So many articles have been written recently about Apple defending it or explaining why this glorious fruit will turn into a shriveling pumpkin by midnight (with Samsungs help) that I really havent felt the need to contribute to the unending debate. But then Apples stock crashed to $450 last month, and we bought a little for our clients. After receiving an outraged e-mail from one of them calling the purchase irresponsible and proclaiming that everyone (including his neighbor) knows that Apple is going down to $300, I decided it was time to join the discourse. Clients rarely (almost never) contact us about stocks we own in their accounts. More important, this is far from the most radioactive stock we own or have owned.
Here, in the first of two columns on Apple, I have no intention of defending or prosecuting the company, but I would like to share some thoughts about it that many pundits have either overlooked or ignored.
What makes Apple stock difficult to own is psychology. The companys success since 2000 is a black swan. We tend to think of Nassim Nicholas Talebs black swans as significant random negative events, but Apple is a positive one. When co-founder Steve Jobs came back to the company in the late 90s, Apple was about to take its last breath. Jobs pulled off a miracle. He revived the companys computer product line, making Macs exciting again, and then came out with three revolutionary i products in a row: the iPod, iPhone and iPad. You could argue that the success of each i product in itself was a black swan, exceeding all rational expectations and revolutionizing, transforming and in some cases creating new categories of merchandise that had never existed before.
Apples revenue and market capitalization deservedly surpassed those of almighty Microsoft Corp. the hairy monster with stinky breath that performed CPR on dying Apple in the late 90s by injecting liquidity into the company by buying its preferred stock. We have a hard time processing this highly improbable success and an even harder time imagining that there is another black swan about to take flight from the Apple labs, especially with no Steve Jobs around to sit on the egg.
Black swans come out of nowhere, unannounced, but their impact may be long-lasting. The wildly successful i gadgets dug a formidable moat around Apple. They created the most valuable and still most inspirational brand in the world, funded an enormous research and development effort, enabled huge buying power (Apple locks up supply and pays much lower prices than many of its competitors for parts), filled out a mature product ecosystem and stuffed Apples debt-free balance sheet with $137 billion half the market capitalization of Microsoft. The moat is wide, deep and unlikely to be breached any time soon.
One reason the psychology of owning Apple stock is so difficult: its high price. (Note: I am talking not about its valuation but purely about its price.) Apple has had only one stock split since the late 90s, when it was trading in double digits, and it now changes hands at about $450 (down from $700 just a few months ago). Stock splits create zero economic value in the long run absolutely none. Apple could split its stock ten to one and youd have ten $45 shares, and nothing about the company or its business would change. But Id argue that a 3 percent slide of $1.35 would grab fewer headlines than a $13.50 drop there is a media magnification factor that is hard to ignore.
Is Apple a hardware or a software company? This is a very important question because Apples net margins of 25 percent are dangerously higher than those of Microsoft, a software monopoly that, with the minor exception of the Xbox and its new venture into tablets, sells only software, which has a 100 percent incremental margin.
Apple is either a smart hardware company or a software maker dressed in hardware company clothes. Take a look at the PC businesses of traditional dumb hardware companies like Dell and Hewlett-Packard Co. (I am not insulting these companies, I am just highlighting their lack of PC-directed R&D.) They buy hard drives from Western Digital Corp., graphic cards from Nvidia Corp., processors from Intel Corp. and an operating system from Microsoft, then they have contract manufacturers put together these parts in Asia and ship PCs all over the world. Dell and HP engineers design the PCs but contribute minimal R&D to their boxes; most of the R&D is done by the suppliers. Dell and HP are really asset-lite marketing and logistics companies this explains their razor-thin margins. (Side note: Because of a lack of fixed costs, Dell and HP can remain profitable despite the ongoing decline in PC sales.)