Financial Alchemy: David Einhorn’s “value” play for Apple

If you are an Apple stockholder, yesterday was an eventful day. First, you had David Einhorn becoming more “activist” with his Apple holdings, moving from being just bullish on the stock to pushing for change. Second, Einhorn also unveiled his plan for Apple: the company should give its stockholders preferred shares in the company, with a 4% dividend yield. In pushing for the change, he is quoted as saying that doing so will “unlock billions of dollars in value".

There will be NO value created.. none.. 
Before I look at the trade off on and the alternatives to the preferred stock issue, let me dispense with the one part of his claim that cannot hold. Issuing preferred stock will not add value to the company, not one cent. Before I get accused of being a “theorist” or “academic” (which I now know are code words for much worse insults), let me explain my rationale:

1. The first law of thermodynamics, applied to value: You cannot create value out of nothing and giving preferred stock to your common stockholders is a “nothing” act, as far as the value of the company is concerned. It will not increase the cash flows from operations nor will it alter the risk in Apple’s business. 
2. The cost of capital will not change: This action will not change the cost of capital. At first sight, it looks like it should since the cost of preferred stock, at 4% (assuming that it trades at par) is much lower than Apple’s current cost of equity (which I estimated at 12% or higher). However, that savings is a mirage, since common stockholders will now have to price in the risk of the additional commitment that has to be met (the preferred dividend) into the cost of equity. If this were not true, every company with a healthy cash flow (Coca Cola, Microsoft, Google) could become a money machine, granting preferred stock to its common stockholders. 
3. The constant PE ratio is a myth: The most cringe worthy argument that I read yesterday was the one that went as follows: Apple currently trades at a PE of approximately 10.2, $450/share on earnings per share of $44. If you grant each common stockholder a $100 preferred stock, with a dividend of $4, your earnings per share will drop to about $40, and preserving the same multiple will generate a value per share of $400. Add that on to your preferred stock that is worth $100 and you have valuation magic: you have created $50 in value. This is the worst kind of nonsense, since it is nonsense with a believable twist to it, and that is why it has been investment conman’s favorite tool over history. The PE ratio is not a constant, and it will change as you change the nature of your equity risk or cash flows, as you are in this case. 

Bottom line: If Apple’s share were trading at fair value today (let’s say, at $450/share) and each Apple shareholder were granted a preferred share, with a preferred dividend of 4% and face value of $100, here is what the shareholders will end up holding tomorrow: a common stock with a value of $350 and a preferred share with a value of $100.

But the price MAY be affected
While I would contest Mr. Einhorn's claims of "value creation", let me take a more charitable view of what he is trying to do. Perhaps, he is trying to unlock the “price’, rather than the value, a distinction that may make more sense if you read my post on value versus price from yesterday. To make this "unlocking price" argument, you have to not only assume that the stock is under valued (which I would support) but that the under valuation is occurring for a very specific reason. It is not because investors are misjudging the value of Apple’s operations but because they are not giving Apple credit for either its huge cash balance ($130 billion +) or its capacity to generate huge cash flows ($30-$40 billion/year), for one of two causes:

1. There could a trust discount attached to the cash balance, because investors are worried that Apple might be tempted to do something stupid with the cash, and with this much cash, there is only one action that can do you significant damage and that is overpaying on a really large acquisition. 
2. Investors may fear that while the cash builds up in Apple, they may never see the cash, because managers are so attached to it that they will not let go or because it is trapped and therefore unavailable for user, due to tax reasons. 

If investors are discounting cash for one or both of these reasons, the preferred stock may serve to increase the price because it commits Apple to returning the cash (in the form of preferred dividends) in perpetuity. Presumably, “relieved” investors will now breathe a sigh of relief and remove the discount on cash, causing the stock price to go up. The upside is limited to the discount on the cash. Even if cash is being treated as worth nothing today (which would be a 100% discount), that would translate into $140/share.

Even if we accept this argument, though, it is not clear that granting preferred stock to common stockholders is the optimal way to create this commitment. In fact, there are three alternate routes that the company can go:

1.  Increase common dividends: The simplest and least involved alternative is to increase the common dividends per share from the existing level of $10.60 per share to a higher value. In fact, if you are looking at granting a $100 preferred stock with a 4% dividend to each common stockholder, you could create an almost equivalent commitment by just raising dividends per share by $4/share. I know that the commitment is a little weaker, since common dividends are not guaranteed, but given how sticky common dividends are (healthy companies very seldom cut common dividends), but not by much. In fact, since investors tend to build in expectations of growth into common dividends that will not get built into a perpetual preferred share, the net commitment effect may actually be neutral. 
2. Buy back stock or pay a special dividend: If investors distrust you with cash or are discounting it, the best response is to return in right now, rather than commit to return it to the future. The problem for Apple, though, is that a big chunk of the cash cannot be touched unless Apple decides to pay the “differential tax” (between the foreign tax rate and the US tax rate) on the trapped cash (estimated to be $80 billion+ of the cash balance). With Apple’s cash balance, though, you could still put together a substantial buyback ($40 billion) and commit to more buybacks in the future. 
3. Issue bonds: Instead of giving common stockholders shares of preferred stock, you could give them Apple bonds instead. The advantage of doing so is that you could now potentially have a value impact, not because your operations have magically become more valuable but because the government in its wisdom allows you to subtract interest expenses for tax purposes. Thus, if you were able to give each common stockholder an Apple bond with a face value of $100 and an interest rate of 3% (unlike the preferred stock, you cannot arbitrarily set interest rates at any level you want, since the tax authorities will object), the potential value of the tax benefit per share , using a marginal tax rate of 40% and a cost of capital of 12%, can be computed as follows:

• Interest tax savings each year = $3 (.40) = $1.20 
• Present value of these savings in perpetuity = $1.20/.12 = $10/share 
• The commitment to make interest payments is far stronger than the commitment to pay preferred dividends, since the consequence of failing to make interest payments is default. That is why there is a limit to how many bonds you can issue, before the trade off starts to work against you. 

