh.   So this guy basically just cut everything he had an authority to cut and I think walked away with a nice bonus (or he may have gotten fired before collecting for cause, but I don't even know;either way he wasn't around for too long).

As it says in the Fifer book, the trick is to cut costs that don't add to business and increase spending on what does.  It's not about cutting cost across the board.

The problem with middle management is that when someone is in charge of a section or division, it's a rare manager that will work hard to shrink it.  Most people want to expand their divisions regardless of whether it's a profit center or cost center.   When you go to a budget meeting, who the heck goes, "I want my budget cut 10% next year!".

Sorry for the long, meandering post.  Eventually this will turn into an idea and a more cohesive post.

Greenblatt on CNBC: Market Reasonably Valued

So Joel Greenblatt was just on CNBC and said some interesting things.  I don't intend to post every time someone I respect shows up on TV, but this appearance was especially interesting to me for a couple of reasons.  One major reason is, of course, market valuation.

I don't really care about the many folks that call for a crash or call the market overvalued and whatnot, as many of those people have no track record of turning their market views into long term profits.  If you think about the guys that show up on TV as bears most of the time in the past ten or twenty years, most of them don't have good long term track records.

But the other day, Seth Klarman was reported to have been pretty bearish saying that there is an impending asset price bubble (in his letter to investors).  It's true that he has been cautious since the 1980's (and yet still manages to make a lot of money year after year), but still, his recent warning is not to be taken lightly.

On the other hand, Warren Buffett has said recently that the market remains in the "zone of reasonableness" or some such.  He doesn't feel that the market is particularly overvalued but not especially cheap.

And then of course there is the Robert Shiller P/E ratio (CAPE) that shows serious overvaluation.

What are we to make of all of this?  I have posted in the past about market valuation, but since it seems to be such a hot topic again now, I thought Greenblatt's input on this would be interesting.  He is one of my favorite investor/authors so I do take what he says seriously.

Here is the link to his appearance:  CNBC Greenblatt video

Anyway, this is what he said:

What he likes
Hewlett Packard (HPQ) and Apple (AAPL).  They trade very low on measures of free cash flow with "huge return-on-capital businesses".  Most people don't like them because they're old and stodgy (referring to HPQ).

AAPL
This is one of the parts that was really interesting to me.  I always wondered why Greenblatt liked Apple.  If you look at Greenblatt as the author of "You Can Be a Stock Market Genius", it doesn't make a whole lot of sense.  The future of Apple is hard to predict; it doesn't pass the five or ten year test of what the business will look like etc.

Greenblatt explained that when there is a business with a lot of change, where the technology changes, competition changes and you don't even know what the company will be selling three or four years from now, he tells students to skip it and find something they can figure out.

But if you buy these businesses at such low valuations as a group, then you can do well.  You don't buy one Apple, you buy a basket of Apples.  And when you buy a basket at such low valuations, it's good.  This bucket of technology stocks is cheap.  He later mentions Microsoft (MSFT) as also one of the large, cheap tech stocks.

So now I understand that this is the author of "The Little Book That Beats the Market" talking.  He doesn't know or understand the future of Apple, but he is confident that a basket of tech stocks trading so cheaply will do well going forward.  He has no view on the sort of things we talked about here regarding AAPL.  I should have known that since every recommendation he has made on TV since the Little Book was published were basically magic formula stocks.

Large Caps Reasonable
Greenblatt said that looking back over the past several decades, the Russell 1000 index is trading at the 42nd percentile in terms of valuation; the index has been cheaper 58% of the time over the past several decades.   So it is reasonable.  His data shows that from here, the one year forward returns is somewhere between 7-12%.  That's not bad. 

Small Caps Not
He said that the Russell 2000 index tells a "very different story".  That index is in the top 5 percentile of valuation, meaning it has been cheaper 95% of the time in the past several decades.  The one year forward return from this level is a negative 3%. 

Super-Large Caps Reasonable
He said that the top 20 names in the S&P 500 index, which is 30% of the index by weighting, are reasonably priced, even Google (GOOG).

What Do I think?
So this is all very interesting.  You have some of the smartest investors saying all sorts of things about the market and not in agreement.  Klarman said that on almost any metric, the market is "quite expensive", and that a "skeptic would have to be blind not to see bubbles inflating..."

And yet we have Buffett pretty mellow about it all, still buying stocks and his underlings still buying and Greenblatt saying things are reasonable.

I personally don't spend too much time on this stuff.  I would rather spend time on bottom up and not worry too much about the top down.

For example, of all the posts I've made about investment ideas, the overall market doesn't really make a difference to me.  I wouldn't say that JPM is attractive here only because the market p/e is 20x or some such.  I like what I talk about here pretty much on an absolute basis.  Of course, if the market was really overvalued at 30-40x p/e, then I would like my ideas more (at the current valuation), and if the market was trading at 7x p/e, then I would probably like the market more.   But those are extremes on both ends.

I think the key is what Buffett said in the annual letter.  If you own a business that you like that is a good business run by good people and is reasonably valued, why sell it just because some people think the overall market is overvalued?  (Well, Buffett talks about macro factors, but I think the same applies to overall market valuation; why sell your business you like just because something else is overvalued?).

Identifying the market as overvalued and undervalued is fun stuff, but it is really hard to turn into long term profit.  You can always guess one or two turns.  You will always run into the guy that sold everything in August 1987 or early 2007.  You may even run into folks that got out in August 1987 and then got back in in December 1987, or got out in 2007 and got back in in early 2009.  But you really won't find people who did that over several cycles.

In my previous life, I read just about every investment newsletter (of course courtesy of my employer), followed every guru and nobody calls the market continuously through cycles, even using rational, simple tools such as valuation.

Even recently, there is one prominent strategist that is a good read, but this strategist jumped in and bought gold just about at the top of the market.  Another fund manager/economist who writes an interesting, well-written, convincing and widely-read newsletter has performed horribly over the long term.  Yes, maybe the market is toppy so the fund looks the worst now (just as value investors look really bad at bear market lows), but I don't think losing money is really acceptable for something that is not supposed to be a bear fund (it's supposed to be hedged, which is not the same thing).

Klarman has been cautious for a very long time but still manages to make money, so that's a bit different (and rare!).

