Buffett Sells IBM, Jumps On Apple Bandwagon – Blessing Or Curse?

Warren Buffett’s decision to invest a large sum in Apple (AAPL) in recent quarters was so surprising because he once regarded tech companies to be outside his so-called “circle of competence.” Then six years ago he started buying IBM (IBM) shares, which only served to confirm that the legendary investor indeed should probably steer clear of the sector and focus on the areas of the economy he knows best.

In recent days we have learned that Buffett has begun selling off his IBM position (about 1/3 thus far), but his new tech favorite is clearly Apple, which he has been accumulating so much that it now represents his second largest single stock investment in dollar terms behind Wells Fargo (WFC).

His timing with Apple appears to have been quite good, although I suspect that is more due to luck than anything. For the last year or so, Apple bulls (other than Buffett) have been touting the idea that the company is not actually a hardware company, but rather a software and services company with valuable recurring revenue. It should follow, they say, that Apple stock deserves a much higher earnings multiple than it traditionally has received (below the S&P 500 due to the perceived fickle nature of technology products, especially on the hardware side of the business).

I am not convinced that this argument makes sense, at least yet. Every quarter we hear investors tripping over themselves about Apple’s service revenue growth, and yet whenever I look at the numbers I still see a hardware company. Consider the first half of Apple’s current fiscal year (which ends September 30th). Service revenue made up 11% of Apple’s total sales, versus 67% for the iPhone, 10% for the Mac, 7% for the iPad, and 5% everything else. Clearly, Apple is not a software company.

Now I know that services have higher margins, so although they represent 11% of sales, they contribute more than that to profits, which is a good thing. But in order for software and services to really become a large contributor to Apple’s bottom line, the revenue contribution has to rise materially, in my view. And that is where I think the “Apple is a services juggernaut” thesis gets shaky.

Over the last six months, services made up 11% of total revenue. Okay, so clearly that number must be accelerating pretty quickly given how bullish certain shareholders are about Apple’s earnings multiple expansion potential, right? Well, in fiscal 2016 the figure was also 11%. In fiscal 2014 it was 10%. In fiscal 2013 it was 9%. Services thus far are not growing much faster than hardware, which actually makes sense when you think about the Apple ecosystem.

If you want more people to buy the services, they have to buy the hardware first. So maybe the two go hand in hand. Put another way, if many iPhone owners have not subscribed to Apple’s services yet, why would they suddenly begin to adopt them at higher rates in the future? At least, that is the argument for why services might not become 20 or 30% of sales over the next few years.

Interestingly, since Buffett started buying more Apple, the earnings multiple has increased. Much of that likely has to do with the prospect for corporate tax reform and the potential for the company to repatriate their large cash hoard ($30 per share net of debt) back home at a low tax rate, but some probably is linked to the idea that services are about to explode to the upside. Color me skeptical on that front.

Year-to-date Apple shares have rallied from ~$116 to ~$152 each. On a free cash flow basis, the multiple on fiscal 2016 results has risen from 12x to nearly 16x. As a holder of the stock, I am certainly happy about that, but I wonder how much more room the multiple has to rise. And will it turn back the other way if services growth disappoints or if tax reform is less aggressive than hoped? Perhaps.

If that happens, the stock price could very much depend more on Apple’s future product lineup than anything. On that front, I am nervous about the company. In recent months I have come to the conclusion that Amazon (AMZN) might be the “new Apple” in terms of tech innovation. Not too long ago it was Apple that would be first to market (the iPad, the iPhone, etc), and then everyone else would copy them (and fail). Lately it seems that Amazon has taken over that role and Google (GOOG), Microsoft (MSFT), and Apple then copy them.

I am thinking about Amazon Echo, which Google quickly copied and rumors are that Apple is not far behind in doing the same. With Amazon’s announcement this week about Echo Show I had the same thought. Dash buttons – same thing. Drone delivery – same thing. Apple is reportedly funding original TV shows and movies now (years behind the curve). The Apple Watch wasn’t first to market, etc. Oh, and the attempt to build an electric car in Cupertino? The perfect example of mimicry.

If that is the case, then Apple’s hardware growth, which has been halted, may be difficult to accelerate. And if services need to pick up the slack, there is a lot of work left there as they seem to be stuck as a percentage of total sales.

While I am not bearish on Apple as an investment – their ability to generate cash remains more than formidable – with the recent earnings multiple expansion I am starting to think about where future upside will come from. If the most exuberant bulls are right and the stock can garner a multiple a la Coca Cola (KO) or McDonalds (MCD) (20-25x earnings), that is definitely the answer. I am just not sure sure that makes sense, at this point anyway.

