Apple's Buyback: Does It Still Make Sense?

Not long ago, Carl Icahn began calling for Apple (AAPL) to buyback $ 150 billion worth of its stock.

He eventually pushed for a large and immediate tender offer.

Prior post: A Bigger Buyback For Apple?

Essentially, Icahn wanted the company to quickly buyback lots of its stock before the window of opportunity closed.

Here's what he wrote in a late October letter to Tim Cook:

"In our view, irrational undervaluation as dramatic as this is often a short term anomaly. The timing for a larger buyback is still ripe, but the opportunity will not last forever."

This more recent CNBC article points out that Icahn has now reduced the amount of stock he thinks Apple should repurchase to more like $ 50 billion.

Well, I'll just point out that the stock has not only risen nearly 20% since he started pushing for the $ 150 billion buyback, but is also up more than 40% from its lows earlier this year.

The better time to buyback at that kind of scale has, at the very least, temporarily passed.

So the window of opportunity to buyback stock may not have completely closed, but eventually that rising price begs for the scale of the buyback to be smaller.

The arithmetic is such that what would have had powerful effects on per share intrinsic value at lower prices increasingly becomes less compelling.

Each dollar invested in the stock simply goes less far and naturally, as a result, returns less for continuing shareholders.

So, inevitably, the "relentless rules of humble arithmetic" dictate what makes sense here. For those who own Apple with longer term outcomes in mind, the merit of a very large buyback is just not quite as clear as it was not too long ago.

Naturally, those attempting to trade around the company's nearer term prospects likely have a totally different agenda.

 Warren Buffett, who had talked to Steve Jobs about whether buying back Apple's stock was a smart thing to do several years back, did say the following about the idea of increasing the buyback this past October:

"I think the Apple management and directors have done a pretty darn good job of running the company. My vote would be with them."

Now, keep in mind that earlier this year Apple expanded its share repurchase authorization to $ 60 billion and, when the stock was much lower, did buyback a nice chunk of their own shares. So it's not like they don't already have a meaningful buyback program in place even if not at the scale Icahn seems to want.

Share count is down to 909 million compared to 948 million a year earlier (and seems certain to be even lower when they next report).

Buffett, who is no small fan of buybacks when they make sense, also added the following about the pressure on Apple to buyback even more of their stock:

"I do not think that companies should be run primarily to please Wall Street and largely shareholders who are going to sell. I believe in running Berkshire for the shareholders who are going to stay and not the one's who are going to leave."

His emphasis is always on doing what's best for those who are willing to have a longer investment time horizon.

That doesn't change the fact that, as I've said before, tech stocks are generally not what I like -- and that includes an enterprise as capable as Apple -- unless extremely cheap. It has to be priced in such a way that little good has to happen to get a nice result considering the risks.

With the company's already sizable repurchase authorization and increased stock price in mind, I'm not sure whether an increased/accelerated buyback plan matters a whole lot at this point.

What matters more right now is whether the stock can remain cheap enough to warrant buying more.

"The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another." - Warren Buffett in the 2011 Berkshire Hathaway (BRKa) Shareholder Letter

In fact, if Apple's stock does continue to rise, it will eventually make sense to put a halt to their buyback plans altogether.

More generally speaking, continuing long-term shareholders are generally better off when a stock underperforms in the near term (or even intermediate term) and the business continues to have sound long run economics. Potential reward is actually increased while risk is reduced* when the stock of a sound business remains cheap, there's no imminent intent or need to sell, and the investment time horizon is long enough. The further an investor is away from selling, the better off they become much further down the road. The reason is simple: It not only allows the investor to buy more shares cheap, it allows the company to buyback shares cheap over time. This can have a significant compounding effect longer term.

With patience, the combination of a not so great performing inexpensive stock and a sound business that's been bought at a reasonable price can be a powerful one.**

It may not be a lot of fun -- and professional money managers must consider "career risk" -- to stare at the quoted price of a listless stock, but the arithmetic at work here is undeniable.***

An investor can develop a trained response that more heavily considers the longer run big picture while mostly ignoring the shorter term noise. Learning a more rational trained response should, on the surface, not exactly be difficult or impossible to learn but things like loss aversion do tend to make it a real challenge. 

An investor has to also appropriately weigh the opportunity costs and make high quality ongoing assessments of future business prospects. Sometimes prospects change; other times they're misjudged out of the gate.

In other words, this approach to investing works for a sound business that's bought well.

It doesn't work for a broken business. 

It doesn't work when a big premium to intrinsic value was paid in the first place.

Stubbornly holding onto shares of an unsound business is a great way to wreck investment results.

The same is true for the investor who stubbornly holds onto shares after it becomes clear that a dumb price was paid (usually in a desperate attempt to get their money back out).

These are mistakes that must be avoided.

Adam

Long position in AAPL and BRKb established at much lower than recent prices. No intent to buy or sell shares near current prices.

* Risk and reward need not always positively correlated even if modern finance theory, not to mention cultural norms, seem to more than suggest otherwise.
** The potential impact on risk and reward over time from this is not insignificant but also may not be completely obvious. For me, creating and working with simple, but meaningful, spreadsheets is one useful way to develop this into something that's more intuitive. The compounded effect over, lets say, 20 years or so isn't small at all. That can be easier to see with a thoughtful, but not unnecessarily complex, spreadsheet.
*** Especially a stock that ends up selling quite a bit below where it was bought -- and for a long period of time. Even if an unpleasant experience for some (I mean, nobody really likes seeing even paper losses no matter how rational this may be) and maybe just a bit counterintuitive, this approach still works out over the long haul if the company produces lots of cash flow, capital gets allocated well over time, and the price paid made sense. This way of thinking will no doubt be of little interest to those primarily in the business of trading price action.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

A Bigger Buyback For Apple?

Earlier this year, Apple (AAPL) expanded its share repurchase authorization to $ 60 billion.

Well, Carl Icahn is calling on the company to repurchase more like $ 150 billion in stock. From this recent Icahn letter to Tim Cook:

"We want to be very clear that we could not be more supportive of you, the existing management team, the culture at Apple and the innovative spirit it engenders. The criticism we have as shareholders has nothing to do with your management leadership or operational strategy. Our criticism relates to one thing only: the size and timeframe of Apple's buyback program. It is obvious to us that it should be much bigger and immediate."

Warren Buffett did recently say "I wish I had bought the stock many years ago" and also mentioned he had advised Apple on buying back their stock -- if they thought it to be undervalued -- a few years ago or so.
(At that time they did not.)

Buffett is no small fan of buybacks when they make sense yet said the following about the pressure on Apple to buyback even more of their stock than they are already doing:

"I think the Apple management and directors have done a pretty darn good job of running the company. My vote would be with them."