Faced with these four choices: the Einhorn preferred stock grant, an increase in common dividends, a stock buyback/special dividend and bond issuance, there is one final consideration to keep in mind. The common stockholders in Apple have to think about the consequences of each of these for their personal taxes. With the common dividends and buybacks, we are on familiar ground and the effect on taxes is straightforward. Dividends will be taxed at the 20% dividend tax rate for most individual investors, as will the capital gains that arise from a buyback and are close to equivalent (though there is a tax timing option embedded that gives the latter a slight advantage). With the granting of preferred stock or bonds to existing stockholders, there is an added tax twist to consider. The preferred dividends will get taxed at 20% whereas interest income from bonds is taxed at the ordinary tax rate (higher than 20% for most investors), giving preferred dividends an advantage over bonds (but not over common dividends/buybacks). In addition, from my limited understanding of tax law, the grant of bonds will be treated as income at the time of the grant whereas the grant of preferred stock will not. (Thus, the Apple stockholder who receives a $100 Apple bond will be treated as having income of $100 in the year of the grant, whereas the receipt of $100 in preferred stock will just reallocate the basis for the Apple stockholding). 

Bottom line: If the objective behind the preferred stock is to remove the “trust” or the “trapped” discount on cash, why create a complicated mechanism, when a simple one will do? Just raise common dividends, if you do not want to open the door to debt at the moment, but leave that door ajar for the future.

Preferred Stock: The Big Picture
Contrary to many reports that I read yesterday, preferred stock is neither widely used nor is it favored by mature, non-financial service companies and for good reason. It brings many of the disadvantages of debt into a company (the fixed commitment, albeit with lesser consequences for failure to pay) without the tax benefit. In fact, there are three big users of preferred stock and Apple does not fit into any of the three categories:

1. Control freaks: The use of preferred stock is widespread in some parts of the world, such as Latin America, but it takes both a different form (from US preferred) and often has a different motive. In much of Latin America, preferred stock does not entitle you to a fixed absolute dividend but instead gives you a first claim on the dividends and a percentage of the profits. Thus, these preferred shares are really common stock without voting rights. They are used by companies, where insiders hold the voting shares and have no desire to be accountable to the capital markets. 
2. Young and start-up firms: Young firms often use preferred stock to raise capital because they want to raise capital, without diluting the existing owners’ stakes in the companies. For these companies, the tax benefits of debt are irrelevant in the decision process, since they are often money losers, and the risk of default is too high. To sweeten the pot for investors, they will often add the option to convert into equity to the preferred stock (creating convertible preferred shares). 
3. Financial service firms: Financial service firms use preferred stock because some measures of regulatory capital allow them to count preferred stock as part of capital. Thus, while they view preferred stock as expensive debt (since it does not have the tax advantages), it does serve the purpose of augmenting regulatory capital. 

Studies of both US and European companies suggest that when CFOs are asked about their preferences on raising funds, there is a financing hierarchy. Topping the list as most favored is straight” debt and at the very bottom of the list is preferred and convertible preferred. For non-financial service firms, the issuance of preferred is more a sign of desperation than it is of health. No matter what you think about Apple’s prospect, I don’t think you would view them as being desperate for new capital right now.

Generalizations
If David Einhorn’s idea is a non-starter when it comes to value creation and not particularly effective even as a price catalyst, he is not alone in his sales pitch. In fact, what he is doing is widespread among companies, consultants and banks and I would propose three changes in the way restructuring plans/ proposals are presented to investors and public.

1. Stop using price and value as interchangeable terms: Much of what passes for value creation in many companies is not what it is made out to be. I have seen the hue and cry around stock splits, issuing tracking stock and accounting restatements of assets on balance sheets and wondered why we make such a big deal about these actions. All of these tend to be purely cosmetic and have no effect on value. However, they could impact stock prices, if there is a gap between value and price. So, let’s require truth in advertising. 
2. When you talk about value enhancement or creation, be specific: If an investor, company or consultant claims that an action will enhance value, the onus has to be on the claimant to explain where the value increase is coming from. Simply put, it has to come from increasing cash flows in existing assets, reducing the risk in these cash flows, improving the tax benefit/default risk trade off or from growing more efficiently (improving competitive advantages). That is a broad canvas and every true value enhancing action has to wend its way through one of these paths. 
3. If you are talking about price enhancement, say so: If you believe that taking an action will increase your price (and has nothing to do with value), don’t claim otherwise. Here again, be specific about what market mistake or friction you are exploiting. If at the limit, your argument is that the price will go up because investors are naive or stupid (which is the basis for the constant PE argument), you might as well say so. 

In closing, I am glad, as an Apple stockholder, that David Einhorn is rocking the boat, even if I think his proposal is the not the most effective catalyst or game changer. It opens the door to a healthy discussion about how Apple should deal with its large and growing cash balance, and that is a good thing for all concerned.

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Back to Apple: Thoughts on value, price and the confidence gap

I know that you are probably sick and tired of reading about Apple, and I am getting close to that point too, but this post is really more about investing than it is about Apple. In my post on Apple on January 27, I also posted "my" distribution of value for Apple, concluding that there was a 90% chance that Apple was under valued. One of the responses I got was interesting and it questioned the courage of my convictions by asking why, if I believed that there was a 90% chance that the stock was under valued, I would not "bet the house" (I put a 10% cap on Apple in my portfolio). That, of course, gives me a platform to return to a theme that I have harped on for much of the last year: that valuation and pricing are two very different processes and that many analysts/investors often being confident about one does not imply confidence about the other.

