Christopher Lum Lee
I recently read The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor by Mary Buffett and David Clark. The key lesson that I’ve learned from this book is about Buffett’s “Ten Points of Light” to determine if the company is one that Buffett would invest in.
In an attempt to take this information from the book and incorporate it into my investing style, I have conducted an analysis in previous articles about Pfizer (PFE) and Verizon (VZ). I was asked to provide an analysis on Apple (AAPL), though I hold no position in Apple, I would like to take this opportunity to provide this analysis so hopefully anyone considering an investment or already has one in this business can make use of.
In the book, Buffett states that for him to invest in any business, they must have a durable competitive advantage and meet all ten of the following criteria. Some of the criteria is fairly objective, some remain subjective in interpretation and you may decide to allow some leniency in the criteria evaluation.
Number 1. The Right Rate of Return on Shareholders’ Equity
In examining Apple’s shareholders’ equity, the company has to show a consistently high rate of return on equity- above 12%, which is considered by Buffett to be ‘above average.’
Net Income and Shareholders’ Equity has been taken from Yahoo! Finance. Given this information, the following calculation of net income divided by shareholders’ equity is done:
*All numbers in thousands
|Year||Net Income||Shareholders’ Equity||Return on Equity (ROE)|
|2010||$1,4013,000||$47,791,000||.293 = 29.3%|
|2011||$25,922,000||$76,615,000||.338 = 33.8%|
|2012||$41,733,000||$118,210,000||.353 = 35.3%|
Though we only have three years worth of data, looking at this information shows a consistent increase in ROE that has increase 6% between 2010-2012.
Number 2. The Safety Net: The Right Rate of Return on Total Capital
According to Investing Answers, the return on total capital is calculated by taking the sum of net income less dividends and dividing that by the sum of debt plus equity. Buffett looks for a consistently high rate of return on total capital.
Looking at some more quantitative data, debt was determined as the total current liabilities plus long-term debt.
*All numbers in thousands
|Year||Net Income – Dividends||Debt + Equity||Return on Total Capital (ROTC)|
|2010||$14,013,000||$68,513,000||.204 = 20.4%|
|2011||$25,922,000||$104,585,000||.247 = 24.7%|
|2012||$39,245,000||$156,752,000||.250 = 25.0%|
Between 2010 and 2012, we see that Apple has delivered a positive rate of ROTC.
Number 3. The Right Historical Earnings
Buffett looks for companies that produce an annual Earnings Per Share (EPS) that historically shows a strong upward trend. Nasdaq.com provides more historical data on the annual EPS. Let’s look at this data since 2007:
As you can see by this data, the annual EPS has grown hand-over-fist.
Number 4. When Debt Makes Buffett Nervous
The book states that “…companies with a durable competitive advantage typically have long-term debt burdens of fewer than five times current net earnings.” Let’s look at the debt-to-equity ratio using the formula of total liabilities divided by shareholders’ equity. Looking back at 2010-2012 again with data courtesy of Yahoo! Finance, we receive the following information:
|Year||Total Liabilities||Shareholders’ Equity||Debt-to-Equity|
This data shows that not only does Apple have a low debt-to-equity ratio, but it also steadily decreases the ratio as liabilities and equity increases over this period.
This is one of the sections that I feel could be slightly subjective because the book didn’t state what an ideal debt-to-equity ratio would be. However, I feel that this is still a good showing.
Number 5. The Right Kind of Competitive Product or Service
The book advises asking yourself the following questions: “Is the product that kind that stores have to carry to be in business? Would the businesses that carry this kind of product be losing sales if they didn’t carry this particular brand-name product?” The idea is to find a business/product that consumers are continuously in need of, not one they buy once in their lifetime.
Producing a competitive product is what made Apple truly shine over the years! Apple is now a household name because of the products made such as the iPod, iPhone, iPad, and Macbook are the biggest selling products at this time. This begs the question of who are the biggest competitors to Apple’s legacy? The answer guides me to Samsung (SSNLF.PK), Google (GOOG), Microsoft (MSFT). Samsung and Google are competitors of the iPhone as Microsoft is the competitor of Apple’s operating system platform.
The competitive advantage comes from putting out newer models and versions of software or products. The demand for the newer, sexier, smaller, and more technologically heavy product will remain consistent.
Number 6. How Organized Labor Can Hurt Your Investment
“Seldom will you find a durable-competitive-advantage company with an organized labor force.”
In 2011, the (unofficial) Apple Retail Workers Union was established to represent the retail employees. This initiative was started by Cory Moll, who departed from Apple in April 2013. The union was established for the same reasons that most other unions battling corporations are established: better wages, benefits, and promotability. In response to the creation of this union, the administration has required all retail managers to undergo “union awareness” training to learn more about attempts by employees to unionize.
While a labor union isn’t the worst thing to happen to a big company like Apple, depending on the relationship between the labor and management, a union could be crippling. In my research of the interactions between Apple and the Apple Retail Workers Union, I couldn’t find any evidence of anything that would cripple Apple’s ability to remain profitable and continue to manufacture competitive products.