Full Disclosure: Long shares of Apple and Amazon at the time of writing, but positions may change at any time

Does Buffett’s Big Buy Signal A Top In Apple?

For decades legendary investor Warren Buffett refused to buy technology stocks. He missed the huge bull market in the mid to late 1990’s and people repeatedly questioned his decision in light of the obvious tech revolution. After the dot-com bubble burst he looked brilliant, for a while at least. Interestingly, Buffett avoided tech stocks not due to some core issue such as high valuation, but instead because he simply did not understand the industry. As someone who popularized the term “circle of competence,” his lack of deep understanding of the sector meant that he did not feel like he could analyze these companies well enough to make an investment.

Then in 2011 something changed. Buffett started to amass a huge stake in his first technology investment; IBM. Close followers of the Oracle of Omaha, especially those who knew a decent amount about the tech sector, were doubly shocked at hearing this news. Not only had Buffett violated his decades old rule, but he had chosen for his first tech investment a giant that was widely seen within the industry as being a symbol of “old tech” – one that was only going to be marginalized by newer companies and technologies.

Fast forward six years and Berkshire Hathaway’s 2016 annual report shows that Buffett’s firm owns a staggering 81.2 million shares of IBM. Since purchasing 63.9 million in 2011, he has increased his position by another 27% in subsequent years. That stake was worth $13.5 billion as of year-end 2016. The annual report also discloses his total cost basis in IBM; $13.8 billion. Given a cumulative loss since the initial purchase in 2011, it is hard to argue that Buffett should have ventured into an industry he admittedly knew little about.

While the IBM story is old news for Buffett watchers, I think it is noteworthy given his recent comments on CNBC two weeks ago that during the month of January he acquired 76 million shares of Apple. Buffett admitted in the interview that he did not have an iPhone and that he queried his young family members to see how they like Apple products.

Apple shares have been on a tear in 2017, in part due to news that Buffett was buying.

I have to wonder if this second step into the tech world will share any of the same characteristics of the IBM investment.

Perhaps the bigger point is this idea of one’s circle of competence when it comes to investing. When I look back at my own career managing money it is obvious that my batting average is far higher within industries I am more familiar, and vice versa. There are multiple instances where I have lost money on energy exploration stocks and early stage biotech stocks, to name a couple of areas outside my circle. While I have never instituted a rule that prohibits me from buying stocks in certain sectors, over the years I have definitely allocated more capital to sectors I know best.

That decision does not always help me, especially when investment managers are compared with very diversified indexes. For instance, since the election of President Trump, companies focused on manufacturing, construction, and infrastructure have performed very well. I own very few of these types of names, and in some cases none at all. That lack of exposure to a strongly performing group has materially impacted my short term performance.

My hope is that my clients would rather me avoid sectors I don’t understand well (even if that means poor relative short-term results), as opposed to feeling like I need to have exposure to a little bit of everything in case sectors outside my circle of competence happen to perform well for a while. If I am going to be judged on mt ability to pick individual securities, I may as well stack the odds more in my favor, right?

Regardless, I can’t help but believe that such a strategy makes the most sense, even if it does not always pay off in spades. And if I had to guess, that probably goes for most other (both professional and amateur) investors too.

As for Apple stock, while I continue to hold some both personally and on behalf of clients, the recent run-up to $140 per share probably means that future returns will be more muted, as the stock now trades for roughly 15 times annual free cash flow per share.

Full Disclosure: Long shares of Apple at the time of writing, but positions may change at any time

U.S. Stocks Reach Valuations Rarely Seen, Making Material Earnings Growth A Requirement For Strong Future Returns

In the face of the current highly ebullient stock market, close watchers of valuation metrics are frequently dismissed as ignoring the prospect for accelerating GDP growth and lower corporate tax expense, but I will step onto that turf anyway. It may make me look foolish, as Warren Buffett recently played down concerns about the market’s valuation, even though his often-preferred metric in years past (total stock market value relative to annual GDP) is dangerously high, but that’s okay.

Here is a look at my preferred valuation metric; a variant of the P/E ratio that uses “peak earnings” (the highest level of corporate profits ever produced in a 12 month period) instead of trailing 12 month earnings (impacted solely by the current economic environment) or forward earnings estimates (usually overly optimistic). We’ll go back more than 50 years, not only to get an idea of historical trends, but also because that is the data I have.