To set the table for the comparison, let me start with my assessment of the differences between the valuation and pricing processes.

• The value of a business is determined by the magnitude of its cash flows, the risk/uncertainty of these cash flows and the expected level & efficiency of the growth that the business will deliver. While discounted cash flow valuation may be one way of estimating this value, there are other intrinsic value approaches that also try to do the same thing: estimate the intrinsic or fair value of a business. 
• The price of a publicly traded asset (stock) is set by demand and supply, and while the value of the business may be one input into the process, it is one of many forces and it may not even be the dominant force. The push and pull of the market (momentums, fads and other pricing forces) and liquidity (or the lack thereof) can cause prices to have a dynamic entirely their own, which can lead to the market price being different from value. 

Last year, in the aftermath of the Facebook IPO, I posted on the difference between pricing and valuation and my view that much of what passed for valuation in Facebook (in the IPO pricing by the investment banks and by investors in the aftermath) was really pricing. In fact, I think that this picture illustrates my point:

So, let us assume that you value a company (using whatever your favored valuation tool) is and come to the conclusion that there is a gap between the value and the price. Before you act on this value, you have to answer three questions:

1. How confident are you about the magnitude of the gap? Since you know the market price, this is entirely a question about the confidence you have in your valuation.
2. How confident are you that the gap will close? This, unfortunately, is generally not in your control and will be driven by the pricing process.
3. What are the catalysts that can cause the gap to close? If the gap is to close, the price has to move towards your value and you need "something" to get it started.

In sum, whether you invest will depend upon the answers to all three questions. You could, therefore, find a big gap between value and price, feel confident about your estimate of value and not invest in the stock, if you don't feel comfortable with the forces that are driving the market price or hopeful about catalysts in the near future. Let me apply this structure to Apple to reconcile my assessment that there is a 90% chance that Apple is under valued at $440/share and my decision to cap my holding of Apple at 10% of my portfolio.

The Magnitude of the Gap
I started with a discounted cash flow valuation of Apple at the end of 2012, which yielded $608/share. With the stock trading at $440, that gives me an estimated gap of $168, impressive but meaningless without a measure of confidence about the magnitude of the gap. To arrive at this confidence measure, I used Crystal Ball (an add-on to Excel that allows you to do Monte Carlo simulations) and revalued Apple, with distributions, rather than single values, for three key inputs: revenue growth rate in the near term, target operating margin and a cost of capital. The results of 100,000 simulations (that is the default in Crystal Ball) yielded the distribution for values for Apple:

APPLE SIMULATION RESULTS: END OF 2012

All that I did to arrive at the 90% estimate that Apple was under valued was count the number of simulations that delivered values less than $440; in reality, it was closer to 94% but I rounded down to 90%.  Note that to end up at values less than $440, the distributions for the key variables all had to be close to the "bad" ends of their distributions. Thus, for Apple to be worth only $440 (or less), you would need negative or close to zero revenue growth, pre-tax operating margins of 25% (current margin is closer to 35%, down from 40% plus a year ago) and the cost of capital would have to be at 15% (the 97th percentile of US stocks).

The Closing of the Gap
Now, comes the trickier question. Will the gap close and if so, when? There are three factors to consider in making this judgment:
(a) Information: Are you using information in your valuation that the market does not have yet? I know that this would be dangerously close to insider trading in the US, but it is possible that in some markets, you have to access to proprietary information. The gap will close when then information is revealed. With Apple, I used the company's filing with the SEC, and there is no private information in the valuation. I have exactly the same information as everyone else in the market does.
(b) Liquidity: Are there market trading restriction or liquidity barriers that are preventing the price from adjusting to value? If you have a lightly traded stock, with minimal float, it is possible that the price may stay different from value, until trading picks up. If the stock is over valued (price > value), there may be restrictions on short selling that prevent the price from adjusting to value. With Apple, given its market cap and liquidity, I don't see this as a a problem.
(c) Behavioral forces: What are the pricing forces in the market and which direction are they pushing the gap? As I noted at the start, prices are subject to the push and pull of momentum, to institutional investors flocking into a stock and then abandoning it and to equity research analysts blowing hot and cold about its next earnings report. With Apple, these forces, for the last year and a half, have been powerful and unpredictable, pushing the price up to $705 a few months ago and down to $440 now. Part of the unpredictability comes from the mix of growth, value and momentum investors who drive the price and part of it comes from the rumor/news ecosystem that the market has developed to fill in the news vacuum created by Apple's secrecy about its future plans. As a consequence, the price/value gap could stay where it is or even get larger in the near term, but the odds of the gap closing do improve as you extend your time horizon. For instance, here are my very rough estimates (based on what I know about momentum and price movements in stocks over short and long periods) of what I see happening to the gap, as a function of time horizon:

Over the next month, there is a higher chance that the gap will increase rather than decrease, but as the horizon extends, the likelihood of the gap increasing drops. But here is the bad news for intrinsic value investors. Even with a 10 year time horizon, and assuming that you are right about value, there is still a non-trivial chance that the gap will get bigger. Hence, there is good basis for the old Wall Street adage: that the market can stay irrational longer than you can stay solvent.