I've talked about how Greenblatt and the Superinvestors of Graham and Doddsville made money over time (see here), not to mention Warren Buffett.  These guys didn't do it by getting in and out of the market based on market p/e, market cap to GDP, CAPE or anything else that I know of.

So What to Do?
So for stockpickers, just look at your stocks and if you like the business and where it is valued, who cares about the market?

What about folks invested in the S&P 500 index?  Well, Greenblatt did say that the 20 largest names in the index are reasonably valued, so the index should be fine to own.

Even if Greenblatt didn't say that, the stock market overall returned 10%/year or so historically, and that was only achieved by owning the index during good times, bad times, when they were cheap and when they were expensive.  10% was not achieved by getting in when they were cheap and sitting out the market when it was expensive.

If the market is expensive, the correct thing to do is not to sell out, but to adjust your expectations.  Greenblatt did say something like that; if the market typically earns 8-10%/year and it's a little overvalued now, then the returns will be a little lower, but still good.

I think the mistake is that when markets are overvalued, people think that it then must go down.   So they take a short position or buy puts.   Or they get out completely and wait to get back in cheaper.

Maybe the correct way to look at it is that when markets are higher we should expect lower returns going forward and that's that.  To assume that when markets are expensive, that we can sell out now and get back in cheaper later is a risky assumption, and one that hasn't worked out over time (again, show me someone who has done that successfully over many cycles!).

Newton's Apple

So Apple has fallen below $400 and it seems like most people still talk about how cheap it is. Yes, it does look really cheap.  But others have pointed out that Apple is only cheap if they can maintain their sky-high margins.

I decided to take a quick look at this since I sort of follow Apple and have posted about it before.  I still don't like Apple as a long term hold and am short the stock off and on (I did flip long once after my Apple LEAPs post, but sold out of it deciding that it doesn't make sense to go long a stock I didn't like just because the stub/LEAP idea was interesting).  

Anyway, my views on Apple hasn't changed much (see Apple is No Polaroid).  The JC Penney fiasco (I followed JCP too but fortunately stayed away from the stock as I thought it was 'too hard') sort of reinforces the idea that Jobs was indeed an incredible talent and people who have done well with Jobs may not be able to retain that 'magic' without him.  Of course, this probably has nothing to do with JCP as Ron Johnson was a successful retail executive before going to Apple.  But anyway, that's whole other topic.

Back to Apple.

Apple Looks Cheap
First of all, a quick look at the cheapness of this stock.  As of the end of the last quarter, Apple had $137 billion of cash and marketable securities.  Taking 75% of that (net of taxes), we get $103 billion and with 939 million shares outstanding, that comes to around $110/share in cash and marketable securities.

Analysts estimate that Apple will earn $44/share in the year ended September 2013.  10x that gives us $440 (interest rate income should be deducted from this, but since rates are so low I won't bother).  At 10x that, we get $550/share in total value for Apple.  With Apple trading at $400/share, that would be a 30% discount to what it's worth.

Margins
One of the keys in the Apple story is the margin.  Can this be sustained?  Of course, what Apple comes out with next is the big story for the long term of Apple; if they can't keep coming up with hit products like the iPod / iPhone / iPad, then Apple is not worth anywhere near what it is today.

But never mind that for a second.  Let's just look at what they have now.  In 2012, their gross margin was 43.9% and their operating margin was 35.3%.

People say that this can't be maintained as their competitors operate with half those margins.  If the gap between products keep closing, how can the spread in margins be maintained?  I think that by many accounts, the difference between Apple products and others are rapidly shrinking.

Anyway, I think the one big competitor is Samsung.  They do break out sales and operating profits for their mobile segment (IT & Mobile Communications).  This segment in 2012 had operating margins of 18%.

If Apple had operating margins of 18%, how cheap is Apple stock then? 

Analysts predict revenues for the current year to be $181 billion.  18% of that is $32.6 billion.  With a 25% tax rate, net earnings (excluding other income) would be $24.5 billion, or $26/share.  10x that is $260, and adding back the cash and securities from above of $110/share, that gives us a total value of $370/share.

Suddenly, Apple stock at $400/share doesn't look so cheap anymore!

Of course, there is no reason why Apple's operating margin has to go down to 18% right away if ever.  But I do think that the historical tendency in these fluid, fast moving industries is that excess margins get competed away.

So anyway, maybe we can't really compare Apple to Samsung.  They are different beasts, and Apple does in fact own the operating system and the eco-system whereas Samsung only provides the hardware.  This is the tricky part.  We know that software has much higher margins than hardware (look at Dell versus Microsoft, for example).  So maybe Apple will always earn a higher margin.

I figured that Apple always did both, so why not take a look at Apple historically?

Here is the gross and operating margin history for Apple since 1992 (I can only get data back to 1992):

Historical Apple Margins

So even though Apple did both the hardware and the software, their gross margins were never above 30% until the iPhone era.  Their operating margins were subpar too for most of the period since 1992. 

Yes, we know that Jobs left in the 80s and Apple was mismanged for years.  But Apple products were still loved by fans and were often said to be the best computers out there.  And yet this is their margin history. 

Things are different now for sure once Jobs came back and fixed the place up.  But there is no guarantee that Apple won't go back to what it was before Jobs came back.  It can still be making the best products, but the above shows that that doesn't guarantee fat margins.

The last time Apple had gross margins above 40% was in 1992 and it went down since then.  Here is what the 10-K said about the drop in gross margins in 1994:

"The downtrend in gross margin was primarily a result of pricing and promotional actions undertaken by the company in response to industrywide pricing pressure."
 

And for the 1992-1993 drop, they also said it was:

"primarily the result of industrywide competitive pressures and associated pricing and promotional actions"
 

And here's a chilling quote too:

"Although the company's gross margin was 27.2% for the fourth quarter (1994), resulting primarily from strong sales of Power MacIntosh computers and the PowerBook 500 series of notebook personal computers, it is anticipated that gross margins will remain under pressure and could fall below prior year's level worldwide due to a variety of factors, including continued industrywide pricing pressures, increased competition, and compressed product life cycles".

If operating margins go to 10%, which would be respectable for a manufacturing company and happens to be the long term average for Apple since 1992, let's see what Apple looks like.  With $180 billion in sales (never mind for now that if Apple takes pricing actions to reduce margins, sales would change too but there is no telling by how much).  That would give us an operating profit of $18 billion.  At a 25% tax rate, that's a $13.5 billion net profit and $14.40/share in EPS.  10x that would be $144/share and add to that the $110 in cash and you get $254/share total value for Apple.