When people ask me about my view of the market, I tend to give a tempered response because it is hard to argue that we should really get any earnings multiple expansion. After all, we now sit above 20 times “peak earnings” and that has only happened once in the last 55 years. As you can see, that one time (the dot-com bubble of the late 1990’s) is not exactly a time we probably want to emulate this time around.

It is important to note that high valuations do not guarantee poor future returns. There is a high correlation, but you can map out mathematical scenarios whereby P/E ratios mean-revert and stock prices don’t crater. Simply put, it requires extraordinary earnings growth that can more than offset a decline in P/E ratios (which we should expect if interest rates continue to increase). Right now the U.S. market is banking on this outcome, so earnings and interest rates are probably the most important things to watch in coming quarters and years when trying to gauge where the market might go from here.

Author’s note: The use of “peak earnings” is not common, so it is worth offering a brief explanation for why I prefer that metric. Essentially, it adjusts for recessions, which are temporary events. If investors use depressed earnings figures when they value the market, they might conclude stocks are not undervalued even if prices have declined materially. This is because they inherently assume that earnings will stay low, even though recessions typically last only 6-12 months and end fairly abruptly.

As an example, let’s consider the 2008 recession. The S&P 500 fell 38% that year, from 1468 to 903. S&P earnings fell by 40%, from ~$82 to ~$50. If we simply use trailing 12-month earnings, we see that the P/E multiple on the index was 18x at the beginning of 2008, and was also 18x at the end of the year. So were stocks no more attractively priced after a near 40% fall? Of course they were, but using traditional P/E ratios didn’t make that evident.

If we instead used “peak earnings” (which were attained in 2006 at ~$88), we would have determined that the market was trading at ~17x at the outset of 2008 and had fallen to just 10x by the end of the year. By that metric, investors would have realized that stocks were a screaming buy when the S&P traded below 1,000.

 

Is Facebook Stock Approaching Bubble Territory?

Here is a list of the U.S. companies that are worth at least $300 billion today based on stock market value:

  1. Apple $522B
  2. Microsoft $392B
  3. Exxon Mobil $365B
  4. Berkshire Hathaway $357B
  5. Facebook $336B
  6. Amazon.com $318B
  7. Johnson & Johnson $311B

If you are surprised to see Facebook (FB) registering as the 5th most valuable U.S. company you are not alone. Given the company’s high growth rate, many investors do not mind the stock’s valuation. At $117 per share, the stock trades at 33 times this year’s consensus forecast of $3.54 per share of earnings. Given that Wall Street is currently estimating more than 30% earnings growth in 2017, this P/E ratio seems high, but warranted, if you are a true believer in the company’s future.

I am not going to delve into the company’s future growth prospects in this post, as I have been wrong about them so far. My thesis was that Facebook usage would decline over time as early adopters such as myself tired of the service and the network became overloaded with parents, grandparents, aunts, uncles, etc. That has proven to be wrong. Perhaps Facebook has evolved from a cool place to connect with friends to a crucial hub to connect with family. At any rate, the stock’s valuation is what has peaked my interest lately.

Facebook is one of a growing number of growth companies in the technology space that is overstating its profitability by paying its employees with stock and not treating it as an expense when speaking to Wall Street analysts. The official GAAP financial statements do disclose how much stock they dole out to employees (for instance, in 2015 the figure was a stunning $3 billion), but when investors quickly look at earnings estimates, they see the $3.54 figure for 2016 which does not include stock-based compensation.

So what happens to the stock’s valuation if we treat stock compensation as if it were cash? After all, if Facebook decided to stop paying its employees with stock, we can assume they would have to replace it with cash. Below I have compiled the company’s free cash flow generation since 2012 and subtracted the dollar amount of stock they have paid their employees. This simply tells us how much actual free cash flow Facebook would have generated if they compensated solely with good ol’ U.S. dollars and cents.

FB-FCF

As you can see, adjusted for stock-based compensation Facebook had free cash flow of $1.09 per share in 2015, which is about 50% less than their actual reported free cash flow ($2.13). Put another way, Facebook’s employees (not their shareholders) are being paid out half of the company’s profits.

From this perspective, Facebook stock looks a lot more overvalued. If you annualize the company’s first quarter 2016 free cash flow adjusted for stock compensation ($0.38 per share), the company trades at a P/E of 77 ($1.53 of free cash flow). There is certainly an argument to be made that such a price resembles bubble territory. That potential problem could be rectified if the company continues to grow 30% annually for the next five years, resulting in $4.05 of “adjusted” free cash flow in 2020. But buyers of Facebook stock today at paying about 30 times that 2020 estimate right now, which is still a very high price.