The Catalyst
If there is a gap between price and value and that pricing gap persist, it is no surprise that investors start looking for catalysts that can cause the gap to close. Not surprisingly, there is no easy model to follow, but here are some choices:
a. Be your own change agent: As investors, it would be nice if we could tilt the game in our favor by having some influence over the gap. While you and I may not be able to do much to alter market dynamics, this is a place where activist investors with enough money and access to megaphones can make their presence felt. And the good news for the rest of us is that we can sometimes piggyback on their success. As Apple investors watch Nelson Peltz tussle with Danone and Bill Ackman take on Herbalife, they may find fresh hope in David Einhorn's frontal run at Apple.
b. A company act/decision: While publicly traded companies often play the role of helpless victims to the pricing process, they feed the momentum beast when it works in their favor. In my last post, I noted some actions that Apple can take to cause prices to move towards value including being more open about their long term plans, returning more cash to stockholders and finding new markets to disrupt.
c. A market shift: It remains one the great mysteries of markets. Momentum has a life of its own and it does shift, often in response to small events. While I am not a tape watcher, I believe than trading volume shifts, historically, have been better predictors of momentum changes than watching pricing charts. So, if your technical analysis skills have not rusted, get busy!

Speaking of Einhorn, the news stories today are about his suggestion that Apple issue preferred shares to its common stockholders with a 4% dividend. I am afraid that this post has already gone on too long for me to comment at length, but here is what I believe. Issuing preferred shares will have no effect on value (so, forget about unlocking value...) but the best case scenario is that it will be a price catalyst, by convincing (some) stockholders of the company's commitment to return cash to investors in the future. Cryptic, I know.. but I will have a separate post on it tomorrow.

The Bottom Line
Summing up, my high confidence that there is a big gap between value and price (that Apple is under valued) is tempered by my low confidence, at least in the near term, that the gap will close substantially and that there will be a dramatic game changer (catalyst) in the next few months. While I have a long time horizon, it is not entirely within my control (since I have no idea what financial emergencies may lie in my future), and hence my cap on my Apple investment.  In fact, it was the fear of the havoc that these forces could wreak that led me to sell Apple in April 2012, when the stock was trading at $600+ (at my estimated value of $700, there was a 60% chance that it was under valued).

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It's time: A new semester begins.. and you are welcome to join in...

As those of you who have been reading my blog for a while know, I have been posting my valuation and corporate finance classes online. A year ago, at the start of my Spring 2012 class, I provided my rationale for doing so, which is that the modern university business model is broken and inefficient and that change is needed. At the start of the Fall 2012 valuation class, I pointed to the lessons that I had learned from the earlier semester and the tweaks I had made as a consequence. The learning continued through the semester and I hope to incorporate what I have learned this semester, since I will be offering my corporate finance and valuation classes online, as in prior semesters and I hope that you will be able to join in (at least for portions). The classes start on Monday (February 4). You can follow my corporate finance class or my valuation class, or if you are a glutton for punishment, both.

Corporate Finance
I am undoubtedly biased, but I believe that no matter what you do in business, you should understand corporate finance. By understanding corporate finance, I don’t mean that you have to agree with what I have to say on the topic, but that you have to develop your own narrative that is internally consistent about what it is that business should aspire to accomplish and how they should allocate resources to get to that objective.  This semester-long class should be accessible to anyone who can read a financial statement and can do basic statistics and you can take the class in one of four forums:

a. My website: I track the class on my website, with links to the webcasts of the lectures posted a few hours after each lecture, all of the lectures notes, quizzes and exams and even emails that I send to the class. You can find the links to the website for the class and to the webcast page below:

Website for class: http://www.stern.nyu.edu/~adamodar/New_Home_Page/corpfin.html

Link for just webcasts: http://www.stern.nyu.edu/~adamodar/New_Home_Page/webcastcfspr13.htm
The webcasts can be seen in one of three formats: a direct stream from the NYU server, a downloadable video file that you can watch on your computer at your own leisure and a downloadable audio file, if you want a smaller file with just lecture audio. In the interests of not straining the NYU servers (and creating some backlash for me), please try to use the downloadable versions of the sessions, if you decide to use this forum. The classes are scheduled from 10.30-12, Monday and Wednesday and should be accessible a few hours afterwards.

b. Lore: I have used Lore (which used to be called Coursekit) before and it provides an interesting mix of social media (a Facebook-like discussion page where you can interact with others in the class) and a place for content (where I will post lecture notes, exams and other material to go with the class). To audit the class on Lore, go to the website
http://www.lore.com
When prompted, enter this code: NHHXJU. You should be added to the class and you will get emails when anything is posted to the class site. If you find that bothersome and would prefer to check at your own convenience, you can go into your settings on Lore and turn off the email prompting (though you may not be able to turn off my postings… the privileges of being the instructor). 

c. iTunes U: If you have an Apple device (iPad, iPhone or iPod), you should first download the iTunes U app (which is free). Once you have it downloaded, you can directly join the class using the link below:
https://itunesu.itunes.apple.com/audit/COHMND8KF3
Alternatively, you can enter this enrollment code (KA3-L7J-E46) into your iTunes U app and the class should be added to your library. Again, you will be prompted, whenever I post anything to the site but you cannot post directly on the site.

d. Symmynd: This is a new entrant into the mix and I used it in the Fall. They have the Fall 2012 class archived and you can get to it by going to:

http://www.symynd.com/courses/view/abfixK/

They will also be carrying my Spring 2013 class and the link should show up on the site shortly.