Of course, I don't expect Apple to post a 10% operating margin any time soon.   I'm just fooling around with figures to get a sense of this thing.

I know that the universal view is that Apple will keep creating new products just as industry-changing as the iPod, iPhone and iPad.  But if they don't, Apple may, over time, start to look more like the long term Apple than the short term Apple (with hit after hit).

In that case, the stock would be worth much less than it is now because you will have years of good hits and years where nothing really interesting happens and industry competition eats away at margins (like it has before).

Again, this is not to say that this has to happen any time soon.

Increasing Pricing Pressure
I don't cover this industry so this is just a casual viewpoint, but I do think that there will be a lot more pricing pressure in the next couple of years.  I'm not just talking about Samsung and other gadget makers catching up. 

I think the mobile industry is getting more and more competitive and it seems like that maybe growing through acqusitions and subscriber growth may be coming to an end.  When they are adding new customers and growing through acquisitions, Apple did great because the iPhone was a great way to add subscribers.

As this starts to peak out, you then get more and more price competition. When that starts to happen, then mobile operators start to look to cutting costs to provide cheaper service.

John Malone was on CNBC the other day (I may post about that later too as it was a fascinating interview on why he bought Charter Communications) and he said that he wants to consolidate the cable industry as an offset to the content providers.  He says that cable bills (due to content prices rising) has gone up so much over the years that people can barely afford it anymore.  The business model, he says, is unsustainable (mostly due to the expensive sports content that 80% of the people would not willingly pay for at wholesale).  He thinks cable will be unbundled and the old cable model will be gone in a couple of years.

This is not the perfect analogy, but I do sort of feel like the same thing is happening in the mobile market. Phones get better and more expensive to the point that people can barely pay their phone bills.  And like ESPN in the cable world, a lot of dollars seem to be going to the phone makers (Apple).

When phone companies start to see their subscriber growth stall, growth through acquisitions plays itself out and margins get pressured due to competition, it's only a matter of time before they start looking at where those dollars are going and demanding better deals.

But again, I don't follow the industry so this is just a casual observation and not expert insight at all.  We don't have to be experts in an industry to know which direction things tend to go (increasing competition = lower margins.  When customers (mobile operators) face margin pressure, they pressure their providers (phone manufacturers) etc...).   Only the timing is difficult to get right.

Conclusion
This is just a quick look at Apple.  My view hasn't really changed, but with the stock down so much it's not as interesting a short as it was last year.  But there could still be a lot more downside if these margins can't be maintained.

For these companies that depend on 'hit' products, I think it's really dangerous to normalize, or capitalize super-high margins far into the future (which is what you're doing when you put a 10x multiple on it).

I understand the bull argument too.  Apple has the eco-system, it's not just a gadget marker.  It has the great stores.  But to a large extent, I think these things are tied to and depend on Apple making cool gadgets.  Who the heck would go to an Apple store if they didn't have cool products?  Who would download anything from the app store if they didn't have the latest cool gadget? 

Lollapaloozas (Munger's definition), like leverage, can work both ways.

Although I am way less bearish than last year, I am still very skeptical of this stock.  And yes, I know, to the bulls this whole post must come across as totally ludicrous.  I have no idea what is going to happen.  This is just sort of a thinking out loud thing.

Oops, and the title of the post:  I was going to make some comments about Newton's laws of motion, the apple etc... but forgot to do so.  But never mind. You can imagine for yourself all the bad jokes I might have come up with...

 

Create Your Own Apple Stub

Einhorn is unhappy with Apple's $137 billion cash hoard on the balance sheet and wants Apple to issue perpetual preferred shares to enhance shareholder value.  He said in an open letter that every $50 billion of preferred shares it distributes (at 4% rate) will increase value to Apple shareholders by $32/AAPL share.

First of all, I noticed that there were some mistakes in talking about this and one press report stated that Einhorn made this claim "without elaborating".   I think he made it very clear how the value would be realized.

So let's just look at this for a second before I go on.

Here are just some basic figures I pulled off the internet:

AAPL shares outstanding:               940 million
Analyst EPS estimates:
      Year-ending September 2013:  $45/share
      Year-ending September 2014:  $50/share

Einhorn assumptions:
          AAPL valuation:             10x P/E
          Yield on preferred:            4%

Before Preferred Distribution: 
          EPS:                                  $45/share
          Cash per share:                  $145/share
          Value per AAPL share:     $595/share (10x p/e + cash per share).

After $50 billion Preferred Distribution:
          EPS:                                  $43/share  (EPS - ($50 bn x 4% pref dvd/ 940 mn SOS)
          Value per AAPL share:
               Cash per share:             $145/share
               AAPL shares:               $575/share (EPS of $43 x 10 + cash per share)
               Value of preferreds
                      (per AAPL share):  $53/AAPL share ($50 bn / 940 mn SOS)
               Total Value:                 $628/AAPL share

$628 - $595 = $33/share (difference due to rounding).

Voila!

[ Note after the fact: In response to comments below, I revised the above table to include cash per share in the total valuation of AAPL. The result is the same as before as cash per share doesn't change pre and post preferred distribution.  But by not including it, it looked like it would be even more value accretive if AAPL distributed cash instead of preferreds.  Anyway see comments below. ]

This is pretty much the stub stock scenario in Greenblatt's Genius book.  Speaking of which, this is another perfect case of where we can go out and create our own stub, like Greenblatt said we could (and should).

Create Your Own Stub
So the problem with AAPL is basically that it is ridiculously underleveraged.  They have so much cash on their balance sheet that it's a drag on the performance of the whole company.  They have $137 billion cash on the balance sheet that comes to $145/share.  That's just nuts.

But Greenblatt reminded us that even if companies don't do leveraged recapitalizations too much anymore (except private equity owned entities), we can do our own recap and create our own stub.

So here I'll just take a quick look at creating an AAPL stub, which I thought I'd never do.  Who the heck buys LEAPs on volatile tech stocks?  Who needs leverage to own a stock that went from $100 to $700 almost overnight?

Anyway, let's just say we want to lever up 2-1.  I'll just look at the $250 strike January 17, 2015 calls.  You can go up or down the strikes according to your taste.
Apple is now trading at $458.60/share and the 250 strike calls is offered at $211.