He then added this:

"I do not think that companies should be run primarily to please Wall Street and largely shareholders who are going to sell. I believe in running Berkshire for the shareholders who are going to stay and not the one's who are going to leave."

So they agree on how well the company is being run.

The important difference comes down to time horizon.

Buffett has always had a strong bias in favor of building and serving a base of shareholders who mostly are going to stick around for the long haul. With that in mind, he naturally has a preference that decisions are made, first and foremost, for long term owners. He's just not that enthusiastic about responding to pressure from someone who might not be around as a part owner for very long.

Pressure for change from those who intend to own shares for years to come -- under the right circumstances -- can be just fine; pressure from those with shorter time horizons is not.

So those who push for action to achieve a profitable near term outcome then move onto the next target should be considered of secondary importance to those in it for the long haul.
(What moves the stock up near-term may or may not also be favorable for long term owners.)

Still, what Carl Icahn usually does is hardly the equivalent of short term trading.

Agitating for fundamental change at the senior management and board level can be a very useful thing. No doubt more than a few companies need it. In fact, the investing world would benefit from more large shareholders who are willing to do so and are competent at it. The question is whether those who push for the change are willing -- alongside other owners -- to stick around for the long run repercussions of the change they helped facilitate.

Some will no doubt argue that the sticking around part isn't all that important as long as the right kind of change happens.*

Icahn wants Apple's board to move more aggressively and announce a $150 billion tender offer. He thinks it should be financed with debt or a mix of debt and balance sheet cash.

In the letter, Icahn does say "to invalidate any possible criticism that I would not stand by this thesis in terms of its long term benefit to shareholders, I hereby agree to withhold my shares from the proposed $150 Billion tender offer. There is nothing short term about my intentions here."

Of course, that definition of long term -- a willingness to withhold shares during the tender offer -- probably isn't exactly a time horizon that Buffett would consider long term.

Now, if someone like Carl Icahn can actually improve corporate governance more generally (and maybe improve/change the laws of consequence that can undermine long term oriented owners) that would be a very useful thing.

The quarterly results Apple released back in July revealed they've already been buying back a whole lot of stock. The company was also likely doing so, in a meaningful way, during the quarter that just ended.

One of Icahn's chief concerns seems to be that the window to buyback the stock when it is actually cheap will close sooner than later. That's certainly a legit concern. Now, the existing $ 60 billion buyback authorization is not exactly small but, the question is, how fast can it be executed. The company indicated back in April it expects the buyback to be completed by the end of 2015.

Well, if the buyback takes all of that time to complete and the stock price rises materially, it just won't be as effective as it could otherwise be. It may still have a favorable impact, of course, but a bit less so than if it were completed while the stock was selling for much less.**

It's also possible that the stock becomes truly expensive. In that case the buyback should naturally be halted. Buybacks generally only make sense when the share price represents a plain discount to per share intrinsic value, the company is comfortably financed, no superior alternative investment(s) exist, and all other important expenditures (including whatever solidifies/widens the moat) are covered.

Apple reports its quarterly results next week. At that time, it will become more clear just how much more stock they've been buying since they last reported.

The buyback activity may not be quite as much as some would like to see, but they still likely repurchased more than a few shares outstanding.

In any case, I'll still never really be all that comfortable with tech stocks as long-term investments.

They have, on occasion, become of mild interest (in small doses) when selling at a substantial discount to conservatively estimated per share intrinsic value.

That's about it.

Adam

Long position in AAPL established at much lower than recent prices

* The following seems relevant here. Does the owner of an asset (e.g. a car), someone who intends to sell sooner than later, spend money on the things that will assure reliable performance many years from now or, instead, mostly just do those things that polish it up for sale? Time horizon impacts owner behavior. This naturally also applies to businesses. Crucial things must be often be done today to make sure a business remains competitive many years down the road. Those who are mostly (if not entirely) trying to get a near term result aren't likely to weigh those important long term considerations appropriately against their own near term objectives and interests. Sometimes there's no tension between near term and long term considerations; other times there is.
** One wonders how much of the recent rally in the stock can be attributed to Icahn's actions. In other words, how much has the higher than otherwise price inadvertently reduced Apple's buyback effectiveness. That may not be precisely knowable but it certainly matters. Around the more recent market prices, the buyback is already meaningfully less impactful than it would have been not long ago.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Buffett's Purchase of IBM Revisited

In November of 2011, Warren Buffett revealed on CNBC for the first time that he had been buying shares of International Business Machines (IBM).

Buffett on IBM: Berkshire Buys Big Blue

He apparently began buying in March of that year and some will rightly note that the stock hasn't done much since then.

Certainly not, for example, compared to the S&P 500.

Berkshire Hathway's (BRKa) cost basis in the stock is something like a little over $ 171 per share.

As I write this it is selling at roughly $ 185 per share (though, fortunately, earlier this week it went even lower).

So has it been a good investment for Berkshire?

It is, in fact, a very large and likely long-term position for the company. The stock hasn't done much but, as I'll get to below, earnings per share sure has.

Why Buffett Wants IBM's Shares "To Languish"

Here's how Buffett explained how he looks at IBM -- a company that's been repurchasing shares at a good clip for some time -- in the 2011 Berkshire Hathaway Shareholder Letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."

IBM has been aggressively repurchasing stock for quite some time and, as Buffett notes in the letter, that seems likely to continue over the next five years.*

If shares are selling at a clear discount to value, an even lower share price just increases share repurchase effectiveness for shareholders.

Buffett goes on to explain his thinking on IBM and their share repurchases this way:

 "....what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years."

This mostly comes down to the power of well executed share repurchases. They work extremely well over the long haul when shares are bought nicely below intrinsic value, business prospects are at least solid (i.e. moat reinforcement/strengthening is not being neglected) and the company is in a comfortable financial position.
(A healthy balance sheet, lots of liquidity sources, along with robust even if fluctuating somewhat free cash flow.)

Buffett walks through the math in the letter to further explain why he wants IBM's stock to "languish".**

The bulk of the IBM position for Berkshire was established in the 2nd and 3rd quarter of 2011. Buffett would have been able to see that IBM had earned $ 11.52 per share in its, at that time, most recently reported full fiscal year (2010).

Let's compare that to now. For 2013, earnings per share should come in at more than ~ $ 16.00 per share with earnings per share of ~ $ 17.50 per share not at all a stretch for 2014. So, if that happens, that'd be a 50% percent plus increase in per share earnings power over 4 years.
(There's hardly a guarantee this earnings power is persistent, of course. That's only one of the many important judgments -- some easily quantifiable, many that are not -- any investor has to make.)

Berkshire has also been receiving a growing but still just decent annual dividend that now sits at roughly 2%; a nearly 50% increase in the dividend payment since early 2011.