Valuation

The valuation class is a second-year MBA elective course and many of the students in this class have already taken my corporate finance class. However, the class is a stand-alone class that does not require corporate finance. If your interests lie primarily in valuation, you can just take this class, which is about valuing businesses: public or private, small or large, developed or emerging market. It is not a theoretical class. In fact, I firmly believe that there is little theory in valuation and that almost every big question is a pragmatic, estimation question. By the end of the class, my objective is that you will have both the tools and the big picture feel to value just any type of business. As with the corporate finance class, you will have four ways of taking the class.

a. My website:  You can find the links to the website for the class and to the webcast page below:

Website for class: http://www.stern.nyu.edu/~adamodar/New_Home_Page/equity.html

Link for just webcasts: http://www.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqspr13.htm
All of the caveats and notes that I posted about the corporate finance class apply. The classes are scheduled from 1.30-3, Monday and Wednesday and should be accessible a few hours afterwards.

b. Lore:  To audit the class on Lore, go to the website
http://www.lore.com
When prompted, enter this code: WHKP39. 

c. iTunes U: You can directly join the class using the link below:
https://itunesu.itunes.apple.com/audit/COJL8LZCE3
Alternatively, you can enter this enrollment code (KKY-C8B-D56) into your iTunes U app and the class should be added to your library. Again, you will be prompted, whenever I post anything to the site but you cannot post directly on the site.

d. Symmynd: The Spring 2012 corporate finance class is archived and you can get to it by clicking below:

http://www.symynd.com/courses/view/abfixJ/

The Spring 2013 class will be added soon on the site and you can follow online in real time.

Bottom Line

I know that you lead busy lives and that it is asking for too much of your time to take an entire class in real time. To alleviate some of the time pressure, I plan to do the following:

a. Leave the content on for at least a year on the sites: You can take a break, if life gets busy, and come back and finish the class...

b. Make individual sessions detachable: Many of you already know corporate finance and valuation. If you prefer to dip in and just take a session or two, it should work.

c. Create shorter versions of the lectures: I know that 80 minutes online is way too long. I am creating 15-20 minute versions of each of the lectures and hope to have those online sometime during the semester. Hopefully, that will relieve the time crunch.

I also know that it is easy to lose your moorings during an online class, without the feedback that you get in a real class. To counter this issue, here are some of the things I will be trying:

a. The Lore social media site: I plan to post questions and topics on this site for general discussion. Please feel free to post your questions and responses there.

b. Class pop quizzes: I will post the pre-class test that I start every valuation class with (with the solution) and a post-class quiz that you can take to see if you get the concepts in the class.

c. Regular quizzes & exams: While I cannot grade all of the quizzes/exams, I will provide you with a grading template that you can use to grade yourself.

d. Projects/ Valuations: Both classes revolve around real time, real world projects where you analyze a company or value it. I will try to guide you along, on these projects, but here again, I will not be grading them. I will still provide a template you can use to assess yourself.

e. Emai

If you decide to join either class, I hope to see you Monday. 

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Market Mayhem: Lessons for Apple

In my last post, I looked at the options that investors in Apple face today. In this one, I hope to look at what Apple can learn from the market mayhem in its stock, and, in the process, adapt. As an Apple stockholder now, I am at least partly motivated by self interest, but I am also a long time Apple product user and I would like to see the company on steadier footing. So, here are some general suggestions that I would have for Apple management (though I am sure that they are much too busy tending to day-to-day business to be reading blog posts):

1. Build up credibility with investors: The company has to regain credibility with investors. Apple has acquired a reputation for lowballing its expected results, prior to earnings reports. Instead of making it easier for the company to beat expectations, it has led instead to markets paying little heed to the guidance. In fact, it looks like Apple is taking the first step towards doing this by adopting the Amazon strategy of giving wide bands of forecasts for expected earnings. There will be traders/analysts/investors who will be upset, and may abandon the stock. Good!!!
2. Be transparent: Become more open about long-term strategy and products. I think that Apple’s secrecy about new products and strategies may be a great marketing strategy but it creates an information vacuum, which is filled with rumors and fantasy. I know that Apple also worries about giving away information to its competitors, but when you are a company the size of Apple, the news will get out to your competitors any way. So, stop acting like you are protecting national security and start acting like a business!!
3. Take a stand:  The company has to stop trying to be all things to all investors and make its stand on whether it sees itself more as a growth company or a more mature company. Picking one does not mean that the company is giving up on the other, since a mature company can still pursues growth prospects, but it does lay down markers that will determine your investor base. 
4. Behave consistently with your choice: Once Apple makes its stand as a growth or mature company, it has to behave consistently. Thus, if it decides that it is a mature company, it should return more cash to its stockholders, though I think stock buybacks make more sense to its stockholder base now than dividends do. At the moment, with its huge cash balance, it clearly does not make any sense for Apple to borrow money, but somewhere down the road, it has to consider the debt option, since not using it is depriving itself of the tax benefits embedded in the tax code for using debt instead of equity.

I know... I know... All of this will make Apple a more boring company, but I do have one avenue that the company should explore that can still provide excitement to investors, while also creating value. Apple’s great successes in the last decade have come from “creative destruction”, where it has gone into established markets with game changers – retailing with iTunes and Apple stores, portable music players with the iPod, the cell phone market with the iPhone and the tablet market with the iPad. Its success in each of these markets has made it a large player in each of them, which is a problem. As Clayton Christensen, Harvard’s strategy guru, notes, it is difficult for established players to be "disruptive innovators" because they have too much to lose, and Apple can no longer afford to be revolutionary in any of its existing markets. It has two choices. It can put its youthful, creative destruction ways behind in and grow up, or it can go for creative destruction in new markets. I think it should try for a combination, playing defense in the smartphone and tablet markets, and using its competitive advantages to crack open new markets. Unlike Samsung or Microsoft, Apple has never been just a technology company. Its strength has always come from a unique mix of design (software & hardware), elegance and efficiency, and it is this combination that has given it pricing power.

So, where should Apple look next? I would suggest looking for businesses where existing companies churn out poorly designed and consumer-unfriendly products, but are trapped by a lack of imagination and legacy choices into continuing down that path. I can think of at least a dozen that I use or interact with on a day-to-day basis. While televisions have been bandied about as the next big Apple market, I don’t see why the business has to be electronic. I am sure that my airline experience would be better on Apple Air, my hotel stay more comfortable at Apple Hotels and my tax money better spent with Apple Government. 