So buying the $250 strikes at $211 means you are paying a $2.4/share premium (($250 + $211) - $458.60).  Plus you don't get dividends by owning LEAPs, so you lose out on that.  Dividends now is an annualized $10.40/share.  The $2.40/share premium above is for two years (let's round this to two years), so that's a premium of $1.20/share per year.  Add that to the $10.40 in dividends you don't get and that's an annualized carry cost of $11.60/share.

Since you are 'borrowing' $250 over two years, your annualized financing cost is 4.6%/year.  But this assumes dividends don't go up this year and next.  This may be unlikely given all the talk of too much cash on AAPL's balance sheet.   If dividends go up 20%, then the carry cost will go up to 5.5% (assuming a one time bump up in dividends of 20% for the two years).

But this ignores the put option value of owning a 250 strike call instead of actually borrowing cash to buy shares.  If you bought AAPL on margin and the stock really tanked, you would get margin called.  With a call option, you can't possibly lose anything below $250 as you are only long a call option that becomes worthless (if AAPL goes below $250 and stays there).

A $250 strike January 2015 put option is offered at $8 or so, so to be really accurate, you should deduct $4/year off of the financing cost above.  That gets the carry cost (cost of loan) down to 3% (or 4% if dividends are 20% higher). 

That's not bad at all.  I know interest rates are zero, but for a small investor to be able to borrow money at 3-4% is not bad at all.  I realize there are discount brokers that offer lower margin rates, but still.

All Options Expire Worthless!
I don't want to push this stuff too much (as I don't really know who is reading this), but just to show how low risk something like this can be, let's think about this for a second.

Many people rightly believe that all options expire worthless.  Never mind that that's not really possible, but it's not a bad way to think so as to stay out of trouble and not buy calls and puts out of an urge to hedge or get some 'free' upside on a momo stock.

But a well thought out LEAPs strategy can be very good. 

Let's take a look at this trade, for example.

If you buy a 250 strike AAPL LEAP for $211, you can't lose your entire investment unless AAPL goes down to $250/share in two years.  From what I read, I think that's a low probability (well, more on what I think of AAPL later). 

One thing that kills option investors is the time value decay.  You buy at-the-money or out-of-the-money calls to try to capture upside in a big momo stock that you are afraid to own outright.  Or you buy at-the-money or out-of-the-money SPY puts because you are terrified at what the fiscal cliff will do to your IRA.

When you buy at-the-money options over the near term, you are not really borrowing money.  You are paying more for the volatility; you are paying a premium for the opportunity to buy or walk away depending on what happens to the stock.   This optionality is what you are paying for.  You can test this easily by calculating the financing cost of a position and compare it to the option premium.  For short-dated options, the financing component is tiny compared to the total option premium.

I have no proof, but I think if someone did a study on options and how people lose money in them, I bet that most of the money is lost due to the amount people pay over the instrinsic value of an option (intrinsic value is simply the in-the-money amount of an option).  In other words, it's the time value that kills them.

Not!
So using this unproven rule of thumb that I just pulled out of thin air, let's look at this AAPL LEAP trade again.

The stock is at $458.60/share.  The strike price plus option premium on the 250 strike LEAP is $461/share.  So you are paying $2.40/share over the stock price.  Add the $21/share of dividends you won't get and you are paying $23.40 over the stock price.   So if the stock price does nothing for the next two years, this is what you lose.  You lose $23.40/share (or more if dividends go up).  That's just 5% of the notional amount of the trade, or 2.5%/year.  That doesn't sound too traumatic.

If the stock price goes up or down, you make the same amount as if you were holding the stock, pretty much on a dollar for dollar basis (at expiration, of course.  Until then, your option will go up and down according to the delta of the option).   And then under $250, you don't lose any more.

My point is that on a time value basis, you are paying very little premium so you don't lose a lot of money here if the stock goes nowhere.  Compare that, for example, to owning an at-the-money call option which, by the way, is offered at $69 now for the same maturity (2 years).  That means you lose 20% of the notional amount of the trade with the stock flat over two years (including dividends you don't get).

So I would tend to look at these in-the-money LEAP trades (and even shorter maturity options) differently than 'typical' option trades; they act more like financing trades.  Of course it's still risky as you are levering up.

What I Still Think of Apple
Not that I have much to add to the Apple debate going on all over the place, I still view Apple the same way as when I made my previous posts about it last year.  (Why I Left Apple and Apple is No Polaroid)

I still think Apple was a Steve Jobs story and not an Apple Inc. story.  I still think the market breathed a huge sigh of relief after Jobs passed away as Apple continued to perform in the following year.  That's what took the stock up to $700.   I keep reading about how "Apple did this.  Apple did that.  Dell couldn't do that.  Microsoft didn't do that".  And I always think, no,  Steve Jobs did this.  Steve Jobs did that.

I still think that the cell phone market will get more and more competitive and mobile companies will get more and more resentful about the huge subsidies they pay for subscribers to get iPhones.  When price competition heats up in mobile markets around the world, more and more operators will opt not to pay $500-600 subsidies.   I understand that early on it was the other way around.  Mobile operators needed the iPhone to attract subscribers.

Over time, I think the "amazingness" of Apple products will become increasingly commoditized. Sure, Apple may still be able to maintain a premium brand status just as they held on to that over time with the Mac, but that may not be enough to maintain or increase the value of Apple as a company.

I do think that Apple is only cheap if one assumes that Apple will come out with something just as mind-blowing as the iPod was, then the iPhone and then the iPad.  If all we have going forward are upgrades to iPhones and iPads and competitors continue to close the gap, then I tend to believe that Apple is probably not a cheap stock.

Anyway, I know many people disagree with this view (and many agree), and the hard thing about this discussion is that there really is nothing I can point to to prove it one way or the other.  There are plenty of people who know way more about Apple than I do so don't mind my opinion too much.

Advantage for the Little Guys
But having said all of that, this Apple LEAP trade does look interesting.  This is one of the advantages of being small investors.  Someone like Einhorn probably couldn't put this trade on.  He has no choice but to activist management into action. 

But little guys like us can just say, hey, if you don't want to lever up, I'll just do it myself, thank you very much.

Apple is No Polarioid, But...