Make some conservative assumptions on dividend growth going forward and that now modest payment seems likely to be rather a whole lot less modest 7-10 years out. Consider that more than 3x as much capital has generally been getting allocated to share repurchases compared to dividends. No guarantee that continues but, if they do and the price shares are repurchased at remain attractive, those buybacks will help fuel earnings per share and ultimately the dividend per share in the long run. Over many years, especially if the stock remains low and the business performs reasonably well, the compounded impact of the share repurchases should be not inconsequential.

"The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."

So the key is the price compared to value and whether one thinks business prospects are likely to remain attractive (even if, as in the case of IBM, maybe a bit unexciting). The current valuation just doesn't demand spectacular business performance to achieve satisfactory risk-adjusted returns. Instead, it simply demands persistently solid business performance and continued smart financial management.

Unfortunately, with some public companies, share repurchases are done at unattractive valuations and for the wrong reasons (e.g. to prop up stock or to offset dilution from stock options).

It's when a stock sells for a plain discount to conservatively estimated per share intrinsic value, and the company can comfortably afford it, that a buyback makes sense.

I don't doubt that market participants primarily in the business of betting on price action will maintain this was not such a great investment. Those looking for quick speculative gains will likely find IBM to be a mostly uninteresting place to put their money at risk. If nothing else, IBM is the sort of investment that's almost certain to not make someone quick and substantial returns.

Some will correctly point out the lack of revenue growth prospects; IBM's organic revenue growth has been pretty much nonexistent (or worse) for some time.

That's likely to continue.

While revenue growth can be a fine thing, it can't be viewed in a vacuum; not all incremental revenue is of the high return variety.

Ultimately, besides never paying too much in the first place, what really matters for long-term investors is persistent and attractive returns on capital and whether capital gets put to good use.
(If no attractive investment alternatives exist, excess capital should be returned shareholders.)

Of course, some might view IBM's share repurchases as just an attempt to prop up earnings. No doubt some companies do just that. I happen to think this doesn't apply to IBM when you consider how they've handled their financial management responsibilities over time.
(Buffett does highlight the quality of IBM's financial management in the 2011 letter.)

The specific context matters when it comes to share repurchases.

Among other things:

- How the price paid compares to a conservative estimate of value

- The attractiveness of investment alternatives

- The durability of the core business franchise

- Inherent capital intensiveness

- Financial health

IBM is ultimately a technology products and services business.

That's the bad news.

For that reason alone the company's stock will never be a favorite.

Naturally not all technology and technology-related businesses possess similar inherent risks; some new tech startup, for example, has very different specific risks associated with it compared to IBM. Up to a point it's true that the price paid can minimize the risk of permanent capital loss, but only up to a point.

Sometimes the risks of a business are so difficult to gauge that no price is low enough to provide sufficient margin of safety.

At some point the right answer is to just avoid.

For me, that's often the right answer with shares of technology businesses.***

From earlier in the 2011 letter:

"The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another."

There are certainly far better businesses out there but, once the inherent risks and opportunities are understood well enough that it gets beyond the go/no go decision, the investment process always comes down to price.

Adam

Long position in Berkshire Hathaway established long ago at much lower than recent prices. Recently added a small IBM position for the first time at somewhat lower than current prices. 

* Share repurchases may be likely but will only make sense if the shares remain cheap enough. In other words, nicely below per share intrinsic value. Repurchases that are executed above approximate per share intrinsic value is generally poor use of capital. Since estimated per share value is best case an imprecise range, there should be a plain margin of safety. The discount to value should be obvious. Share count reduction needs to accomplished in am economically sound manner. This should be something an investor can count on but, unfortunately, that's not the case.
** In the letter, Buffett explains the relatively simple yet important repurchase math: Essentially, he points out that if IBM's stock price were to average something like $ 200 during a given period the company would acquire 250 million shares for its $ 50 billion. If the stock instead sold for $ 300 on average during the five-year period IBM will acquire only 167 million shares. He says that, over the five years, Berkshire's share of those earnings would be a full $ 100 million more in this "'disappointing' scenario". Also, if the stock were to fluctuate near current prices -- which are now even lower than the "'disappointing' scenario" -- it would work out even better. In the very long run the "weighing machine" will reflect roughly the additional per share value of those incremental earnings.
*** I realize some others may feel more comfortable with tech stocks but, with investments, buying only what one knows well is essential. That is necessarily unique to each investor. Gauging the future prospects of most tech businesses is tricky at best. At least it is for me. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Apple's Record-Breaking Launch

Apple (AAPL) sold nine million iPhone 5S and 5C smartphones over this last weekend topping the former first weekend record sales of five million for the iPhone 5.

Or did they?

Apple's 9 million weekend

Some are arguing that the numbers are inflated while others maintain that the nine million number is a sound one (and maybe even understated).

Apple analysts and the nine-million iPhone kerfuffle

The company also separately announced that revenue and gross margin would be near the high end of their previously provided range.

So, I guess, it'll take some time for the dust to settle on this. I'll happily leave that for others to sort out. Whether they sold a bit more or less than nine million that's an awful lot of business -- rather profitable I might add -- in one weekend.

Eventually Apple's cumulative product execution will matter massively, of course, but the company's intrinsic business value and how it may change certainly can't be figured out based on one product launch.
(Though this reality no doubt won't stop some from trying to make short-term bets on price action based upon perceived the success/failure of a particular launch. Nothing wrong with that, of course, but my interest in that sort of thing happens to be effectively zero.)

If the nine million turns out to be a reasonably good number then that's, give or take, more than $ 5 billion in just one weekend. This assumes something close to the $ 581 price per iPhone from the previous quarter roughly holds up.
(The unsubsidized/unlocked price is, of course, much higher than the suggested retail price with a two-year contract.

iPhone Price and Specs

The question is how many upgraded phones were purchased and the related product sales that might have occurred.

The 16GB iPhone 5S sells for $ 649. The 32GB and 64GB versions each sell incrementally for $ 100 more.

The 16GB iPhone 5C sells for $ 549 with the 32GB version selling for $ 100 more.

With that pricing in mind the $ 581 per iPhone assumption doesn't at all seem a stretch.

This is especially true considering that the 5S apparently outsold the 5C by more than 3x.

Consider that $ 5 billion plus sold in one weekend, if correct, in the context of Apple's sales history. For some perspective, Apple's sales across everything it was selling back in 2003 was $ 6.2 billion over the course of a full year.

So, during a product launch, they can now nearly sell in a bit more than a few days what roughly a decade ago would have taken all year.

Keep in mind that what they are selling has far more attractive margins -- at least for now -- than what they were selling a decade ago.

In fact, Apple was barely turning a profit back in 2003.