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Are you a value investor? Take the Apple test

The bottom has clearly fallen out for Apple's stock price. After last week's earnings report, the stock that had already dropped 30% from its high of $705 set in September to $500/share, dropped another 15% to finish at $440/share. The company that could do no wrong a few months ago now is viewed as incapable of doing anything right. Has the stock fallen too much or is this just the beginning of a longer term drop in value? Is it time to buy, time to sell or time to sit on your hands?

Looking at the landscape, I would categorize Apple investors and potential investors into three groups right now, based on their views of its value and the current price.

1. The Pricers: As I see it, the bulk of the investors in Apple have no idea what the value of the stock is and do not care that they don't know its value. They are intent on playing the pricing game, where the key becomes gauging what the rest of the crowd thinks about the stock and trying to get ahead of them. At any stock price, the question they ask is not whether Apple is under or over valued, but whether the price will go up or down in the near term. I have never been good at this game and it must be exhausting, being at the mercy of market sentiment, moods and fancy.
2. The Value Skeptics: This group has always viewed Apple's rapid rise to the top of the market cap heap with suspicion, convinced that its value could not have risen that fast. Some of this group belong to the hardcore value camp, where no technology company, especially one with intangible assets and an elusive "cool" factor, would be a good value, at any price. Some, though, have reasonable doubts about the capacity of technology companies to maintain earnings in an volatile environment and believe that those of us who assume long term growth prospects for these companies are under estimating the risk of the disruption from new technologies. Just as Apple undercut RIMM and Nokia, they believe that some other company will undercut Apple in the future. Many in this group are feeling self-righteous, arguing the price drop was long overdue but not enough to make the company an attractive investment yet.
3. The Value Optimists: This group believes that Apple is a bargain at $440 and that its true value is much higher. Some, in this group, base this judgment on simple comparisons. At a market cap of $413 billion, with a cash balance of $120 billion and net income of $42 billion, they note that Apple is trading at roughly seven times earnings, cheap in a market where the median PE ratio is about 16. Some are basing their views on cash flow based valuations and I am one of that group, as you probably already know from my post at the end of 2012. In that post, I valued Apple at $609/share and the latest earnings report barely changes that estimate. I did a follow up simulation, bringing in the uncertainty about my estimates about revenue growth(-2% to +14%), margins (25% to 35%) and cost of capital (11%-14%) into the mix, with the following outcomes:

Based on my estimates, and they could be skewed by my Apple bias, at its current stock price of $440, there is a 90% chance that the stock is under valued.

If, like me, you are in this last group, you are being tested mightily now, torn between a belief that the stock is under valued and a market that does not seem to care. It is a good test of whether you are a value investor and what you do will depend upon two assessments:

• The Gut Check: Are you really a value investor or do you just like talking like one? It is easy being a contrarian value investor, in the abstract, but much more difficult to be one in practice, since you are taking a position at odds with the rest of the market. Not all investors have the stomach  for that, and if you don't, it is a good time to find out. 
• The Confidence Check: How confident are you in your assessment of value? That confidence will stem from your comfort with the valuation metric/model that you used and the inputs that you used in that model, as well as from your prior experience in investing based on your valuations. Again, you cannot talk yourself into being confident, and if you are not, it is best not to take a stand. 

If you pass the value investing test and feel confident in your assessment of value, I think you should take the leap.  If you do, as I did (albeit at $500/share),  keep the following cautionary notes in mind:

1. Don't bet the house: No matter how confident you are in your value assessment, don't go overboard and invest a disproportionate amount of your portfolio in Apple.  This is not just about you being right on the value but also about the market coming around to your point of view, and that is not in your control or mine; betting more than 10% of your portfolio on this stock strikes me as foolhardy.
2. Don't double down (Dollar averaging): I have never been a fan of dollar averaging, which not only muddies the water about when/how much you invested in a stock but results in increasing your bets as the market goes against you. Take a stand against the market but do not make this an ego trip, where admitting that you are wrong becomes impossible to do. Thus, while I feel more confident now that the stock is under valued than I was a week ago when I bought the stock for $500, I don't plan to buy more shares.
3. Think of buying the business, not the stock: The old adage that you are buying a piece of a company, not a share of stock, is particularly relevant when you make a bet like this one. My intrinsic valuation is determined by Apple's capacity to generate profits and cash flows and is not dependent upon whether portfolio managers are investing with me or analysts are lowering their price estimates. If I buy Apple at $440 today and I can hold the stock, I will get a share of a cash that is paid out and a share of ownership in the cash that is withheld. I have to keep reminding myself of that truth, even if the market moves against me.
4. Do not track the day to day stories: In an increasingly connected world, I know that this is really difficult to do, but there is no harm trying. Turn off your financial news channel, don't read opinion stories about Apple and avoid equity research reports like the plague. 
5. Be willing to wait... even if you are not sure what you are waiting for: The big question that those of us who chose to make this bet face is what the catalyst will be that brings the market back to its senses (at least as we see it...). From my experience, it is almost impossible to tell. For instance, how did Netflix, which was a tailspin, a year ago, turn itself around? There was no single precipitating event but a collection of small news stories and solid earnings reports that seemed to settle the fears that investors had about the company's future direction. With Apple, it could be a new product, a couple of healthy earnings reports or a stock buyback. 

Let me close by saying that I will go to bed tonight, not thinking about what Apple's stock price will do tomorrow or the day after. I have made my choice and I am at peace with it. If you lie awake at night thinking about the stocks you have bought or sold, you just failed the final test of value investing.