I spent the last couple of weeks reading some books on Polaroid and took some notes that I thought were interesting and goes to the heart of my problem with Apple stock.

Of course, Apple is not Polaroid.  Polaroid was 'just' an instant camera, made irrelevant by digital technology.  Apple has a deep eco-system and the halo-effect of multiple products working with each other (iPhone buyers may buy a Mac, then a Macbook Air etc...).

The simple way value investors deal with something like Apple is simply that it goes into the "too hard" pile as it is in a fast changing, highly competitive industry.

Everyone seems to love Apple stores and Apple products now and they would never change to something else. But at one point in time, people felt that about the Palm Pilot and the "crack"-berry too.  Apple may be better off and more deeply entrenched than these, but that doesn't mean it's a permanent situation.

Someone said to me that Polaroid was made irrelevant by technology.  Well, of course it was.  It's easy to see what happened now in hindsight, but at the time it may not have been so easy to see, or they may have figured they have time to evolve into digital technology. As for Apple, there is no telling what will come next in the tech world, and Apple is not guaranteed it's current status forever.

In any case, my argument really isn't about "this is tech and it's too hard", or that Apple is a fad or some such thing.  My beef is quite a bit more specific than that, and that's why I am spending some bandwidth on this issue.

I'm not trying to convert Apple bulls into bears either as I don't think I necessarily have a strong bearish case.    The point would be more that we have seen this movie before.  Something gets so popular that's it's dominance just seems inevitable.   The stock price is cheap so it attracts all sorts of investors; from growth funds to value funds (due to the low p/e) and even income funds (thanks to the dividend).  Can it really be so simple?

The cheapness makes it a not so favorite short (although I know there is always a small group of bubble-callers on any popular stock; especially in the short-term trading world).

Anyway, my biggest problem is that Apple's success, to me, was a Steve Jobs story, not an Apple story.  When Jobs died last year, people were worried.  The rally in the year since his death reflected the continuing momentum at Apple, but also was a collective sigh of relief;  whew, Jobs is gone but Apple is still doing OK.  Maybe Cook can pull this off.

I tend to think that's the wrong conclusion.  Apple is still coasting on Jobs' creation so they haven't really been tested yet.  This is the thing that worries me.  It's not about market share of iPhones/iPads or anything like that.

Anyway, as I read the Polaroid books, I jotted down these very interesting points (which admittedly supports my view/concern).

The first book I read was Land's Polaroid: A Company and the Man Who Invented It, by Peter C. Wensberg (published in 1987).  It's a fantastic book.  It takes a good, close look at Polaroid and Land.  I do think Apple owners should read it.

Here is a snip from p. 235:

"In 1959, two years after the color work had first been shown to Kodak and several patent applications made for it, Land addressed the Boston Patent Law Association.  Characteristically, he extolled the importance of the individual's contribution - Ptolemy, Copernicus, Galileo, Newton, Faraday, Maxwell, Einstein - rather than science as a group effort.  He derided the notion of teamwork as the ideal framework for scientific endeavor.  "There is something warm and appealing and cozy," he said, "about this picture of the human race marching forward, locked arm in arm and mind to mind; and there are insecure ages in life and insecure people in life to whom this vision of progress by phalanx brings comfort and strength.  But I, for one, think this is nonsense socially and nonsense scientifically.  I think human beings in the mass are fun at square dances, exciting to be with in a theater audience, and thrilling to cheer with at the California-Stanford or Harvard-Yale games.  At the same time, I think, whether outside science or within science, there is no such thing as group originality or group creativity or group perspicacity."

While some in the audience grappled with the notion of Land having fun at a square dance, he went on.  "I do believe wholeheartedly in the individual capacity for greatness, in one way or another, in  almost any healthy human being under the right circumstances; but being part of a group is, in my opinion, generally the wrong circumstance.  Two minds may sometimes be better than one, provided that each of the two minds is working separately while the two are working together; yet three tended to become a crowd."

This supports my (and others) view that Polaroid was a story about Land, not a company.  I conclude that the recent Apple success was also a Steve Jobs story, not an Apple story.  Of course, Jobs couldn't have done what he did without the company and it's employees, but the key driver of the success was Jobs.  Land's above view supports this conclusion, I think.


 From the Epilogue, page 247:

...He had wanted to create new things; the polarizer and the instant camera would remain the best known.  But perhaps his most original invention had been his company.  It was no less the product of a conscious process of experimentation and insight and repeated failure and creation and ultimate success than had been the other inventions.  In the slough of the Depression he was already shaping the idea of a new sort of corporation whose characteristics were so unusual as to be bizarre, almost ludicrous.
  At a time when steel companies, automobile factories, and textile mills were slowing to a halt, spilling workers into the streets, he was talking and thinking and writing about a company founded on science that would design new products not imagined by the public, which would be attracted to the products because they filled a hitherto unperceived need.  He wanted a company to create an environment for art at a time when many were worried about meeting the next payroll.   He talked about a company where the work life would be so satisfying that workers would look forward to the day's beginning and regrets its end, while sweatshops were in their heyday and unions fought to establish basic rights on the job.  These were the ravings of a pioneer.

The italics are from the book, the underlines are mine.

Despite the above, it didn't quite work out.  Land thought he created the right company, but without him it went nowhere.  Jobs was pleased that he got the culture right at Apple while Sony got it wrong.  But I think he also said Land got the culture right.  And look what happened.


Another book (I just got whatever Polaroid book was available at the library) The Polaroid Story: Edwin Land and the Polaroid Experience by Mark Olshaker (published in 1978) was also an interesting read since it was published in 1978, when Polaroid was still doing very well.  (I read the paperback which was titled Polaroid Story, but the original hard cover was called The Instant Image.)

It gives us the sort of color/sentiment regarding Polaroid and it's post-Land future at the time:


Page 3, at the 1977 annual meeting, Land commented that:

...the corporation is currently involved "not with products and industries, but new concepts of what a company should be."

Page 47, a long time Polaroid employee said,

"Land told us what we were going to make, Bill McCune showed us how to make everything."

(Is Tim Cook the Bill McCune of Apple?)

