Thesis and the timeless power of value investing
In turbulent times like this, we kept reminding ourselves and our readers about the importance of discipline – the need to stick to a few timeless and well-understood principles. And the following chart is one of our favorite charts showing the timeless power of value investing. It’s a chart taken from Professor Robert Shiller’s Irrational Exuberance.
It shows the relationship of PE to future returns. More specifically, the x-axis shows the real “PE 10 ratio” of the S&P Composite Stock Price Index (or the so-called CAPE). The PE 10 ratio is inflation-adjusted price divided by the prior 10-year mean of inflation-adjusted earnings). The y-axis shows the geometric average real annual return (with dividends reinvested) 20 years later. You cannot miss the strong correlation here. Shiller himself stated that his plot above:
“confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low.”
Now back to the market and Apple (NASDAQ:AAPL). To be clear, despite large corrections in the past few weeks, our current market, valued at a CAPE around 31x as of this writing, is not cheap. Hence, here we’re not guessing if the market has bottomed yet or not or suggesting you bet on a rebound. The thesis of this article is to look past the “stock market” and show that AAPL is a quintessential example of value investing under current conditions. You will see a simple Fama French scorecard for AAPL next, and see why the scorecard reveals a large disconnection between AAPL’s profitability and its valuation.
AAPL’s Fama French scorecard
A bit of background of the Fama French method first. The method is named after Eugene Fama and Ken French (and in 2013, Eugene Fama shared the Nobel Prize in economics with Lars Peter Hansen and Robert Shiller for their empirical analysis of asset prices). The Fama French method involves a three-factor model and is considered a significant improvement over the CAPM method because it adjusted for outperformance tendency.
Specifically, the raw data used in this article were pulled from the Dartmouth Tuck Business School database. We then analyzed the raw data using a simplified version of the Fama French method. We do not like unnecessary complications and in this case, we think the case for AAPL is so strong that two simple charts, as shown below, will suffice.
Out of the three factors in the method (or five factors as extended later), the following two charts show two of AAPL’s factors (operation profitability and valuation) compared to the general market. Many market researchers have tested the various factors in the Fama and French method, and past results have shown that these two factors have truly held up over all time periods. Details of these factors are provided on the Dartmouth website. A brief recap is provided here for the ease of reference:
- The OP factor (Operating Profitability). The operating profitability factor in period t is defined as the annual revenues minus cost of goods sold, interest expense, and selling, general, and administrative expense divided by the sum of book equity and minority interest for the last fiscal year ending in time period t-1.
- The PE factor (the Price/Earnings ratio). The PE factor is based on total earnings before extraordinary items, from Compustat.
Now, as seen from AAPL’s score on these two factors below. AAPL is truly the best of breed in the market of stocks. The first chart shows the OP factor of AAPL compared against all the other stocks in the market by percentile. As you can see, AAPL’s OP has been truly in its own category since 2018. It has been exceedingly top 10 percentile of the overall market by more than a factor of 2x since then. Another metric that we love to use ourselves to measure profitability is the return on capital employed (“ROCE”). And in this metric, Apple’s profitability is truly astronomical and off the chart literally.
The second chart shows AAPL’s PE factor compared to the overall market, again also in percentile. This chart now shows a completely different picture. As you can see, AAPL’s PE has been hovering below 20 up to 2018 and has been consistently below the medium PE of the overall market. It has actually dipped to the bottom 25% percentile or even close to the bottom 10% percentile of the total market from time to time. Thus there’s no wonder why Buffett bought into Apple heavily during those years and enjoyed such spectacular returns afterward.
As of this writing, you can see that the valuation of Apple is still quite reasonable. It’s a far cry from the top 10 percentile of the market, which is at a ridiculous level above 60 as of this writing, and we highly urge you to take a look at these stocks if some of them are in your portfolio. Apple’s PE factor is actually close to the medium range of the market (i.e., the 50 percentile line shown in green).
To us, such disconnection between quality and valuation is too large to ignore, representing a textbook example of value investing.
Looking ahead, we see AAPL’s OP factor to further expand given the strength and resilience in its product lineups and especially its growing ecosystems, as detailed next.
AAPL’s wide moat and ecosystem
In its most recent earnings report (FY 2022 second quarter ended March 26, 2022), AAPL reported a quarterly revenue record of $97.3 billion, up 9 percent YOY. The strong performance was driven by growth across all regions and in nearly every product and service category.
Looking from a strategic point of view, Apple has successfully established an ecosystem consisting of both its hardware and services. Its hardware (iPhone, iPad, wearables such as Apple Watch, et al) integrate with its software and services seamlessly as you can see from the next chart. The ecosystem is so successful and sticky that customers (and this author’s entire family can testify) find themselves “locked in” once entered.
Going forward, the higher-margin Services segment will be a bright spot well-positioned for future growth. It’s an excellent long-term growth driver. As its base of active devices reached a staggering 1.8 billion units, services become a natural next step. As CFO Luca Maestri commented (the emphases were added by me)
“We are very pleased with our record business results for the March quarter, as we set an all-time revenue record for Services and March quarter revenue records for iPhone, Mac, and Wearables, Home and Accessories. Continued strong customer demand for our products helped us achieve an all-time high for our installed base of active devices. Our strong operating performance generated over $28 billion in operating cash flow, and allowed us to return nearly $27 billion to our shareholders during the quarter.”
All told, services revenues were up 24% in the last quarter to $19.5 billion. Paid subscriptions across all platforms climbed by 165 million to 785 million in the last year. Apple continues expanding its range of services. And I’m optimistic that the demand for its cloud, music, video, advertising, and payment services will continue to show robust growth.
Final thoughts and risks
We never invest in the “stock market.” We feel much more comfortable investing in stocks. We shop in the “market of stocks” and look for excellent businesses with a reasonable valuation. Under the current market conditions, our shopping reveals AAPL as an attractive buy.
AAPL’s operation profitability factor exceeds even the top 10 percentile of the overall market by more than 2x. Yet its valuation factor is still quite reasonable – actually more than reasonable. It would be reasonable if it trades among the 10 percentile given its off-the-chart profitability (which would be above 60x). But the Apple PE factor is actually close to the medium range of the market. The disconnecting between quality and valuation is a textbook example of value investing.
Finally, risks. The company faces some short-term uncertainties including the potential impact of COVID-19 and the Russian/Ukraine situation. Apple will not be immune to these unpredictable risks. The ongoing supply chain interruptions and silicon shortages could negatively impact its operations in the near future too. The ongoing lockdowns in several of China’s key cities such as Shanghai also are a concern. China is one of Apple’s major markets, and Shanghai, besides being a key metropolitan hub, also is a major port city. Such lockdowns could create second-order complications to further exacerbate the ongoing supply chain interruptions and ship shortages.