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Data Update 2013: The Dark Side of Numbers

For the last two decades, I have dedicated the first two weeks of each new year to a ritual. I obtain/collect/download data on all publicly traded companies listed globally, using a variety of data sources, and then analyze and present the data, aggregated at a number of different levels: by country, by region (US, Europe, Emerging Markets, Japan, Australia & Canada) and by industry. I report on measures of operations (profit margins, turnover ratios, working capital), measures of leverage (debt ratios), measures of risk (beta, standard deviation, equity risk premiums, country risk premiums) and pricing measures (earnings multiples, book value multiples, revenue multiples). I just completed my 2013 update and you can find it by clicking here.

I start with a belief that all data should be accessible and available to all investors at low or no cost, but my motives for providing my reading of the data are far from altruistic. I draw on the numbers that I estimate through the rest of the year for my teaching, analysis (valuation or corporate finance) and writing (blogs, books). In other words, I would have analyzed all of this data anyway and having completed the work, I see little benefit in keeping it behind a pay wall or passwords. Let me hasten to add that nothing that I do is particularly original nor is it path breaking and my task is made easier by the easy access that we have to raw data. I do hope, though, that while I do make mistakes, that I have not let my personal biases or views color the data, and that that nothing that I do is opaque.

Each year, I also try to add something new to the dataset to keep it fresh and this year, I have added company-specific estimates of  costs of equity and capital (in US dollar terms) in the individual company data sets (look to the top of the linked data page). In making these estimates, though, I had to make very broad assumptions about country risk.  For instance, I used the risk premium of the country of incorporation to the company, though it is preferable to use the risk premium based on operations. So, take these cost of capital estimates with a grain of salt, and if you prefer a more precise estimate for a company, you should do in more detail.

When I finished my update a year ago, I posted on it here, and talked about one of my favorite movies/books, Moneyball, in the context of arguing that intuition & experience were vastly overrated in business. Much of what we think we have learned or think we know about investing and corporate finance is skewed by psychological flaws that we all share: faulty framing, hindsight bias and selective memory, and good data can play a cleansing role. That post represented the “good” that I see in data/numbers, and I thought that this year’s post, for balance, should offer the other side of the argument. I know that data can be misused and manipulated, and that some of my own data has been used to back up specious arguments in multiple settings. In particular, here are three practices relating to data that I find distasteful and suggestions on how you can counter them.

1. Data to intimidate: An article in the Wall Street Journal  pointed to fact that people who are unfamiliar with numbers tend to give them too much weight to them and are particularly swayed by "mathematical" arguments, even if they are nonsensical. It is this weakness that is used by some number crunchers to intimidate those that may not have the same degree of facility with numbers. I have seen corporate financial analyses and valuations where analysts use table after table of numbers, to bludgeon others into submission, using acronyms, jargon and greek alphabets to further the rout.
The counter: The best weapons against number intimidation are common sense and a focus on the big picture. I hope that having access to my data will give you some ammunition in this endeavor but having a solid grounding in first principles of valuation and corporate finance alway helps.

2. Data to mislead: If you have access to a great deal of data, you can parse the data and choose pieces to back up a preconception or argument that you want to advance. A couple of years ago, the effective tax rates that I publish on my site, for US companies, were used by some to advance the argument that US companies were not paying enough in taxes. Looking at the 2013 update on tax rates, that number is low (14.93%), but it is the average effective tax rate across all US companies, including those that are money losing (and thus paid no taxes). Looking only at money-making companies, the average effective tax rate is 28.37%, and the weighted average tax rate is even higher at 30.05%. So, if you have an agenda, you can take your pick to make the argument that US companies pay too little, just enough or even too much in taxes.
The counter: While there is little that you can do to stop people from using data selectively, you can counter their arguments by presenting them with the numbers that they are ignoring. In fact, it was in response to the tax rate debate that I started reporting the average tax rates for money-making companies and aggregated tax rates in my datasets.

3. Data to deflect and evade responsibility: Many analysts use data to avoid making tough judgments about businesses or dealing with uncertainty. Thus, assuming that a company will earn a profit margin typical of the industry is much easier to do than analyzing its competitive advantages and estimating a margin, based on your assessment. Similarly, using a historical or a service supplied equity risk premium in valuation is far simpler than estimating one, based upon the macroeconomic risks that we face in markets today. In fact, using an expert or a service estimate of these numbers (using an equity risk premium from a data service like Ibbotson or even my website) allows analysts to claim immunity from errors and to pass the buck, if the numbers turn out to be wrong in hindsight.
The counter: I have absolutely no concerns about you borrowing data and spreadsheets from my website but please make them your own by adapting and modifying them to not only fit your needs to but also to reflect your points of view.

I hope that you find my data useful in your work or research. If you do, that is more than sufficient return on any time that I have invested in putting it together. If you can think of ways in which it can be more useful or complete, please do let me know and I will try my best to incorporate those suggestions into next year's update.

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Death and Taxes at year end: Unpredictable Certainties

There is one trading day left in the year and thus one last day for last-minute tax planning. More than any year in living memory, this one is unsettled simply because no one knows what the tax code will look like for either corporations or individuals next year. As a consequence, I have found that taxes have dominated my thoughts about investing for the last couple of weeks and that makes me uncomfortable, since some of the least sensible investment choices I have made in my lifetime have come about when tax considerations have been preeminent. To ground my thinking and actions for these last few weeks, there are three propositions about taxes that I have had to remind myself about repeatedly over the period.

1. The objective in investing is not to minimize taxes paid but to maximize after-tax returns
If you hold pre-tax returns constant, your objectives when it comes to taxes are simple: you want to pay less taxes rather than more, and later rather than sooner, and that is precisely what most tax advantaged investments offer as their selling points. The catch, though, is that you generally have to accept lower pre-tax returns in return for these tax advantages and it is often the case that these tax advantaged investments generate lower after-tax returns than conventional alternatives. An investment strategy built around minimizing taxes can lead to bad choices. Do you want an investment strategy that ensures that you pay not taxes next year? That's easy!  Just buy non-dividend buying stocks that go down over the course of the year!!