Page 22, in 1937 when Polaroid Corporation was formed with Wall Street financing, they said:

"So even at this stage, the 28-year-old Land struck the Wall Street establishment as being so unique that they turned back control of the company they had just bought and made the man they had bought it from promise to stay for at least a decade.  Everyone acknowledged that the future of Polaroid Corporation would be determined by what went on in the brain of Edwin Land.  Unlike most new business ventures, what they had bought into was not a new technology, a product or an array of concrete assets, but one man's mind."  (my underline)

In the last chapter, "Conclusion", page 260, it says:

"Even at a time when the company is anxious to point out that the new generation of management has the situation well in control, Land's presence is still felt as strongly as ever.  Though Land is far from being the only inventor inhabiting the Polaroid research laboratories, his interests, confidence, and personal dreams have determined each direction the company has followed.  Will another individual emerge with both his inherent authority and his persistence of vision?  Or will Polaroid's corporate direction be determined by the committee system in the future?

     Regardless of Land's pervasive influence as Polaroid's single guiding force, the corporation will probably survive his loss at least as well as the Ford Motor Company survived the loss of Henry Ford and Eastman Kodak weathered the loss of George Eastman.  Whether the basic nature of the institution Land created will remain the same is a matter of speculation.  One corporate structure that is often compared with the relationship between Land and Polaroid is that of Walt Disney Productions.  In both cases, the product and social impact of the company arose out of the imagination of one master. 

     When Walt Disney died in 1966, numerous observers predicted that the organization would not long outlive the Mouse King, just as many predict that Polaroid cannot continue in the same spirit without Edwin Land.  But Disney Productions did survive, and continues generating both product and profit at an unprecedented rate.  On the other hand, while the company is still brilliantly successful - in television and films and the two theme parks - it has not moved out in any new creative directions since Disney's passing.  Instead, it has optimized what was already in the hopper when he died.  Polaroid's second-generation leadership must obviously be cognizant of the lesson in this for them.

The author didn't really mention the long period of time that Disney did have trouble after Walt's passing.  Steve Jobs famously warned Tim Cook not to sit around and ask what Steve Jobs would do (which is what post-Walt Disney had a problem with).

And on page 262,

     The most carefully Land has publicly addressed himself this issue was in the interview he gave Forbes in June 1975:  "There is only room for one of me in this company, and if while the one is there, all the others are growing and learning, the worst thing that could happen is that we could become one of the two or three best companies in photography and running along steadily.  The best thing that could happen is that we would not merely do that, but one or two or five of the young people around me - the apprentices in every sense - will take over and we might go three or four times as fast." 

This is a little off the topic, but there was a quote of Land's that is very inspiring from this book so I'll post it here:

The Five Thousand Steps to Success

If you dream of something worth doing and then simply go to work on it and don't think of anything of personalities, or emotional conflicts, or of money, or of family distractions; if you just think of, detail by detail, what you have to do next, it is a wonderful dream even if the end is a long way off, for there are about five thousand steps to be taken before we realize it; and start making the first ten, making twenty after, and it is amazing how quickly you get through those five thousand steps.  (Edwin Land to Polaroid employees, December 23, 1942)

Anyway, this book ended with optimism that Polaroid will do just fine without Edwin Land.  Again, we know that that wasn't the case.  It took until 2001 for Polaroid to go bust, but they had many bad years before that.

There is an interesting new book out written by a former Polaroid employee that takes a close look at Polaroid of the post-Land era up to and even after the 2001 bankruptcy.  It is quite an interesting read:

Fall of an Icon:  Polaroid After Edwin H. Land:  An Insider's View of a Once Great Company by Milton P. Dentch

Dentch lists all sorts of reasons why Polaroid failed post-Land and he feels that a different approach/managements might have been able to keep Polaroid viable.  After reading his book, I still think the main issue was that without Land, Polaroid was toast.   People will argue that Polaroid was toast way before Land was fired in 1982 as he was responsible for the Polavision fiasco.  But either way, I tend to think Polaroid had very little chance of success after Land.

Anyway, the book quotes from the Polaroid Handbook from the mid-60s,

    We have two basic aims here at Polaroid.  One is the make products which are genuinely new and useful to the public, products of the highest quality at reasonable cost.  In this way we assure the financial success of the Company, and each of us has the satisfaction of helping to make a creative contribution to society.
    The other is to give everyone working for Polaroid personal opportunity within the company for full exercise of his talents; to express his opinions, to share in the progress of the Company as far as his capacities permit, to earn enough money so that the need for earning more will not always be the first thing on his mind - opportunity, in short, to make his work here a fully rewarding, important part of his life.
    These goals can make Polaroid a great company - not merely in size, but great in the esteem of all the people for whom it makes new, good things, and great in its fulfillment of the individual ideals of its employees.

And about Jobs and Land:

     Jobs himself spoke about Land in a 1985 magazine interview with Playboy. "Eventually Dr. Land, one of those brilliant troublemakers, was asked to leave his own company - which is one of the dumbest things I've ever heard of," he said.  Jobs - a brilliant troublemaker in his own right, was pushed out of Apple months later.  Polaroid drifted after Land's departure, and eventually filed for bankruptcy.  Apple also fell on hard times after the Jobs exit, but the company revived when its founder returned to lead it again.  Jobs and Land shared a creative gift that gave the world products it had to have.  Call it genius or call it magic.  You can't replace that.  (Steven Syre, the Boston Globe, October 7, 2011)

(emphasis is mine)


In a previous post, I mentioned how the intense focus of Apple can be a risk post-Jobs since they may focus on the wrong thing; if whatever they focus on doesn't sell, they might get in trouble.

In the case of Polaroid, it seems like they lost focus after Land.  Here is the last two chapters from the Dentch book:

     The lack of focus was a bigger problem than I realized when I started my book.  When Dr. Land decided to produce instant color film, develop the perfect Instant photographic process, the SX-70, make Polaroid negative or Polaroid batteries, employees at all levels jumped on board gladly.  It was exciting to be part of;  we had focus and got the job done.

     The Polaroid Corporation was the embodiment of one person, Edwin Herbert Land; he was the founder, inventor and the protective father figure to his employees.  When Land was pushed out of his company by the board of directors in 1982,  his successors never found or maintained a viable focus again.

 (emphasis mine)

Yes, there have been great founders where the companies have survived for many decades after their passing or retirement.  Most of the S&P 500 companies would probably fit into that category.