Below is a summary of Facebook’s stock market value relative to reported and adjusted free cash flow since 2012, as the stock has nearly quintupled in price:

FB-Pr-FCF

How do situations like these typically play out? One of two ways. The less likely scenario is probably one where Facebook’s growth hits a wall and investors quickly slash the P/E ratio they are willing to pay by 2-3 times. That would be ugly, but does not appear to be the most likely outcome given their momentum right now. The more likely scenario is the one that we usually see with very good companies that have staying power but simply have seen their stock prices get ahead of the fundamentals. In that case, the cash flow multiple comes down slowly over a period of several years, resulting in the stock price lagging the company’s underlying profits.

If I had to guess, I would say the latter seems like a real possibility going forward from here. Regardless, investors should check to see how much of a hit a high-flying tech company’s cash flow would take if stock compensation was factored into the equation. As Warren Buffett likes to say, “if stock-based compensation is not a real expense, I don’t know what it is.”

Full Disclosure: No position in Facebook at the time of writing, but positions may change at any time

Best Section of Warren Buffett’s Annual Letter to Berkshire Hathaway Shareholders: Why Buybacks Are Preferred Over Dividends

This weekend I had the pleasure of reading Warren Buffett’s annual shareholder letter (an annual exercise for me) and I wanted to share a section of the 23 page document with my readers. In it, Buffett discusses why he prefers share buybacks over dividends (Berkshire has never paid a dividend). Not only did he present a clear and concise explanation, but I also think it sheds much light into the current debate at Apple, where shareholders are hoping that management there finally makes some wise capital allocation decisions, as the stock hits a new 52-week low today. I have created a PDF file consisting of just the 3 page section on dividends versus buybacks if you would like to read it.

JPMorgan Sell-Off Excellent Example of Contrarian Opportunity

News of a $2 billion trading loss at JPMorgan Chase (JPM) last week prompted a 15% sell-off in the stock, which now sits more than 20% below its 52-week high, at a trailing P/E ratio of 8, at only a slight premium to tangible book value, and with a dividend yield above 3%. One of the best ways to be a successful investor is to buy quality companies at times when their share prices are temporarily depressed due to short term news headlines that likely will not impact the long term profit generation of the company. Warren Buffett has perfected this investment strategy over many decades. While JPM was not really on my radar before last week, the recent events at the company have changed that. At around $36 per share I think JPM makes for a very attractive long term investment. As a result, I have initiated a position in the company.

Full Disclosure: Long shares of JPM at the time of writing, but positions may change at any time

First Carl Icahn, Now Former Warren Buffett Co-Manager Lou Simpson Invests in Chesapeake Energy

Corporate activist investor Carl Icahn timed his 6% investment in natural gas driller Chesapeake Energy (CHK) almost perfectly earlier in 2011, buying in the low 20’s and selling in the mid 30’s a few months later after extracting a publicly announced debt reduction plan out of management. Now, with the stock back down to prices even lower than where Icahn originally bought, Lou Simpson (former GEICO executive and Warren Buffett number two investment manager at Berkshire Hathaway (BRK)) has bought 200,000 shares in the energy producer.

Simpson, long considered to be a possible Buffett successor despite only a small age difference, retired from Berkshire in 2010 but remains active as a director on three public company boards of directors. Chesapeake is one of the three and the latest. Interestingly, in recent months Simpson has sunk more than $5 million of his own money into Chesapeake stock, at prices in the high 20’s. This is a rare move for Simpson, who typically does not make moves in the public eye like this. As a director though, he must update his holdings in Chesapeake whenever changes are made. I find this move especially telling because in the case of the other two public companies he is involved with, he has largely been given stock options in return for his service, whereas direct open market purchases are rare for him. Often times new directors make small investments (say, a few thousand shares) to show public support, but Simpson has made two separate purchases of 100,000 shares each, for more than $5 million in total.

Now, some may point out that Simpson is worth a heck of a lot of money, so $5 million to him may be peanuts relatively speaking. And I can’t argue that point, but given Simpson’s investment savvy, coupled with the fact that he has not done this with the other companies he serves, I think it is worth noting and is likely due to his belief that the stock is actually quite attractive.

