The Lato Letter: Volume 2, Issue 4.

The Lato Letter: Volume 2, Issue 4.

The last Lato Letter was exactly one month ago today and since that time, US markets have hit all-time highs and the Padlock composite portfolios have advanced at an even better clip.

The last time I wrote about Apple in The Lato Letter was the morning before their 1st Quarter earnings release on January 23rd. Although Apple exceeded the analysts’ consensus estimates that day, the stock fell 12.3% the next day, has been down 18 out of the next 27 trading days and at one point was down over 40% from its September 2012 high and all of this in a strong market. As mentioned, fortunately for the clients of Padlock, in spite of the decline in Apple, their portfolios have more than weathered the storm and exceeded their benchmarks as the other holdings have more than carried their weight so far this year.

In my 32 years of advising investors, there have been few times where happenings in the market have been as perplexing as the price movement in Apple in the last six months. In my thinking, the mind boggling period in late 1999 and early 2000 when technology and Internet stocks traded at ridiculous price/earnings multiples for months was equally perplexing. That period was dubbed “irrational exuberance” and although I would like to take credit for the phrase, I read an article on the weekend calling the trading in Apple shares “irrational pessimism”.

The press is filled with articles justifying the decline and in many cases concluding that it was inevitable. The reasons cited include:

1) Apple’s iPhone has lost market share to Android phones
2) Apple is not the cool brand any longer
3) Apple’s margins are shrinking and will continue to shrink
4) Apple is no longer able to sell their products at premium prices
5) Apple has not introduced a revolutionary new product since Steve Jobs died
6) Apple is simply the latest technology wonder stock to be surpassed by the competition
7) Apple is hoarding cash and has become extremely “shareholder unfriendly”

Some of these reasons do have merit and bear being mindful of but all in all the many, many positive attributes of this company are being totally ignored and the valuation of the stock has become completely divorced from any of these positive attributes. Consensus estimates for the year ending September 30, 2013 are still $44.53 per share which at yesterday’s closing price ($431.14) gives Apple a price/earnings multiple of 9.7 times. The company last reported $145 per share in cash which now represents over one third of its market value and since we are now nearing the end of the quarter that number is likely higher than it is today. Those are the stock fundamentals but as I mentioned, they are completely divorced from the economic value of the company just as the 80, 90, 100 times multiples of the Internet stocks in 1999 and 2000 were divorced from their economic reality.

In addressing the reasons listed above to perhaps try to justify the decline, yes the iPhone has lost market share and some of the “cool factor” to Android but it continues to be a dominant player in the industry and the continuation of the improvements in each generation should allow the company to remain a dominant player. Unlike when the iPhone was introduced and truly revolutionized the smartphone industry, competitors have risen to the challenge but have hardly revolutionized the smartphone thus ensuring that Apple will continue to be a major factor as it continues to improve the functionality and distribution of the iPhone.

Margins have come down but those reduced margins are partly a function of the simultaneous introduction of several new products (iPhone 5, iPad Mini, new MacBooks) in a compressed time frame and should start to see signs of improvement as the products mature. Prices have come down in a sense as the iPad Mini is lower priced and has taken down the average selling price of the iPad down but at the same time, has expanded Apple’s reach into a broader area of the tablet market.

Steve Jobs was truly a genius and was responsible for a significant part of Apple’s success but the fact that no new “revolutionary” products have been released since his passing 17 months ago is a bit of a red herring. The time frame between the release of the iPod and the next revolutionary product, the iPhone and then the time frame to the next, the iPad, were both significantly longer than 17 months. Apple’s research and development exenditures have increased dramatically over the last two years and it is the same group of brilliant engineers, including Jony Ive, still doing that research with a much bigger budget. I cannot predict when or if the next new revolutionary product will emerge but I also cannot say that it will never happen again.

As mentioned above, Tim Cook, Apple’s CEO, has been criticized for hoarding cash and being shareholder unfriendly. I cannot disagree with those sentiments but I also agree that his main function and the company’s main focus is to make the best products in the world that consumers want and continue to buy in very large quantities. The company is focused on doing this as evidenced by the following quote; “The only thing we’ll never do is make a crappy product,” he said at the Goldman Sachs Technology conference last month. “That’s the only religion that we have. We must do something bold, something ambitious, something great for the customers, and we sweat all of the details.”

If the company is successful in doing that and there continues to be few reasons to doubt that, whether Tim Cook distributes the cash in some way and the stock goes up in the short term, does not alter the fact that the company will continue to create even more long term value if it is successful in meeting its main goal of creating the world’s best products.

Clearly there must be a catalyst to turn this tide of pessimism around and there are a few possibilities including a dividend increase, a stock buy-back, new product releases in the phone or tablet market, a revolutionary new product such as the iWatch or simply a decent earnings report in mid-April that allays the fears of investors.

Looking back to that time in the late nineties, it was extremely difficult to stay true to the beliefs of investing in good companies at reasonable valuations while in many cases bad companies at ridiculously high valuations were soaring. We all know how that turned out for the Internet stocks starting in March of 2000 as those old boring companies that my clients were holding then led them to very solid returns in a declining market that year. March seems to be a month of severe change for irrational markets. We saw it in 2000, we saw it in 2009 and maybe in the case of Apple we will see it again in March 2013 with the change from the “irrational exuberance” of the Internet stocks in 2000 foreshadowing the change from the “irrational pessimism” in Apple.

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change without notice.

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