So why not Apple?  I don't think they will necessarily go bust any time soon.  When Jobs left the last time in the 1980s, Apple survived and the Mac never went away; Mac fans were loyal and continued to use them.  It's just that the business trajectory shifted a bit without Jobs' 'magic'.

Sure, Cook is way better than Sculley so they may do better this time around.

But my thinking is that the Boston Globe reporter is correct from the quote above:

Jobs and Land shared a creative gift that gave the world products it had to have.  Call it genius or call it magic.  You can't replace that.   

After reading these Polaroid books, which Jobs may have too, I wonder if Jobs had any doubts about Apple.  I don't remember him expressing any doubt (except for him saying that the only problem is that Tim Cook is not a product guy), but I wonder if the Polaroid story hung in his mind in his last days.  I wonder what instructions he left to the trust that owned Apple shares (did they sell?).

Anyway, there may be no new information here, but I thought I'd post some of my notes on reading these books.  Some of it was very enlightening to me.

:

Why I Left Apple (Apple is a Speculation)





OK, this title is meant to mock the book about Goldman Sachs with a similar title.  I have never worked for Apple, so this is misleading.

 

Warning:  This post has no data or any analysis.  It's just opinion, like a dinner table conversation with family on what worries me as an Apple shareholder (or former shareholder, current shorter) so maybe it's more of a rant or lengthy rambling.

 

So those looking for spreadsheets, data, channel-checks and information from Asian expert networks on Apple supplier order trends can skip this post.

Anyway, first of all, I do admit that a long Apple position has been the biggest dollar contributor to my performance this year; I owned the stock for much of the first half of the year.   And then I got short starting in October or so when I posted about that here (and got more comments (or close to that) than any other post, ironically).

 

It was on October 11, in my post titled "Crash?!"

 

I'm not proud of trading, but I admit that October was very good for my portfolio largely thanks to the Apple short (which I covered in November).

 

I do understand the long story for Apple.  It is incredibly cheap and it does have tremendous momentum.  Yes, Apple is not Motorola or Nokia.  Yes, it's not just a gadget but it's the eco-system.  And yes, a large market-cap is not barrier to further gains.   I agree with all of that.

The reason I got nervous and dumped my Apple shares was simply because I couldn't see Apple ten years out.  I couldn't see that when I bought the shares, but I bought it thinking I can buy at 10x p/e and sell at 15x p/e or something like that and then enjoy the earnings momentum along the way.   Let's put it this way; it was not a high conviction, buy and hold for a long time position in the first place for me.

 

What triggered my starting to short it was the incredible run-up in the shares and the incredible attention to the stock.  It seemed like everyone was buying Apple stock including dividend/income funds and things like that.  I saw folks on CNBC ridiculing the people who don't get Apple and telling viewers that it's really simple; just buy the stock and enjoy the ride.   People who don't get it are fools.  These people were from some sort of Apple shareholders' club (another thing that set off alarm bells).  The tone was enough for me not to want to be on board with them.

 

Yes, I know.  Julian Robertson and David Einhorn and many other incredible investors like Apple and I don't have any information that they don't have so they are probably right.

 

And it's not a good idea to make investments or trades based on these "feelings".  I rarely do so.  But sometimes, I get such a strong feeling about something that I can't help myself.  And I allow myself to make these trades that I couldn't explain to Warren Buffett or Charlie Munger as long as I don't lose money doing it.

 

Anyway, here are some things that bother me.  I really don't care about iPhone5 sales in China or how many iPads they sell this holiday season.  My concern has nothing to do with these near-term issues that the pundits seem to always talk about when they talk about Apple.

 

I finally finished the book about Jobs by Walter Isaacson.  I read a lot of books simultaneously, so sometimes it takes me forever to finish a book.  Well, I finally did finish it and I was surprised by something; I am actually now much more bearish about Apple than before I read the book!

 

I think in many ways, the importance of Jobs may be underestimated by current Apple bulls:

 

Who's the Product Guy?

People say that Jony Ive is still there and Tim Cook is doing well running Apple.  This is true.  But what scares me is that Ive may create ten or twelve (or more) models of something and then Jobs would come in and take a look at them.  He would pick the ones that look good, demand changes here and there etc.

 

He is the editor that is instrumental in perfecting the product.  Does anyone do that there now at Apple?  Who has that sort of vision that Jobs had?  Who knows what the customer wants better than the customer?  Even Jobs says that Cook is not a product guy.  So who is the product guy there now?  Could Ive have created those great products without Jobs' input and choosing/editing?  

 

Jobs insisted on doing no market research.  That's because he had an uncanny ability to create products and ideas without that.  Who there can do that now?

 

Reality Distortion Field

The energy and charisma of Jobs allowed "impossible" things to get done.  There are many situations where Jobs threw a tantrum and wouldn't take no for an answer.  Who has that power at Apple now?  As I said in another post, it is very interesting to note that Samsung (which is run by a charismatic founder/leader) was able to get things done in a fast changing world while Sony lost it's way after the passing of the founder Akio Morita (one can argue that he lost his way too long ago).

 

Apple products that put Apple back on the map after Job's return were so revolutionary and much of it was possible due to Jobs insistence on all the various aspects he wouldn't give up on.  It is questionable if anyone else could have done the same thing even if they had similar ideas.

 

Focus

Apple is great because they focus on just a few things and just do it really, really well.  I have read Tim Cook's recent interviews and saw his interview on TV.  He is impressive to be sure. 

 

But here's what scares me.  He says that Apple is not going to go out and try to do a whole lot of stuff.  They just want to do a few things but do it really, really well. 

 

This is a good idea when you have such an amazing product guy like Jobs.  But what happens when you don't have someone like that?   Cook is not a product guy.  How do they choose what to focus on next?  What if they choose the wrong thing?

 

I am a portfolio manager (of sorts) so I can't help thinking of analogies in the financial world.  George Soros is a brilliant trader.  He has built (at one time) a great organization that performed incredibly well.  He built up, no doubt, a culture of hard work and deep analysis and an intense focus on risk management etc.  He hired the top people from the top schools and/or competitors.

 

But would Soros organization perform as well without him?  I think history has proven that that hasn't happened.

 

Even if you have the best staff, if the ultimate editor, the one who chooses what to focus on and where to put the resources, things may not work out as well without the 'visionary'. 

 

I know this is not a good analogy at all, but I can't not compare.