Who knows how well the newer smartphones will perform long-term, but whether they're sustaining price, attractive margins, and high returns on capital is far more important than unit volume.

As the negative reaction to the pricing for the 5C reveals, some don't necessarily agree with this premise.

The reaction is unsurprising but enlightening.

Shares of Apple slide, analysts cut targets in disappointment over iPhone 5c pricing

It's, in part, a belief that not so profitable growth early on will lead to big profits later; a belief that market share is king.

That is a strategy (and sometimes maybe even the right one).

So is making sure your product earns then maintains a premium position in the market. It is not easy getting price back once you've given it up. It's not easy to get back a premium image once you've sold something for cheap.

I'm not suggesting I know the correct way to go for Apple. I certainly do not. I'm suggesting it's not a straightforward call and they may just be doing the right thing. Time will tell. Those who confidently assert Apple needs a lower priced iPhone should probably at least be a little less confident.

It's not easy to maintain price in the business they are in. I'm more than a little bit amazed they can do it. I'll be surprised if they pull it off longer term.

Still, if anyone can it's probably going to be Apple.

Market share matters to an extent, of course, but so does profit share.

Apple takes 53% of smartphone profits, Samsung at 50%, remainder lose money

This article has a useful chart on how mobile phone operating profits have changed in the past five years or so through the end of 2012.

Apple has roughly half the profit share with just 13.5% market share. Half the profit share might be impressive, but that is down compared to the previous quarter and where it was in 2011 and 2012.

As I've said on prior occasions, I'll just never be very comfortable with tech stocks as long-term investments.*

Occasionally they become interesting in small doses if they're selling at a very large discount to my own conservative estimate of per share intrinsic value.**

Essentially it has to be a price where nothing particularly great has to happen to get a good result.

Prices like that don't emerge everyday but they do occasionally emerge.

It's patience and discipline followed by decisive action.

While I admire the way a business like Apple can change the world, as an investor I'm just no fan of businesses that reside in such a fast-changing and competitive industry landscape -- a place where the core economics can change quickly. When, over roughly just five years, the distribution of industry profits can change as dramatically as the article and chart above shows, it should make no investor comfortable about the next five or ten years. The best businesses reside in industries they dominate with no such profitability dynamics.

Some businesses that change the world end up being wise investments; some do not.

I mean, what's been better for the world, airlines or tobacco companies?

Yet just compare their long-term returns.

The price that's paid (margin of safety) and whether durable advantages exist (to protect attractive core economics) should mostly determine long-term investment outcomes. An investor has to judge future prospects and value well then pay a smart price considering the risks.

I'm not suggesting that product announcements are irrelevant. I'm suggesting that the next product announcement -- even a relatively important one -- should matter a whole lot less than the bigger picture. Some may find the obsessive hyperactive focus on near-term events in combination with betting on how the stock might react to be an entertaining exercise.

Well, hopefully it is entertaining because for most, if not all, it seems unlikely to produce great results over the long haul.

Adam

Long position in AAPL established at much lower than recent prices

* Though I'm not suggesting all tech businesses are somehow poor long-term investments or are created equal. It's just that technology businesses tend to have a wider range of outcomes. Some of those outcomes will be phenomenal even if often difficult to reliably predict beforehand. Some are no doubt very good at judging the long-term prospects of tech businesses while others might be overestimating their ability in this regard. I try to avoid making the latter mistake whenever possible.
** Of course, my estimate of value -- especially with a tech stock that tends to have a wider range of outcomes -- could easily be wrong. That's where the larger margin of safety requirement comes in. Sometimes the future is so difficult to figure out that no margin of safety is sufficient. Eventually the investment process needs what is effectively a go/no go gauge.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

FPA Crescent Fund Commentary: Steve Romick on Microsoft, Oracle, and Cisco

Steve Romick, a managing partner at First Pacific Advisors, LLC, said the following about Microsoft (MSFT), Oracle (ORCL), and Cisco (CSCO) in his 2Q 2013 FPA Crescent Fund (FPACX) commentary:

"These three companies all face real challenges, including poor management and/or competition from new technologies. But we feel, in each case, the prices adequately discount those fears."

Some businesses -- especially those that reside in dynamic industries, with lots of potential competitive threats, and/or frequent technology shifts that can change fundamental business economics -- are wise to have minimal debt and carry lots of cash for defensive reasons. Those that possess a wide economic moat -- large and sustainable competitive advantages -- need no such rainy day fund.

"...all else equal, we prefer companies with strong balance sheets and this group has those. Moreover, even though cash is akin to a lead weight that depresses a company's return on capital calculation, these companies offer a much higher return on capital than the S&P 500."

Whether it makes sense for these businesses to hold on to so much cash or not, it's a mathematical certainty that return on capital is reduced by all the net cash on the balance sheet. The fact these have more than respectable return on capital while carrying all that cash says a lot about their current core business economics. Unfortunately, it says little about what those economics might look like down the road. With the best businesses this is generally not the case. The long run future economic prospects of the highest quality business -- within a range of outcomes, of course -- are far less uncertain and unknowable.

Still, in Romick's view, the three stocks remain far from expensive:

"Our three tech musketeers now trade less expensively than they have versus the S&P 500 median on a historical basis..."

Enterprise Value/Earning Before Interest & Tax (EV/EBIT) and price/earnings ratio (P/E) are the metrics Romick uses to compare the valuation of these tech stocks to the S&P 500.

"These companies had not historically offered a dividend yield, but now with cash flow exceeding internal investment opportunities, they each now pay a dividend and offer yields in excess of the market.

With certain tech stocks an adjustment to earnings (or free cash flow) needs to be made in order to understand the business economics and estimate intrinsic value.

"...our earnings (and revenue) estimates are less than that of Wall Street. We consider "owner earnings" when establishing our base case, rather than GAAP (General Accepted Accounting Principles) earnings. We, therefore, reduce net income by cash used for stock options and further ding earnings for "required" M&A (Mergers & Acquisitions) that we view as imperative to remain relevant and to sustain earnings on a going forward basis."

Adjusting earnings or free cash flow for the cost of options is certainly very important. Some choose to ignore stock-based compensation because it's a non-cash expense.*

Also, what a company spends on M&A sometimes needs to be treated a bit like necessary capital expenditures (required investments to remain competitive and deal with threats to core economics). The problem is that, at times, it's difficult to judge from the outside how necessary the target investment really is and whether management is overpaying for it. In fact, sometimes it's pretty clear they're overpaying. A tendency to overpay for acquisitions has to be subtracted from any useful estimate of intrinsic value. The amount that should be subtracted is necessarily a difficult and imprecise judgment call but very important.**

These points can easily be overlooked. If so, earning power can be made to look more attractive than it actually is. As I've said previously and more than a few times, I'm not a fan of technology businesses though I'll buy shares in them, reluctantly and in small doses, when they're very very cheap.