I was reminded of this simple proposition as I was considering the coming changes on capital gains taxes, the one aspect of the tax law where we know what next year will bring. The long term capital gains tax rate, which was 15% for the last decade, will jump to 20% for all investors on January 1, 2013, and to 23.8% for those investors who have more than $200,000 in income; the additional 3.8% is the tax on investment income that was part of the Patient Protection & Affordable Care Act of 2010. Thus, if you have $100,000 in capital gains on a stock, selling it on December 31, 2012 will result in a $15,000 capital tax, but selling it later in 2013 will generate $20,000 ($23,800) in taxes. While my first reaction was that I should sell my big long-term (held > 1 year) winners this year and save on taxes, I had to caution myself to go slow, since the savings in capital gains taxes have to be weighed against the value lost by selling early, if the holding in question is still undervalued.  I ranked the investments in my portfolio, based upon absolute capital gains and then revalued each of the five stocks at the top of the list, using updated information. The three stocks that were still under valued (based on today's price and updated valuation) by more than 5% remained in my portfolio, whereas the two stocks that were under valued by less than 5% or were fairly valued (or over valued) were sold. If you don't have the time or the inclination to do a full fledged valuation, you can still ask yourself a question about your big winners: Would you buy the stock at today's prices? If the answer is yes, you should be hold back on selling the stock, even though capital gains taxes are going up next year.

I know that next year will bring more of these trade offs. With dividend taxes, where there is more uncertainty,  the worst case scenario is that they revert back to being taxed as ordinary income. For investors making over $250,000 in income, this could translate into a tax rates as high as 43.4% (assuming that the higher income tax rate reverts to 39.6% plus 3.8% in healthcare taxes). While my first reaction again is that if this scenario unfolds, I should avoid stocks that pay large dividends, I know that that reaction may not be a sensible one. After all, the prices on these stocks could fall to make their returns attractive enough that even with the higher taxes, they are good investments.

2. Look for value first, think about taxes afterwards
When valuing companies, I believe it is best to keep personal taxes out of the analysis, since it is not your tax status or mine that is the determinant of the intrinsic value of a company. That value should be estimated from the perspective of the marginal investors in the company, i.e., investors who own large proportions of the stock and trade it, rather than your own. That is why we measure risk as perceived by those marginal investors (who we assume have diversified portfolios) and that is also why it is their perception of taxes that will determine intrinsic value. Thus, if the marginal investors in P&G and Coca Cola are pension funds (and thus unaffected by dividend tax law changes), it is possible that the intrinsic value of these companies may not change, even in the worst case scenario where the tax rates double on dividends.

Having estimated the intrinsic value of these companies, I can bring my tax status into the mix, when making my choices. Thus, if I have to pay a 40% tax rate on dividends and a 20% tax rate on capital gains, and I have to choose between two equally undervalued companies, one with a high dividend yield and one without, I would pick the latter. If the higher dividend paying stock delivers a higher pre-tax return than a stock of equivalent risk that does not pay a dividend, I will then have to work out the after-tax returns that I will get from each to make my final judgment. For example, if I expect to generate a pre-tax total return on 10% on a stock with a dividend yield of 2% and 9% on a stock that has no dividends, the after tax returns on each would be as follows (with a 20% tax rate on capital gains and a 40% tax rate on dividends):
After-tax return on a stock = (Total return - Dividend yield) (1- Capital gains tax rate) + Dividend yield (1- Dividend tax rate)
After-tax return on dividend paying stock = (10%-2%) (1-.20) + 2% (1-.40) = 7.6%
After-tax return on non-dividend paying stock = 9% (1-.20) = 7.20%
For the last decade, I was able to skip this step as the tax rates on capital gains and dividends converged, but it is a step that I cannot ignore if the tax rates on dividends and capital gains diverge again.

3. Having a long time horizon is the best protection against taxes
As investors look for ways to reduce the tax drag on their investments, they will be tempted by complex products that will claim to save them taxes. For some of the very wealthy, these products may make sense, but for the rest of us, they often create more costs than benefits. I may be simple minded when it comes to taxes but I think that the most effective tax management strategy for most investors is to have a long time horizon. Investors with short time horizons generally pay more in taxes for two reasons: (1) their holding periods are too short to qualify their gains for long term capital gains, thus converting their price appreciation in ordinary income (with higher tax rates) and (2) the high turnover in their portfolios makes it impossible to have a cohesive tax strategy.

The link between turnover and taxes is most easily seen when you look at returns on mutual funds, where Morningstar keeps track of the pre-tax and after-tax returns on funds. The figure below provides the statistics for the tax drag for funds broken down by turnover ratios (total trading volume/ value of the fund) for a five year period (2006- 2010):

While the returns on all funds were depressed by the poor market returns during this period, what is noteworthy is the tax drag (the different between pre-tax and post-tax returns) as a function of turnover ratios. The funds with the lowest turnover ratios (and the highest time horizons) had the lowest tax drag, whereas those fund that had short holding periods and high turnover ratios paid much more in taxes.

In closing
At this point in the fiscal cliff debate, I am resigned to the fact that taxes will go up on January 1, 2013 and the only question is by how much. I have done all I can with my existing portfolio to reduce the impact of the tax law changes, but I have had to restrain myself from over reaching. It is possible that we will know what the tax code will look like before close of trading on December 31, 2012, and the market reaction to those changes will play out over the next few days. For my part, I am done with investing for the year and will spend tomorrow on more important concerns- friends, family and faith. Death and taxes may be unavoidable, but life is too short to be spent obsessing about either. So, have a happy new year and may it bring you health and happiness!!

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