 

If Jobs was a CEO that managed a company that created great products, then it would be a different story (like being the CEO of Fidelity instead of the head of a hedge fund who makes the key investment decisions).

Jobs, to me, is so clearly more the product creator than CEO.  So in a sense, he is more like the talented hedge fund manager that puts up great performance figures with the help of a great staff.  He is definitely not the normal, CEO-type. 

 

This is a problem for Apple post-Jobs.

 

Anyway, back to the point.  For the next product, whether it's the iTV or whatever, they are going to focus intensely on something and if that something is not going to blow the world away, it can be hugely problematic.

 

I think there was a sense of relief after the first year post-Jobs, but all the developments since then were probably already planned out.  Perhaps there is more coming up that has already been planned for the next year or two. 

But what about after that?

 

I subtitled this post "Apple is a Speculation" because we don't know what comes after this.  I don't know that iPhone and iPad upgrades can continue forever like Windows was able to do for so long.  I do tend to think that the PC was much stickier than the iPhone/iPad.  Consumers love it, no doubt.  But it's not nearly as sticky, I don't think, as the PC.  The cost of switching out of a PC-based environment is huge (think of business use, not consumer use which is just emailing, internet etc.) 

 

Apple Got the Culture Right

The other thing that scares me is that Jobs loved Edwin Land of Polaroid and he told people that Land got the culture right.  Well, Land retired from Polaroid in 1982, died in 1991 and Polaroid was bankrupt by 2001.  Yes, that's almost twenty years, but still.  I don't know the financial history of Polaroid from 1982-2001.  I wish I had a tear-sheet from that period.  But I wonder how well they did after 1982.   And this is for a company that got the culture right.

 

Yes, people will argue that technology caught up to them.  But who is to say that can't happen at Apple?  I think Apple is terrified of Spotify, for example.   Many seem to like Spotify more than iTunes.

 

So Polaroid gets the culture right and goes bust in less than 20 years.  This may not happen to Apple.  But that doesn't mean Apple will keep doing as well for the next 20 years.

Sony
I keep coming back to Sony because it's so similar to Apple to me.  There is a lot that is different, but there are similarities.  People will argue that Sony made no-moat gadgets and didn't have the captive eco-system that Apple now has.  This is absolutely true. 

But the lead in eco-system seems to be shrinking versus competitors.  When I look at what people do on the iPhone/iPad, they seem to be either listening to music, watching a movie, shopping or playing games.  The interesting thing is that these things are very low cost.  What does that mean?  To me, it seems like that makes the cost of switching much cheaper.  When you only pay $2.99 or some such for a game, you will most likely easily abandon it if something more interesting comes along.

It's true that the iPad seems to be doing more and more in the business world; at my local 24-hour deli (NYC deli), they swipe credit cards on an iPad.   But at this early stage, they may not have a lock on any given area yet.

On the other hand, maybe Sony did well for a long time (it was founded in 1946) because they actually did do a lot of things. 

The annual reports from 1964 are available at the Sony website and it's fascinating to read through them; especially the old ones.

They were involved in many areas and were never really a one product company.  They had many failures but none killed them because they weren't so focused like Apple is today. 

Just for fun, I snipped some of these pictures from various old annual reports.


This is the laser disk that never really took off:

I don't know what this typecorder is.  I guess it's an early word processor.

Of course the big hit was the Sony Walkman.  This was created by the strong urging of Sony's CEO Morita.  People said there would be no market for such a product, but Morita, in a Jobs-like way, saw a market for this.

And here's a photo of the then largest color TV.  I thought it was funny given how big LCD screens are these days.

Anyway, Sony had the betamax fiasco and various format wars.  They have survived through the years precisely because they did a lot of things, I think.  (They would probably be bankrupt by now if they didn't have Sony Financial)

 

Of course, today, they may be involved in too much and may do nothing well.  But at this point, it's hard to imagine that they can do anything well.

 

 

Other Companies that Got the Culture Right

Recent cases where perfectionist, highly demanding, hands-on, detail-oriented founder/CEOs retiring that didn't go too well are Starbucks, Dell, Fast Retailing (Uniqlo).  Howard Schultz seemed to have gotten the culture right at Starbucks, and yet he had to come back to fix Starbucks.  Fast Retailing has a Steve Jobs-like CEO, Tadashi Yanai, who is highly demanding and has a good sense and feel for retail.  He retired once but since had to come back to fix Fast Retailing.   He too often talks about culture (he may not use that word); he often talks about developing employees etc.

 

I know there must be some successful cases, but these cases came to mind because of the style of the CEO; they were very hands-on.

 

In Apple's case, the runway of growth in front of them on existing products on upgrades and whatever was on the drawing board that Jobs put there may sort of mask this problem; Apple may very well be coasting on Job's achievement for now.

 

When people start to see this (which I think is already happening), it may be difficult for Apple to get a high valuation.

 

Conclusion

So, my thinking is that Apple will probably hit some bumps in the road in the not too distant future.  The stock price is cheap so it may not go down a whole lot, but it's only cheap if they maintain these high margins.  I have no proof, but I suspect that customers will see where all of their dollars are going and will eventually start to demand a better deal.  In an increasing competitive environment, why should Apple capture such fat margins?

 

I think Jobs was basically a genius product creator that was relentlessly demanding and would take nothing less than perfection.  He was the product guy of the century, maybe.  And Apple is very, very product dependent.  They don't sell a lot of products so whatever they come out with next MUST succeed.  Can they do this without Jobs?   This is yet untested. 

 

If H&M or Gap misses on their fashion for a season or two, they will suffer, but it probably won't kill them.

 

With Apple, they are like the portfolio manager that bets on two or three stocks.  When a genius is managing the portfolio, this can be incredibly successful.  But what happens when someone different takes over and still tries to manage a three stock portfolio? 

I don't know.   Apple may continue to do well for many, many years to come.

But I get the sense that the greatest asset at Apple was Steve Jobs, plain and simple.  Just as the best analysts and employees may help some star hedge fund managers achieve incredible returns, that doesn't mean that the analysts and employees will be able to continue posting those strong returns without the star.

 

And in anticipation of the people disagreeing, I understand the bullish argument.  Opposing views are always welcome here (or else why post publicly?).  But I just want to say that I am very well aware of the bull case! (Don't forget, it's the biggest dollar contributor to my portfolio this year).