Romick also added this:

"We can't tell you what the world will look like tomorrow or when Bernanke will raise rates, but we will borrow a line from the investment strategist, Dylan Grice, who said it best when he quipped, 'I'm interested in the possibility of building a profitable portfolio which is robust to my ignorance.'"

Check out the commentary in its entirety. It includes lots of good charts, graphs, and other insights.

Adam

Long positions in MSFT and CSCO established at much lower than recent prices

* It's worth noting that adding back stock-based compensation (as is done in cash flows from operating activities section of the cash flow statement) boosts free cash flow but, for certain companies, is potentially a material source of future dilution and likely quite expensive for continuing shareholders over the long haul. Yes, it's a non-cash expense but, unlike some other non-cash expenses, it shouldn't be ignored. One way to think of this is to calculate how much net cash would be needed to keep share count stable over time. Well, that incremental cash expended is a very real cost to shareholders and should be subtracted from free cash flow for a better understanding of the business economics. It's, at the very least, a rather big stretch to consider economically meaningful any free cash flow calculation that doesn't attempt to account for the cost of stock-based compensation. For those companies that make heavy use of stock for compensation the cost is very real even if difficult to estimate. The reality is that these potentially material costs are generally rather difficult to pin down with any precision. Unfortunately, with stock-based compensation, the best case that can usually be expected is an estimated range of costs (the economic costs...not the accounting costs). A bit messy? No doubt, but that messiness doesn't mean the costs can be ignored to make it seem more neat than it is. Not everything that matters economically can be precisely quantified. In fact, some of the most important things can't be quantified at all.
** See the end of the Intrinsic Value - Today and Tommorrow section from Berkshire's 2010 letter on the "what-will-they-do-with-the-money" factor for more on this. This explanation can also be found toward the end of the past two Berkshire annual reports.)
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Apple's Buyback

Back in April of this year, Apple (AAPL) increased its share repurchase authorization to $ 60 billion.

Apple More Than Doubles Capital Return Program

Well, that naturally meant the company's fiscal 2013 third quarter financial results yesterday was going to be the first chance to see how aggressively it is being implemented.

It turns out they bought back $ 16 billion worth of their shares during the most recent quarter alone.

Quite a lot by just about any standard.

Under an earlier buyback authorization, they had bought back much less ($ 1.95 billion) during their fiscal first quarter (that ended on December 29th, 2012) but none in their fiscal second quarter.

Otherwise, meaningful buybacks really haven't been part of the Apple capital allocation plan (even as their free cash flow and cash on the balance sheet have been dramatically increasing over the past decade).

Even if there's less instant gratification, anyone who's invested in Apple for the longer haul should hope the share price continues to remain low as they carry out this repurchase program (and maybe even follow on programs). That way their cash gets more bang for the buck as they repurchase and the share count is reduced by a greater amount for a given amount of funds.

What's most important -- as long as the business needs are being appropriately funded and there's lots of financial strength -- is that the shares are only repurchased when they sell at a nice discount to per share intrinsic value. As always, what's smart to buy at one price is rather less so at some price that's higher than what an asset is intrinsically worth. That, in just about any real world scenario, ends up being an approximate range of estimated value.

Since the value of any asset is always a necessarily imprecise thing to estimate -- and likely even more so for a business like Apple with the rapid changes that occur where it competes -- the discount should be a meaningful one.*

This$ 16 billion in repurchased shares was far in excess of quarterly free cash flow. Since Apple borrowed roughly $ 17 billion dollars during the quarter, as was announced a few months ago, that means the buyback was more than fully funded by their debt offering.

From here, without additional debt, any sizable buyback will have to be funded by their huge pile of cash (now $146.6 billion but after subtracting the debt they've taken on their net cash is more like $ 129.7 billion) or via free cash flow.

According to their latest reported results, this reduced average shares outstanding from 946 million at the end of the second quarter to just over 924 million in the current quarter. That roughly 22 million reduction in share count represents a 2.3% reduction.

Now, this is based upon the diluted weighted-average number of shares of common stock outstanding.

Yet, the end-of-quarter impact of the $ 16 billion in repurchased shares would clearly be greater than the weighted-average number would indicate.

In other words, it's not difficult to roughly calculate that the direct impact of the buyback on share count reduction -- based upon a reasonable assumption of average price paid -- would be greater than 22 million shares by quarter-end.**

The company also paid out roughly $ 2.8 billion in dividends during the most recent quarter.

So at least they're finally starting to do something material with all their cash.

Adam

Long position in AAPL established at much lower than recent prices

* A more unpredictable range of possible outcomes requires a bigger margin of safety. In fact, sometimes no margin of safety is sufficient. As I have said before, there's really no technology business I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries. That's precisely what makes them unattractive long-term investments. For me, a very large discount is needed for them to be worth the trouble (i.e. an obvious and substantial mispricing) and positions remain on the small side. Otherwise, they're mostly just not worth the trouble. As always, I offer no view (and never will) on what's right for someone else. That's necessarily a unique thing. As a rule I believe no marketable stock should be purchased or sold based upon what someone else says (good or bad) about it. To me, that is a fundamental principle. Stocks should be bought or sold based on one's own sound analysis, conclusions, level of conviction, and within the limits of what the investor uniquely finds understandable. Satisfactory results aren't likely unless an investor is able to consistently and correctly judge the future prospects of a well understood business. Good outcomes aren't likely unless the investor can figure out what something is conservatively worth and always pays a nice discount to that estimate.
** For example, by dividing the $ 16 billion in buybacks by the average market price of AAPL during the quarter. Based on that the share count reduction directly attributable to the buyback would be much greater than 22 million. In fact, even if the shares were purchased at the highest quoted price during the quarter (not plausible, of course) the share count would be lessened by more than 34 million. This is offset, in part, by common stock that is issued under stock plans (employee shares issuances) over time, of course. The $ 16 billion was accomplished via both an accelerated share repurchase (ASR) program and repurchases in the open market. Apple entered into an ASR program with two different financial institutions to purchase as much as $12 billion of its common stock. The total number of shares repurchased (and the average price paid per share) won't be finalized until the program is settled up at the end of the purchase period (which goes beyond the quarter that just ended). Initially, 23.5 million shares were delivered to Apple and retired but that does not represent the final number of shares to be delivered and retired under the ASR program. The other $ 4 billion in repurchases was achieved via the open market. Apple repurchased and retired 9.0 million shares of its common stock in the open market at an average price of $446.74 per share for a total of $4 billion. A further explanation of this can be found under Note 6 in the latest 10-Q. The bottom line is that all of this buyback activity -- especially once the ASR is settled per contract -- will cause the shares outstanding impact to be greater than what's reflected in the weighted-average shares outstanding.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and are never a recommendation to buy or sell anything.

