Editor’s Note: All of us at Real Investment Advice are proud to welcome Vitaliy Katsenelson, CFA to our growing list of outstanding contributors. Vitaliy is the CIO at Investment Management Associates, which is anything but your average investment firm. He has also written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Forbes magazine called him “the new Benjamin Graham.”
It is hard to find a bigger Apple stock cheerleader than me. I’ve been writing Apple stock love poems for years. For a long time, it was easy to love the shares because they were unloved by others and it was cheap.
Until recently, when Apple stock was still trading in the low $100s and at single-digit multiples, we were buying current product categories at a discount and were not paying for future product categories.
At today’s price that is not the case anymore. That is true with any company – the more expensive the stock gets, the more clairvoyance investors need to discern the company’s future growth.
At Apple’s size it is very hard for the company to increase its earnings significantly. Macs, iPads, and even iPhones are mature products.
The iPhone may have a few growth spurts left, but not many. It is facing an unavoidable headwind: the elongation of its replacement cycle. The iPhone improved substantially over the years, but as the i-marvels piled up, the incremental improvements that motivated people to buy a new phone every two years or so became less and less significant.
At some point the iPhone will face the fate of the iPad – its replacement cycle long in the tooth and sales stagnant and declining.
Will the iPhone’s sales stop growing in 2018, or 2020? I don’t know, but from a long-term perspective of the company’s valuation, a few years don’t make that much difference.
(A new iPhone is expected to be unveiled next week. The stock fell slightly Wednesday on concern supply disruptions could cause shipping delays with the new phone.)
Services is the only segment that can grow at a double-digit rate for a considerable period of time, but it only represents 13 percent of revenue. Even the Apple Watch doesn’t really move the needle.
They need another genius
But can Apple come up with new product categories? Let’s ponder on this question in the context of the following quote:
“Talent hits a target no one else can hit; Genius hits a target no one else can see.” – Arthur Schopenhauer
Apple has a lot of talented people designing and redesigning products in the categories that Apple already dominates. They are hitting a lot of targets no else can hit. Apple’s brand is as healthy as ever, and so is product satisfaction.
However, to create a new category of products Apple needs to “hit targets no one else can see,” and this requires a genius. But in an organization of this size with a lot of bright and talented people, it also requires a benevolent dictator – someone able to make bold, unconventional decisions (and own them), someone who in addition to everything else is able to inspire others to create what they may think is impossible. Yes, I am referring to the one and only Steve Jobs, he of the “reality distortion field.”
Here is an instance that comes to mind: Jobs asked his engineers to come up with a touchscreen computer – a tablet. They did. It looked like a bulky version of today’s iPad. Steve looked at and said “Let’s put the tablet on ice,” then refocused the company on miniaturizing that tablet and making a phone instead.
It is important to remember that at the time, though Apple was financially healthy, it was not swimming in cash the way it does today. Jobs made a benevolent dictator-like decision: He diverted engineers who were working on the MacOS to work on what would become the iPhone OS, causing the late release of some Mac products. And only years later, after the iPhone was a raging success, Apple brought the iPad back to life. That was Jobs’ Apple.
Now let’s visit Tim Cook’s Apple. The New York Times ran an in-depth article unearthing why Apple has (so far) failed to come up with an electric self-driving car. These few sentences jumped out at me:
“But the car project ran into trouble, said the five people familiar with it, dogged by its size and by the lack of a clearly defined vision of what Apple wanted in a vehicle. Team members complained of shifting priorities and arbitrary or unrealistic deadlines.”
Nokia spent a lot on R&D too
Even Jobs admitted that Cook is not a “product man.” Cook doesn’t have “the vision,” and thus he doesn’t have the authority to be a benevolent dictator. Nor does he have the charisma to project and maintain a reality distortion field.
Today Apple spends almost $12 billion on R&D – double what it spent just a few years ago. But as outside observers, we really don’t know where this money is going. Or more importantly, how productively it is being spent. I vividly remember how Nokia was increasing its R&D spend every year during the last years of its dumb-phone dominance, but all that R&D did not bring forth new products that would have saved the company from its eventual demise. Apple is not facing Nokia-like collapse, but the R&D argument still stands: R&D spend doesn’t always equal great new products.
The NY Times article said that Apple curtailed its ambition to make a car and is now focusing solely on self-driving technology. In other words, Apple is basically pulling out of the electric car space (at least for now).
If Apple develops and licenses its self-driving technology, it will recover some of its losses on investments made to date. But it will not be able to take advantage of the significant competitive advantage that comes with its incredible brand, its distribution network – hundreds of stores (potential car dealerships) sprinkled all over the world – its know-how in battery management, its design prowess, and its i-ecosystem.
We still own a little bit of Apple stock but have sold most of what we owned at current prices. Maybe Apple’s augmented reality products will become a huge success, or maybe the company is working on a brand new category of products that we have not even imagined. It is all possible.
In making investment decisions you never have perfect information. Apple is no exception. At today’s valuation we are paying for genius – Apple’s ability to successfully create and dominate a new, large product category. While the company is run by very talented people who will do a great job getting us excited about the categories of products they are already in, the company’s genius died with Steve Jobs.
Vitaliy N. Katsenelson, CFA is the Chief Investment Officer of Investment Management Associates, Inc. which is anything but your average investment firm. He is the author of “The Little Book Of Sideways Markets.” Follow him on Twitter and Subscribe to his emails.