Apple of Wall Street's Eye

The stock market has been volatile over the last fifteen months. During that period, Apple, Inc. (AAPL) has stood out as one of Wall Street’s top stock picks. Of the 41 market analysts who follow the stock, 32 have a rating of buy or overweight. Only 2 of the 41 analysts have a sell rating. Experience proves that those ratings are heavily influenced by recent stock performance. With that being the case, it is not difficult to see why AAPL is so loved.

As seen in the chart above, AAPL has dramatically outperformed the S&P 500 over the last ten years with an average annual return of 25.57% vs the index return of 9.73%.  Can the good times keep on rolling?  Unfortunately, we don’t think so.  We believe this to be yet another example of past performance providing no guarantee of future returns.  We will examine three key factors that support our thesis. 

They are as follows:

1. Financial engineering during the 2010s created the illusion of strength when in reality the underlying operating performance was mediocre at best.
2. Apple was an enormous beneficiary of economic stimulus and work from home polices during COVID.  It is highly unlikely that Apple will be able to maintain the same level of performance seen in 2020 – 2021.
3. AAPL stock is currently viewed as one of the best places to take shelter from the economic storm.  While there may be some element of truth in that, when everyone is buying a particular stock for the same reason, the price will eventually grow to a level well beyond what company fundamentals can justify.   

We know that AAPL’s stock price dramatically outperformed the market over the last ten years, but was that performance justified?  Ultimately, stock prices will follow earnings.  If earnings go up, the stock price will follow.  If earnings go down, look out below!  At first glance, it appears that Apple produced strong earnings growth during the years leading up to 2020. 

The chart shows that earnings per share or EPS (blue line) grew almost 110% or 11% per year from 2013 to 2019.  EPS is the headline figure that gets all of the attention.  Unfortunately, for many investors, that’s where the analysis stops.  If we take a closer look, and focus on the operating income line from the income statement (orange line) we can see that the actual economic performance was not nearly as impressive.  Operating income grew 30.47% total or 3.87% per year from 2013-2019.  Earnings growth of 3.8% was barely keeping pace with inflation during those years.  That level of operating performance does not seem to justify a 21% average annual stock return.

How did Apple create the illusion of much stronger performance during this period?  Well, they did what many large companies did during the 2010s.  They took advantage of the Federal Reserve’s artificially low interest rates by issuing bonds and buying back their shares.

This chart shows the change in Apple’s outstanding debt and total number of shares available to the public during the same period (2013 – 2019).  The debt level went from $0 to over $100 billion while the shares outstanding fell by almost 9 billion or 30%.  Some would argue that the strategy of buying back shares is good financial management.  We would agree as long as the company was paying a reasonable price to buy back those shares.  The bigger issue is that this policy, which sustained earnings growth for much of the past decade, is not likely to be a viable option going forward as the cost of borrowing has gone up dramatically. 

The second factor that we believe investors must take into account is the fact that Apple was a major beneficiary of the economic stimulus programs in 2020 and 2021 and the dramatic shift in work from home. 

This chart shows the year-over-year change in Apple’s quarterly sales from 2016 through December 2022.  The average sales growth over that period was 8.17%, however, there was an enormous spike of 53% in March 2021.  That blowout quarter in March of 2021 just happens to lineup with a period when American consumers were receiving the largest installments of stimulus payments.  Coincidence?  We don’t think so.  A company the size of Apple, valued at over $2.5 TRILLION, doesn’t grow sales over 50% in a quarter.  It just doesn’t happen.  We believe that not only will the company not be able to maintain strong sales growth from these levels, but sales are likely to decline sharply at some point as economic headwinds pick up.  Wall Street analysts disagree with our viewpoint.  The consensus estimate for fiscal 2023 EPS is currently $5.93.  Prior to 2020 (Dec 2019), the same analysts forecasted that Apple would earn $3.50 in fiscal 2023.  The message from analysts is that there was no pull forward of sales during the 2020-2021, and that the explosive growth that was witnessed during those years is the new baseline that the company will grow from going forward.

The last factor to consider is the fact that Apple’s stock price has held up very well during the last fifteen months of market volatility.  We last presented our bearish analysis of AAPL in a newsletter that was

sent on January 10, 2022.  Since that time, AAPL is down ~ 8.5%.  However, the stock market is down over 15%, and therefore on a relative basis, AAPL has continued to outperform.  We led off our January 2022 newsletter with the following quote from Ben Graham.  “The danger of paying the wrong price is almost as great as that of buying the wrong issue.”  From the banking crisis to geopolitical concerns, there are plenty of headlines for investors to be concerned about.  We believe that many investors are seeking shelter from the storm in large, dominant companies like AAPL.  As Professor Graham stated many years ago, we believe companies, like Apple, that are viewed as a safe haven, present significant downside investment risk.  For example, AAPL is currently selling at a P/E multiple of 25.43x.  The 15-year average multiple for AAPL is 17.26.  That means that Apple is selling at a 47% premium today compared to the average price over the last fifteen years.  A premium valuation may be justified if the company can somehow manufacture blowout quarters like what we saw in 2020 – 2021.  The price would not be justified, however, if they go back to growing operating earnings at a modest 3.5%, and it certainly wouldn’t be justified if we see sales come back to Earth for the elevated levels of recent years.  

Apple is only one of the 507 companies in the S&P 500 index, yet it makes up over 7% of the index’s weighting given the massive market capitalization.  History does not look favorably upon companies that grow to such an oversized position.  Examples of fallen giants from past decades would include IBM, Cisco, General Electric and Exxon Mobil.  All four of those companies are still around and remain important in their respective industries.  However, any investor who bought those stocks at the peak experienced very disappointing returns in the decade that followed.  Will Apple suffer the same fate?  We can’t be sure, but we would advise investors to be careful of a stock that everybody “knows” is a safe bet.  Those stocks may look good on the outside but be rotten at the core.

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