Share-based Compensation: Impact On Tech Stock P/E Ratios

This Barron's article covers how some tech companies believe that ignoring share-based compensation expense makes sense.

Believing this, they naturally encourage investors and analysts to do the same.

As it turns out, many sell side analysts generally do agree to ignore stock expense for certain tech companies.

Barron's: Beware the Hidden Costs in Tech

Keep in mind that, at least for some of these tech companies, the stock expense is far from insignificant relative to earnings overall.

Below I've listed just some of the examples provided in the article of tech companies who encourage investors and analysts to view earnings excluding stock-based compensation. The article provides even more examples. 
(Clearly there are even more. Cisco (CSCO) and eBay (EBAY) come to mind. Both companies place an emphasis on Non-GAAP results that exclude stock-based compensation but happen to not be highlighted in the article.)

The first number -- 2013 P/E Excluding Stock Expense -- is what the P/E ratio looks like ignoring stock-based compensation.

The second number -- 2013 P/E Including All Expenses -- is what the P/E is including this very real expense.
                                     
Amazon.com (AMZN)
2013 P/E Excluding Stock Expense: 88.9x
2013 P/E Including All Expenses: 200.6x

Google (GOOG)
2013 P/E Excluding Stock Expense: 18.9x
2013 P/E Including All Expenses: 21.9x

Facebook (FB)
2013 P/E Excluding Stock Expense: 43.1x
2013 P/E Including All Expenses: 66.4x

LinkedIn (LNKD)
2013 P/E Excluding Stock Expense: 116.8x
2013 P/E Including All Expenses: 806.4x

Salesforce.com (CRM)
2013 P/E Excluding Stock Expense: 87.3x
2013 P/E Including All Expenses: NM*
Sources: Thomson Reuters; Bloomberg

For certain tech stocks (though not all, of course), the consensus estimates by some analysts are based upon the more optimistic numbers that ignore stock-based costs.
(I personally don't consider analyst estimates in my investment decision-making but, for those who might, the prevalence of this practice should be at least mildly interesting.)

Whether the above are great companies or not, their valuation can't be judged meaningfully when these costs are excluded.

It's worth mentioning (as the article does) that some other tech businesses**, including the likes of Microsoft (MSFT), Apple (AAPL), and Intel (INTC), all report and emphasize their GAAP results.

An approach that includes all costs.***

The article points out that this practice of ignoring stock-based compensation is really not found outside of tech and biotech.

Now, there are situations -- to be judged on a case-by-case basis -- where it makes sense to exclude certain noncash expenses. One example provided in the article is the amortization of intangibles. From the article:

It's easier to argue that those noncash expenses should be excluded from earnings—Warren Buffett advocates such an approach—but amortization of intangibles is relatively small compared with stock compensation.

One seemingly favorable trend is that some tech companies have moved away from compensating with the more difficult to value stock options to compensating with the easier to value stock-based compensation in the form of restricted stock.

For many reasons, this seems a very good thing but one has to at least attempt to estimate the stock-based costs whether it is difficult to value or not. More from the article:

"It's hard to argue that stock-based compensation isn't an expense," says Robert Willens, a New York–based tax expert. 

He also added:

"Because the medium of payment is stock doesn't make it less of an expense." 

The tech industry now advances various arguments for excluding restricted stock as an expense, with the chief being that the stock is "noncash." That's dubious since the stock clearly has value and is highly desired by employees for that reason.

For reasons that seem debatable at best, some tech investors and even analysts choose to exclude stock-based costs:

Tech investors and analysts essentially agree to exclude the stock expense and value companies accordingly. As one major tech investor told Barron's, "The sell side totally ignores the topic."

The article also points out:

- Companies will buy back stock to prevent increases to shares outstanding resulting from things like exercised employee options.

- The cost of those buybacks does not come out of free cash flow.

What's the net effect?

...a phony boost in free cash flow relative to the free cash flow of companies that pay their employees in cash. 

So, if the stock expense is generally ignored, guess what's likely to happen?

Well, it seems likely to encourage more use of stock-based compensation.

Those who choose to ignore stock-based compensation for certain companies but not others are essentially agreeing to compare economic apples to oranges. When a company has to buy back stock to just keep the share count from growing, those are funds that could be used for the direct benefit of shareholders in other ways.

So it's a real cost.

- That cash could be used for reducing share count instead of merely offsetting shares issued when stock options are exercised.

"Sometimes...companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This 'buy high, sell low' strategy is one many unfortunate investors have employed -- but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully." - From the 1999 Berkshire Hathaway (BRKa) Shareholder Letter

- That cash could be used for paying dividends.

- It could also be potentially put to many other high return uses.

Now, if a company needs to use stock to get the best employees it may be very wise to do so.

No problem.

Just count it as the real -- if sometimes difficult to estimate -- expense that it is.

It's worth pointing out that it's not as if the GAAP numbers are always a terrific indication of actual business economics.

Accounting is a very useful things but has its own severe limitations. Some of it likely at least somewhat fixable, while other aspects of its weaknesses may be more inherent. There are many ways that the accounting can also lead investors astray when it comes to valuing a business.

"...although accounting is the starting place, it's o­nly a crude approximation. And it's not very hard to understand its limitations. For example, everyone can see that you have to more or less just guess at the useful life of a jet airplane or anything like that. Just because you express the depreciation rate in neat numbers doesn't make it anything you really know." - Charlie Munger in a speech at USC Business School in 1994

Accounting numbers are, at best, a useful approximation of what is happening in a business. It's only a starting point when it comes to understanding long run economic prospects and intrinsic business value.

Still, in this case, it is a far better place to start than ignoring a whole -- and sometimes quite large -- category of a very real expense.

Some of these tech companies have impressive growth prospects. It's usually a good idea to at least be somewhat skeptical when that growth is accompanied by little in the way of earnings.

That's especially true when those "earnings" don't include very real expenses.

In the long run, growth can be a fine thing if it is achieved in a way that produces a high return on capital.

That may seem a given, but it is not. Growth comes in many forms ranging from extremely poor returns on capital to extraordinary returns on capital. Some assume it is always the latter.

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - From the 1992 Berkshire Hathaway Shareholder Letter

So, it isn't growth, in itself, that matters. Returns, over the long haul, mostly come down to return on capital and the price that was paid relative to intrinsic value.

That's what really matters.

A good investing result should never be dependent on an exceptional selling price.