CHK shares, as mentioned previously, are down a lot in recent weeks, as natural gas prices have sunk to $3 and the company continues to spend more on exploration and production than it brings in (to the detriment of equity holders), but it is now even cheaper than it has been previously. And given that Icahn was very successful with his first investment in CHK, I would not be surprised if he got back in, now that the stock price has given back all of the gains he booked, and more. Chesapeake investors, myself included, have been frustrated a lot in recent years, but these recent buys by Lou Simpson strengthen the case that giving up now might be a mistake.

Full Disclosure: Long shares of CHK at the time of writing, but positions may change at any time

Buffett, Of All People, Should Know It Hurts Shareholders to Telegraph Buybacks Ahead of Time

One of my pet peeves is how frequently public companies announce stock buyback programs before they buy a single share. If you are buying back your stock because you believe it is undervalued, and you know that announcing your intentions is going to give a boost to the stock, you are essentially screwing over your shareholders. Why pay more than you have to for the shares you want to repurchase? Today we learned that Berkshire Hathaway (BRKa /BRKb) has authorized share buybacks at prices up to 110% of book value. I am kicking myself because I took a hard look at this stock last week, concluded it was very attractive, but didn’t rush in to buy any. After all, what catalyst near-term could possibly boost the stock that much in a volatile market? Well, a telegraphed buyback program is about the only thing. And today the “B” shares are up nearly $5, or 7%, to just under $71 per share. They looked good at $66, but much less so now.

Isn’t Buffett smarter than this? If he could have bought the stock at $66 why put out a press release and drive your potential cost basis up so much? Skeptics will say he has no intention of actually buying the stock… that it is just a way to give the stock a boost without committing any capital. Perhaps this will prove true (Buffett thought hard about it decade ago but never actually bought any) but I hope not. The stock really is cheap, and Buffett of all people knows this. I cannot figure out why he wouldn’t buy the stock first, and then announce the amount purchased and price paid. That too would give the stock a jolt to the upside, but it would actually benefit shareholders too. This announcement really seems silly. Other companies do it all the time, but I expect more from Buffett.

Some might argue that disclosing the buyback authorization is a Reg FD issue but I would respectfully disagree. Reg FD is supposed to protect certain investors from getting information earlier than others, thereby providing a level playing field for everyone. Failing to disclose the buyback plan ahead of time does nothing to give anyone a leg up on others. In fact, it treats everyone equally (nobody learns of the plan) and beneficially (all shareholders profit from the accretive nature of the repurchases, which were done at the lowest price possible).

We will see if Berkshire stock holds today’s 7% gain. If it does and Buffett doesn’t buy any shares, not only will this announcement have been a waste of time, but more importantly, he will have balked at a great opportunity to make money for Berkshire shareholders.

Full Disclosure: No position in BRKa or BRKb at the time of writing, but positions may change at any time

Did David Sokol Lie About His Lubrizol Trades on CNBC?

It appears David Sokol picked a bad time to resign from Berkshire Hathaway (BRKA) to start his own “mini Berkshire” investment firm. After appearing on CNBC this morning to try and get out in front of the media blitz regarding his trading in Lubrizol (LZ), Sokol didn’t do himself any favors on national television. Oddly, perhaps the most least talked about detail in press reports today was the explanation Sokol gave on CNBC when he was asked why he bought 2,300 shares of Lubrizol on December 14th, sold them a week later, and then bought them again two weeks after that (in early January). On the air Sokol claimed the sale was for “tax planning purposes” and nobody seemed to question that.

Of course, the problem with that explanation is that when you sell a stock at a loss and want to use that loss to cancel out other gains for the year (which is what Sokol was referring to when he said “tax planning”), you must wait 30 days before buying the stock back again. This is a very well known law called the “wash sale rule” and there is no way Sokol (or his tax advisor if he uses one) is unfamiliar with it. It appears that Sokol may been hiding the truth when he used the “tax planning purposes” defense. Either he is lying about his reasons for selling the stock, or he is unaware of the tax rules and routinely deducts losses even when he violates the wash sale rule.

And to think Sokol was considered a leading candidate to take Warren Buffett’s place. Berkshire Hathaway shareholders really caught a break there…

Update (6:30pm)

The first commenter below has pointed out that Sokol appears to have earned a profit of about $5 per share from his initial LZ sale. In such a case, wash sale rules would not have applied. It is a shame that Sokol did not provide a crystal clear and more detailed explanation for his actions, as opposed to having others speculate. But in terms of this particular speculation on my part, it does appear that Sokol sold the 2,300 share lot of LZ in order to avoid paying taxes on the gain, as opposed to offsetting gains elsewhere with a loss on the LZ position. Thanks to Michael Kelly for the insight. -CB