Number 7. Figuring out Whether the Product or Service Can Be Priced to Keep Abreast of Inflation
“…a business with a durable competitive advantage is free to increase the prices of its products right along with inflation, without experiencing a decline in demand. That way its profits remain flat, no matter how inflated the economy goes.”
When it comes to manufacturers, I believe that a product can be priced to inflation for only so long before customer demand would suffer. Recent developments in the case of the latest iPhone shows that the phone is not targeted towards emerging markets. This means that the limited target demographic is in the developed markets of consumers who can afford high-priced gadgets. This in itself is neither good nor bad – but as inflation kicks in and the pricing structure increases, you could very well see a decrease in demand as less people may be able to afford these gadgets. To make matters worse, this was only in relation to the manufacturer, not the retailers, who also add on their piece of the profit.
While I don’t doubt the popularity of any of Apple’s products, everyone has to admit that there’s a price that people aren’t willing to pay for an iPhone or any other Apple product.
Number 8. Perceiving the Right Operational Costs
This point considers how retained earnings is used to maintain the durable competitive advantage. The idea is to take the amount of retained earnings by a business for a given period of time and measure its effects on the business’ earnings capacity.
The book gives the following example with H&R Block (HRB):
In 1989, H&R Block, a company with a durable competitive advantage, earned $1.16 a share. This means that all the capital the business had accumulated until the end of 1989 produced for its owners $1.16 a share. Between the end of 1989 and the end of 1999, H&R Block paid out in dividends a total of $9.34 a share. So [f]or that ten-year period, H&R Block had retained earnings of $7.80 a share ($17.14 – $9.34 = $7.80) to add to its equity base.
The company’s per share earnings increased during this time from $1.16 a share to $2.56 a share. We can attribute the 1989 earnings of $1.16 a [s]hare to all the capital invested and retained in H&R Block up to the end of 1989. We can also argue that the increase in earnings from $1.16 a share in 1989 to $2.56 a share in 2000 was due to H&R Block’s durable competitive advantage and management’s doing an excellent job of investing the $7.80 a share in earnings that the company retained between 1989 and 1999.
If we subtract the 1989 per share earnings of $1.16 from the 1999 per share earnings of $2.56, the difference is $1.40 a share. Thus we can argue that the $7.80 a share retained between 1989 and 1999 produced $1.40 a share in additional income for 1999, for a total return on 17.9% ($1.40 divided by $7.80 = 17.9%).
Working on Apple using this process, let’s start with 2010:
In 2010, Apple earned $15.15 per share. This means that all capital received until 2010 produced $15.15 per share for its owners. Between the end of 2010 and 2012, the total EPS was $86.98. Of that, $5.3 was paid out in dividends. Therefore, for that three-year period, retained earnings were $81.68 ($86.98 – $5.3 = $81.68). Earnings increased during that time from $15.15 to $44.15. By subtracting the 2010 EPS of $15.15 from the 2012 EPS of $44.15, we get $29.00. Therefore, the retained earnings of $81.68 between 2010 and 2012 produced $29.00 per share – a 35.50% increase in retained earnings.
Number 9. Can the Company Repurchase Shares to the Investors’ Advantage?
Buffett likes companies that buys back their shares- citing that with share buybacks comes price appreciation. More importantly, he likes companies that have buybacks regularly instead of occasionally.
Apple does not have a history of buying back their shares. Apple’s current share buyback plans are overshadowed by activist investor Carl Icahn’s own push for Apple to purchase at least $150B worth of shares.
Though Apple will not get this point, it will be interesting to see in the near future what happens with the talks of the share buyback. Given Icahn’s history as an activist investor, I do believe that an Apple share buyback would increase the share price and ultimate value of the business that will be passed on to investors.
Number 10. Does the Value Added by Retained Earnings Increase the Market Value of the Company?
“Warren believes that if you can purchase a company with a durable competitive advantage at the right price, the retained earnings of the business will continuously increase the underlying value of the business and the market will continuously ratchet up the price of the company’s stock.”
On December 31, 2010, Apple had a price/book ratio of 5.435 per share and traded at $322.56 per share. As of the close of business on Friday, October 11, 2013, Apple had a price/book ratio of 3.630 per share and closed trading at $492.94. This means that the book value has decreased by approximately 33% while the share price has appreciated by approximately 36%! While this isn’t the most definitive determination, this gives an indication that this criteria has not been met.
Final Score: 7-3
Overall Apple is a good company. From a financial management perspective, I believe that Apple has grown to be a market leader that is paving the way for future technological advancement and growth for investors. However, given the information presented, in a black-and-white world, Warren Buffett would not invest in Apple.
While this article may draw criticisms from some readers, either on the formulas used or my interpretation of some of these points, I do encourage readers who are interested in Apple as an investment to read this book and conduct their own analysis and see what your findings would be.