Adam

Long positions in MSFT, AAPL, CSCO, EBAY and GOOG established at much lower than recent prices

* NM = Not meaningful. This is because including stock-based compensation the company would have a loss of 29 cents per share.
** It's worth mentioning -- as I have before on more than a few occasions -- that there's really no technology business I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries. That's precisely what makes them unattractive long-term investments. No matter how good business looks today, it's just not that easy to predict their economic prospects many years from now. With the best businesses that's not the case. For me, it's just too difficult to figure out what the economic moat of most tech stocks will look like in the long run. Occasionally, certain tech stocks have sold at enough of a discount to value that it made me willing to own some shares. In other words, their price was cheap enough that it provided a substantial margin of safety. Even then I'm only willing to accumulate very limited amounts. They will remain, at most, very small positions and are generally not long-term investments.
*** As do the analysts. It's hard to understand why someone would choose to ignore these costs for a business like Google but think it makes sense to include them for Apple. Even if there's a compelling explanation/justification it seems wise to be wary of it. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Apple's Debt Offering: Investor Enthusiasm for Bonds Continues

Earlier this week, Apple (AAPL) sold the largest corporate non-financial bond deal in history.

Apple sold, in total, $ 17 billion in new corporate debt.

It wasn't just historically large, the cost of the funds themselves were historically low.

The huge decline in Treasury interest rates -- a key driver of corporate debt -- has led to some incredibly cheap funding for companies. Some that don't, in many ways, even seem to really need it in an operational sense but, if your stock happens to be cheap (or you'd like to refinance some expensive debt), quite an opportunity.*

The 10-year Treasury currently has a yield of ~1.75%. This compares to a little over 15x earnings for stocks in the S&P 500 according to these estimates. Of course, expressed as an earnings yield (inverse price  to earnings) that would be ~ 6.6%.

A quick summary of Apple's debt deal:

3-year variable: $ 1 billion at .33%
5 year variable: $ 2 billion at .53%
---
3 year fixed: $ 1.5 billion at .511%
5 year fixed: $ 5.0 billion at 1.076%
10 year fixed: $ 5.5 billion at 2.415%
30-year fixed: $ 3.0 billion at 3.883%
Total: $ 17.0 billion at a 1.85% blended rate**

Forbes: Apple Bond Summary

Let's step back a bit. This Wall Street Journal article points out that, according to Lipper (a unit of Thomson Reuters), a record $55 billion flowed into bond mutual funds and investment-grade bond ETFs over the first 17 weeks of 2013.

So there's plenty of demand these days with investors buying especially the higher quality corporate bonds undeterred by the rather low yields.

Well, as a comparison, consider this article written back in February of 2000. It points out how willing investors were to invest in aggressive, high-risk equity funds at a time when stock were quite expensive and, as it turned out, near their peak.

"...investors are gravitating toward--not running away from--high-growth, high-risk sectors thus far in 2000."

So there was plenty of demand for stock funds especially the riskiest variety:

"...Janus, Fidelity, Vanguard and Invesco, reported extremely strong flows in January, a month that saw much market volatility. Much of the money is going into technology, telecom, biotechnology and/or growth funds, company officials say.

In December, 'aggressive-growth' funds attracted $11.5 billion in net new money, whereas more conservative "growth-and-income" funds saw net redemptions of nearly $6 billion.

'That's just unheard of,' said Carl Wittnebert, director of research for the Santa Rosa, Calif.-based research firm Trimtabs.com. 'The public has developed this wild appetite for risk.'

Meanwhile, investors have all but lost their appetite for bond funds, coming off a year in which rising interest rates hurt the principal value of many bond portfolios. Taxable bond funds saw outflows of $6.2 billion in December."

At that time, stocks were already expensive by any measure -- a number were selling at 30x, 40x, 50x earnings and much more -- and the 10-year Treasury was 6.6% (coincidentally, same as the S&P 500's earnings yield right now). So back then, it was pretty close (though not exactly) to the opposite of where we are today as far as valuations go. In the year 2000, investor enthusiasm for stocks was rather high and money was flowing into stock funds -- especially the riskiest variety -- when they were quite expensive.***
(Keep in mind that the riskier funds would likely have owned stocks selling for higher than average multiples of earnings -- if there was any earnings at all -- at that time.)

Now, the enthusiasm is for bonds and record levels of money is flowing into bond funds -- especially the seemingly safest variety. Instead of the "wild appetite for risk" that existed in 2000, many investors seem to have a "wild appetite for safety".

Or, at least, perceived safety. The problem is that safety might be mostly illusion.

I'm not suggesting stocks, in general, are cheap these days. To me, they are not generally cheap though there certainly are some not particularly expensive individual securities.

It's just that investors who are now pouring their money into bonds these days should be considering carefully whether today's yield really provides sufficient compensation considering the risks. Bonds may be perceived as generally safer than productive assets (i.e. businesses, partial ownership of businesses via marketable stocks, farms, real estate etc.) but the risk an investor is taking always comes down to the price one has to pay. I'm guessing how bonds have performed over the past several decades has only reinforced the perception of relative safety. I mean, yields going from where they were three or so decades ago to where they are now has been a tailwind to say the least. Who knows when that tailwind reverses in a meaningful way, but when it does it will not be pleasant. For bonds or currency-based investments more generally, I think Warren Buffett said it best in last year's letter:

"Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as "safe." In truth they are among the most dangerous of assets."

Buffett later added this:

"Right now bonds should come with a warning label."

What's sensible and low risk at one price is risky at another price. It is as Seth Klarman said in his 2010 annual letter:

"Risk is not inherent in an investment; it is always relative to the price paid."

The right time to buy or sell any asset is likely to rarely if ever obvious ahead of time.

The right price to pay for an asset may not be an easy thing to figure out but is, by comparison, at least doable with some work.

Those that try to get the timing and price right are making the job more difficult than it needs to be. When something becomes plainly expensive, avoid it. When something becomes plainly cheap, buy it. Do that consistently well and timing things right becomes far less relevant in the long run.

I'm not suggesting that the enthusiasm for bonds is the equivalent to the extreme enthusiasm for stocks in the late 1990s up until they peaked in 2000. Whether that's the case will likely only become broadly obvious at some point down the road.

Still, what does seem clear is that bonds provide little in the way of margin of safety these days and have lots of downside long-term bought near prevailing prices.

Some other items of note on the Apple bond offering:

- The bond offering was Apple's first in almost 20 years.

- According to Reuters, the offering brought in than $50 billion in orders. So lots of demand to say the least.

- The company was able to borrow at nearly triple-A rates but not quite. Apple's debt is rated AA-plus by Standard & Poor's.

- Microsoft (MSFT), with its AAA debt rating, sold 10-year bonds at a yield of 2.413% last week; almost the exact same rate as Apple with its slightly lower debt rating.

