Thesis and the Timeless Power of Value Investing
In turbulent times like these, we have continued to remind ourselves and our readers of the importance of discipline – the need to stick to a few timeless, well-understood principles. And the following table is one of our favorite charts showing the timeless power of value investing. This is a painting taken from that of Professor Robert Shiller Irrational exuberance.
It shows the relationship between PE and future returns. Specifically, the x-axis shows the true “PE 10 ratio” of the S&P Composite Stock Price Index (or the so-called CAPE). The PE 10 ratio is the inflation-adjusted price divided by the previous 10-year average of inflation-adjusted earnings). The y-axis shows the geometric mean real annual return (dividends reinvested) 20 years later. You can’t miss the strong correlation here. Shiller himself said his plot above:
“confirms that long-term investors – investors who invest their money for ten full years – did well when prices were low relative to earnings at the start of the ten years. Long-term investors would be well advised, individually, to reduce their exposure to the stock market when it is high, as has been the case recently, and enter the market when it is low.
Now back to the market and Apple (NASDAQ: AAPL). To be clear, despite significant corrections over the past few weeks, our current market, valued at a CAPE of around 31x at the time of this writing, is not cheap. Therefore, here we are not guessing whether the market has already bottomed or not, nor are we suggesting you bet on a rebound. The thesis of this article is to look beyond the “stock market” and show that AAPL is a quintessential example of value investing under current conditions. You will then see a simple Fama French dashboard for AAPL, and you will understand why the dashboard reveals a big disconnect between AAPL’s profitability and its valuation.
AAPL’s Fama French Dashboard
A little background on the French Fama 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 French Fama method involves a three-factor model and is considered a significant improvement over the CAPM method as it adjusts for the trend of outperformance.
Specifically, the raw data used in this article was extracted from the Dartmouth Tuck Business School database. We then analyzed the raw data using a simplified version of the French Fama method. We don’t like unnecessary complications and in this case we think the AAPL case is so strong that two simple charts as shown below will suffice.
Of the three factors in the method (or five factors extended later), the next two charts show two of AAPL’s factors (deal profitability and valuation) relative to the general market. Numerous market studies have tested the different factors of the Fama and French method, and past results have shown that these two factors have really held up in all time periods. Details of these factors are provided on the Dartmouth website. A brief summary is provided here for ease of reference:
- The OP factor (operational profitability). The operating profitability factor in period t is defined as annual revenue less cost of goods sold, interest expense, and selling, general and administrative expense divided by the sum of accounting equity and minority interest for the last fiscal year ending in 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 the AAPL’s score on those two factors below shows. AAPL is truly the best of breed in the stock market. The first chart shows AAPL’s OP factor against all other stocks in the market by percentile. As you can see, AAPL’s OP has truly been in its own category since 2018. Since then, it’s been in the top 10 percentile of the overall market by more than a factor of 2. Another metric we like use ourselves to measure profitability is return on capital employed (“ROCE”). And in this metric, Apple’s profitability is truly astronomical and literally off the charts.
The second chart shows AAPL’s PE factor against the broader market, again also as a percentile. This graph now shows a completely different picture. As you can see, AAPL’s PE hovered below 20 until 2018 and has always been below the overall market average PE. It has actually dipped in the bottom 25% percentile or even near the bottom 10% percentile of the total market from time to time. It’s no wonder, then, that Buffett bought Apple heavily during those years and enjoyed such spectacular returns thereafter.
As of this writing, you can see that Apple’s valuation is still quite reasonable. That’s a far cry from the market’s top 10 percentile, which is ridiculously low above 60 at the time of this writing, and we urge you to take a look at these stocks if some of they are part of your portfolio. Apple’s PE factor is actually close to the mid-market range (i.e. the 50 percentile line shown in green).
For us, such a disconnect between quality and valuation is too important to ignore, representing a classic example of value investing.
Looking ahead, we expect AAPL’s OP factor to grow further given the strength and resilience of its product lines and in particular its growing ecosystems, as detailed below.
The Broad Divide and the AAPL Ecosystem
In its most recent earnings report (second quarter of fiscal 2022 ended March 26, 2022), AAPL reported record quarterly revenue of $97.3 billion, up 9% year-over-year. This strong performance was driven by growth in all regions and in almost all product and service categories.
From a strategic point of view, Apple has succeeded in establishing an ecosystem made up of both its hardware and its services. Its hardware (iPhone, iPad, wearable devices like Apple Watch, etc.) seamlessly integrates with its software and services, as you can see in the following graph. The ecosystem is so successful and sticky that customers (and this author’s entire family can attest to this) find themselves “locked in” once they enter.
Going forward, the higher-margin services segment will be a bright spot well positioned for future growth. It is an excellent medium for long-term growth. As its active device base has grown to a staggering 1.8 billion units, services are becoming a natural next step. As CFO Luca Maestri commented (emphasis added by me)
“We are very pleased with our record business results for the March quarter as we established a all-time high revenue for Services and March quarter revenue records for iPhone, Mac and Wearables, Home and Accessories. Continued strong customer demand for our products has enabled us to reach an all-time high for our installed base of active devices. Our strong operating performance generated more than $28 billion in cash flow from operations and enabled us to return nearly $27 billion to our shareholders during the quarter. »
In total, services revenue rose 24% last quarter to $19.5 billion. Paid subscriptions across all platforms grew by 165 million to 785 million last year. Apple continues to expand its range of services. And I’m optimistic that 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 buy on the “equity market” and look for excellent companies with a reasonable valuation. Under current market conditions, our buys reveal AAPL as an attractive buy.
The profitability factor of AAPL’s operations even exceeds the top 10 percentiles of the overall market by more than 2x. Yet its valuation factor is still quite reasonable – in fact more than reasonable. It would be reasonable for it to trade among the 10 percentiles given its exceptional profitability (which is said to be over 60x). But the Apple PE factor is actually close to the mid-market range. The disconnect between quality and valuation is a classic example of value investing.
Finally, the risks. The company faces near-term uncertainties, including the potential impact of COVID-19 and the situation between Russia and Ukraine. Apple will not be immune to these unpredictable risks. Continued supply chain disruptions and silicon shortages could also negatively impact its operations in the near future. The ongoing shutdowns in several key cities in China such as Shanghai are also of concern. China is one of Apple’s main markets and Shanghai, in addition to being a key metropolitan hub, is also a major port city. Such blockages could create second-order complications to further aggravate ongoing supply chain disruptions and vessel shortages.