People too often mistake great companies for great stocks. It seems like the two things should be related: great companies should be great investments. But this is often a dangerously misleading notion. If the market thinks a company is great, its prices that company’s stock accordingly, which can lead to expensive prices and weak returns.
Apple’s stock is the perfect example to highlight the crucial difference between a company and a stock. My intention is not to convince you to buy Apple today, but rather to use Apple to demonstrate that it is more effective to make investment decisions based on stock characteristics like valuation and “shareholder yield” than based on a company’s greatness.
Apple’s stock has undergone a remarkable transformation (for the better) in the past two years in two specific areas: valuation and shareholder orientation. It went from a very expensive market darling focused on growth, to a very cheap market laggard with significant dividend and share repurchase programs.
Great companies are often viewed by investors through rose colored glasses. Investors extrapolate the company’s recent success too far into the future, leaving the stock expensive. Between 2010 and 2012, perception was that Apple was the greatest company in the world. In 2010, Apple was more expensive than 75% of the market based on a combination of simple measures like price-to-earnings, price-to-sales, and price-to-cash flow. Now, in 2014, it is cheaper than 91% of companies, based on those same measures. Look how quickly the change happened. Market perception can turn on a dime.
The other key change in Apple (from the investor’s perspective) is its orientation towards its shareholders. For years, it issued new shares, diluting existing shareholders (shown as negative shareholder yield in the figure below) and paid no dividends. They’ve since pulled a 180, buying back a huge number of shares and paying a regular dividend. Again the change happened fast.
Change in Perception – Apple Inc. vs. $AAPL
Just a few years ago, people thought Apple would soon be the first trillion dollar company. Its leader was the modern day Edison, and its products best in class. Now, a few years later, shareholders and commentators are bemoaning Apple’s lack of new products, declining margin, and less visionary leader.
The consensus is that Apple has less potential than it did a few years ago, but history suggests that its stock has much more potential than it did a few years ago. In 2010, Apple was priced more expensively than 75% of the market. It fell in a valuation group (decile, outlined below) that has historically lagged the market by 3% per year. This -3% means that if you bought every stock in that category (there are about 300 of them) every year, you’d have historically underperformed the market by 3% per year annualized: a big negative gap. Now, in 2014, it sits in the cheapest decile, a group that has historically beaten the market by almost 6%.
Successful investing is all about finding mismatches between perception and reality. In this case, price is the market’s perception and reality is things like cash flow, earnings, etc. Four years ago, perception was out of whack with reality in a bad way: investors expected too much of Apple. Now, the situation is flipped and it appears perception may be much worse than reality—which is when you want to buy.
The same story is true of Apple’s shareholder yield. History teaches us that you should favor stocks that pay dividends and repurchase the most shares (decile 1 below), but avoid stocks that issue the most shares (decile 10). Again, Apple looked unattractive as a share issuer, but looks much more attractive now, as a dividend-payer and share-repurchaser. Note: for more on shareholder yield check out Meb Faber’s great book Shareholder Yield or Chapter 13 of James O’Shaughnessy’s What Works on Wall Street.
Apple Inc., the company, has taken its licks since it peaked at $700 in 2012. The change in perception has transformed $AAPL, the stock, in ways that should make investors take notice. Investors should always buy cheaper companies that reward their shareholders rather than expensive stocks dilute them. Of course Apple itself may flounder and underperform the market, but the odds are that a large basket of stocks with similar characteristics (cheap valuations, high shareholder yields) will do very well over the long term.