- Apple sold the three year floating-rate bonds at 0.05 percentage points over the 3-month London interbank offered rate (LIBOR).

- Apple sold the five year floating-rate bonds at 0.25 percentage points over the 3-month LIBOR.

This borrowing will help, in part, fund a plan to return $100 billion to shareholders (dividends plus $ 60 billion in buybacks) by the end of 2015.

Apple has tons of cash, of course. More than enough to fund a buyback and pay the dividends they have in mind. The problem has been that much of it is overseas and not accessible without incurring taxes (if the funds were brought back to the United States). Raising cash in the bond market helps the company avoid that tax bill.

The 1.85% blended rate is less than Apple's ~ 2.7% current dividend yield (and much less than the company's earnings yield, of course), so each share repurchased will eliminate more in dividend payments than the borrowing cost of the funds themselves.

Keep in mind that interest is tax deductible, while dividends are not. So, with interest being tax deductible, the 1.85% blended after-tax cost to Apple will naturally be even less.

In any case, at least near current prices, the company comes out explicitly ahead when a share is repurchased (and will continue to as long as after-tax interest expense < dividend yield).

In the long run, as always, what matters to continuing long-term shareholders is whether shares can be repurchased comfortably below Apple's per share intrinsic value. Well, at least for me, Apple's per share intrinsic value isn't that easy judge even though its economic performance has been quite impressive to say the least in recent years.
(It would be more easy to judge value if recent performance could be considered reliably indicative of Apple's future economic prospects. When financial results improve as rapidly as they have for Apple in recent years, it's not a bad idea to at least have some healthy skepticism about it being sustainable. Ben Graham makes this point in Chapter 12 of The Intelligent Investor. It's often better to use a multiple year average especially when there's been a recent earnings spike. That doesn't mean Apple won't still do just fine, but their recent exceptional margins on substantial revenue increases may have to continue normalizing -- as they already have been to an extent. Someone else might be more convinced that the recent performance should be considered more indicative of future prospects, of course, and, who knows, they may just be right.)

Apple clearly has many fine, difficult to replicate, business attributes (and what they have accomplished in a short time is rather astonishing) but that doesn't change the fact that it competes in fast changing markets against well-financed, capable competitors (not unlike, if not quite equal to, Apple itself) and sometimes against fresh competitors (who occasionally seem to come out of nowhere); it doesn't change the fact that it depends heavily on rapid innovation; it doesn't change the reality that not always easy to predict technology shifts do occur. Businesses with durable competitive advantages often have characteristics, and are dealing with industry dynamics, that are mostly just the opposite of this.

This poses real challenges for someone trying to narrow down intrinsic value -- or really what has to necessarily be a range of values. That doesn't mean Apple isn't a great company but the focus here is on investment outcomes. It just means, for the investor, that the estimated range of values seems almost certainly rather wide for a company like Apple.

So, the tough part -- at least compared to some alternatives -- is figuring out how Apple's competitive advantages might change over time and, as a result, what its core economics will look like many years down the road.

Judging what Apple is likely worth isn't impossible but there is definitely a wider range of outcomes. To me, that means an obvious and more substantial than average margin of safety must exist if it is to be bought at all. Some have the legitimate concern margins will inevitably decline meaningfully; that even the somewhat reduced margins compared to the recent peak are unsustainable. If they turn out to be correct -- and they just may be at least in part -- what now seems cheap may turn out to be quite a bit less so or worse.

Apple has no doubt created a great brand around products and services that have earned the trust and loyalty of its many customers. For that reason, it seems impossible to not admire Apple as a company. Yet, the reality is that Apple is a highly dependent on innovation business (their own innovation and that of others) even if the company has many rather impressive qualities. So, as far as the investment process goes, that makes long run economic prospects harder to gauge.

It will never be a favorite investment of mine but the brand strength combined with the earned trust and loyalty of it's customers -- if not violated -- is, undeniably, real and valuable.

Having said that, it won't surprise me at all if Apple's business does very well. It's just that, as a long-term investment (not a speculative trade), the company can't be put in the same category as those with more plain to see long-term durable advantages.

Businesses that possess competitive advantages that are likely to persist for many years (if not decades) generally have a far more narrow range of attractive long-term economic outcomes.

Margin of safety still matters for the businesses with durable advantages but -- at the very least -- just a bit less.

I have no idea whether the more optimistic or pessimistic views of Apple's future prospects will turn out to be correct.

All I know is it's better to not be reliant on a favorable outcome to justify the price that is paid.

Instead, better to pay a price that's low enough to provide an attractive investment result even if nothing great happens with the business itself (and even accounts for some of the worst business outcomes).

There'll be no complaints if the business does surprisingly well.

Not complex, but the difficulty can arise out of the necessity for inaction -- sometimes for extended periods of time with the risk being not owning something sensible, or owning too little of something sensible -- until the right margin of safety emerges; it can arise out of the necessity to wait until there is an opportunity to buy only what's understood well; it can arise out of not knowing when to act decisively; it can arise out of thinking you understand something better than you actually do. It is balancing things like this that becomes the challenge. If it were just down to the numbers and a compelling "story" the investment process would be a whole lot easier.

"A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success." - Charlie Munger in Kiplinger

It's the patience and discipline (to wait for the right price) followed by decisive action (when that price finally becomes available) and sticking to what you truly know well.
(Try to understand three hundred different businesses well, and the result will likely be understanding none of them well.)

It's less about brilliant insight, more about the right temperament and, of course, the ability to judge business economics well, and knowing what to pay for those economics.

This all depends on a realistic self-appraisal of individual limitations and strengths.

"A money manager with an IQ of 160 and thinks it's 180 will kill you," he said. "Going with a money manager with an IQ of 130 who thinks it's 125 could serve you well." - Charlie Munger in San Francisco Business Times

"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger's 1998 speech to the Foundation Financial Officers Group

Highly capable individuals with optimistic self-appraisals are more likely to get into trouble investing even if they happen to have all the other necessary characteristics and skills going for them.

It's knowing what you really know and avoiding the pitfalls of overconfidence.

Some will no doubt underestimate this.

Adam

Bloomberg: Apple Raises $ 17 billion in Record Corporate Bond Sale

Long positions in AAPL and MSFT established at much lower than recent prices

* These low cost funds should eventually lead to more acquisitions and maybe even some incremental investments (capital expenditures, new business ventures, etc.) once animal spirits return with greater force. Who knows when but, sooner or later, it generally comes back.
** With 3 month LIBOR at current levels for the variable portion.
*** It was not just tech stocks that were expensive, even if it was their valuations that were the most extreme. Coca-Cola (KO) and General Electric (GE) are just two examples of non-tech stocks that had extraordinarily high valuations.
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