Apple is a Top 10 Stock

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Any good diversified equity portfolio should have a core group of stocks that the investor considers best-in-class and representative of the portfolio's key objectives.  It has been proven time and again that taking a long-term view of stocks, particularly those at the foundation of a portfolio, can help generate market-beating returns.  This is a first in a series of blog posts that outline the 10 largest holdings in my personal portfolio, with insight into the original investment thesis and current discussion on the business and stock valuation as a basis for discussion of whether the company might be a candidate for the core of your portfolio.  There's no better place to start than my oldest, largest holding, that is even a terrible pun at the "core" of my portfolio... Apple (NASDAQ: AAPL).  

The Investment Thesis

Not that I even knew who Peter Lynch was when I first invested in Apple as a teenager, but my investment in Apple was initially based in his sage wisdom to "invest in what you know."  At the time, all I knew was that I liked Apple's Macintosh computers better than anything with Microsoft's (NASDAQ: MSFT) Windows operating system.  Since then the investment thesis for Apple has grown tremendously in both size and complexity, just as the company has.  Apple isn't just a manufacturer of computers with a small cult following. Apple, today's largest company by market capitalization, is a solid investment in my opinion for the very reasons that make it the world's most valuable company:

  • Apple's brand is the second most valuable on the planet behind only Coca-Cola.  This is the direct result of constant innovation and the continuous release of high-quality products.  How does being a sought after brand matter to Apple?  Well, it is quite significant as illustrated by millions of people lining up (either in person or online) to buy the next great Apple device or Apple's ability to generate incredible increases in revenue during a worldwide economic slowdown.  Quite simply, the fact that Apple makes the best consumer devices on the planet makes it immune to a lot of pressures facing other companies.
     
  • The ability to innovate.  Each year, Apple delivers an entirely refreshed lineup of products that are thinner, faster, lighter and more feature-rich than the previous model without increasing the target price range.  Moreover, Apple has repeatedly expanded its lineup of products with new devices.  The iPad is a fantastic example; Apple more or less created a mass market for tablet computers that did not previously exist.
     
  • The halo effect.  Among the many advantages that Apple's devices have are a uniquely convenient way to make different types of devices communicate seamlessly.  Have an iPhone?  Take a picture and it is instantly on your iPad and iMac thanks to Photo Stream.  The result is a phenomenon know as the halo effect, in which a consumer's satisfaction with one Apple device and the seamless integration functionality encourages them to purchase another, and another.   A CNN report from earlier this year noted: "51% of U.S. households own at least one Apple product... Of the households that own Apple products, they own an average of three, making the overall ownership rate of the American public 1.6 Apple products per household. About 25% plan to buy another Apple product in the next year."  It doesn't just stop at hardware purchases; more devices means more app, song and movie downloads, which further fuel Apple's growth.
In short, Apple makes the best computers, smart phones and tablets available.  Consumers recognize the tremendous innovation behind these sleek, well-made products and literally line up to pay prices that are equal to or greater than other products offered in the marketplace.  
 
Recent Performance

To see just how dramatically Apple has grown, I think it is helpful to look at a few financial metrics visually.  Here is Apple's TTM revenue trend over the past 10 years:

<img src="http://media.ycharts.com/charts/2a353324f6c5f0d2f621cb36ccd6f77d.png" />

Similarly, here is Apple's TTM net income and free cash flow over the same 10 year period:

<img src="http://media.ycharts.com/charts/933c8b1b534532365fa5227e330531e9.png" />

Take note of the scale of the y axis of these charts in order to understand just how staggering this growth is.   As you likely are aware, the company's stock has followed a similar path: 

<img src="http://media.ycharts.com/charts/5d41fd85143c29c000ff11db6d4b2c90.png" />

Valuation

For anyone that looks at Apple's stock price over $500 per share and assumes that makes the company "expensive" on that basis alone, please read this before continuing.  By most popular metrics, Apple's shares are incredibly cheap. Here are a few data points of note:
 
<table> <tbody> <tr> <td> </td> <td><strong>Apple Valuation as of 11/14/12</strong></td> </tr> <tr> <td>TTM P/E Ratio</td> <td>12.30</td> </tr> <tr> <td>Forward P/E Ratio</td> <td>9.26</td> </tr> <tr> <td>PEG Ratio</td> <td>0.49</td> </tr> <tr> <td> </td> <td> </td> </tr> <tr> <td>Free Cash Flow Yield</td> <td>8.3%</td> </tr> <tr> <td>Cash Per Share</td> <td>$128</td> </tr> <tr> <td>Dividend Yield</td> <td>2.0%</td> </tr> <tr> <td>Dividend Payout Ratio</td> <td>6.0%</td> </tr> <tr> <td> </td> <td> </td> </tr> <tr> <td colspan="2">Source: Yahoo! Finance - 11/14/12</td> </tr> </tbody> </table>
 
The current valuation is something that you might expect for a company growing at 10% or less per year, not one with a trend like the charts above.  So, this means one of two things: Apple is a screaming buy today, or the investing world is predicting the beginning of the end for Apple's historic run.
 
Things to Keep an Eye On
 
To answer the question of whether Apple is dramatically undervalued today or is beginning an inevitable decline (or somewhere in the middle), it is important to look at reasons to be cautious.   A recent article on the Fool.com's website lists a number of reasons why Apple's recent decline may not be over quite yet.  For me, the risks facing Apple today fall into three simple words:
  1. Competition - Competition is nothing new to Apple, but the range of competitors challenging Apple continues to increase as its product portfolio diversifies.  What was once a single battle line drawn between Apple and PC manufacturers like Dell and HP running Microsoft's Windows operating system now includes a range of challengers in the tablet and smart phone markets as well.  For example, Google's (NASDAQ: GOOG) Android operating system has opened a significant lead in worldwide market share for smart phones.   Likewise, Apple's initial dominance in the tablet market has lessened as competitors have caught up with new releases that have eroded Apple's market share to around 50%.  But another key consideration is that competition is no longer limited strictly to the sale of hardware.  Apps and digital media (music, videos, books, etc.) are a big portion of Apple's business today.  Google licenses Android to as many device manufacturers as possible in an effort to gain a foothold in this portion of the business.  E-Commerce retail giant Amazon.com (NASDAQ: AMZN) has even captured 9% of the tablet market as it seeks to find new ways to draw customers to its media offerings.  
     
  2. Innovation - Apple's explosive success over the past decade has transformed the way people listen to music and dramatically advanced mobile computing (through smart phones and tablets).  With large, deep-pocketed competitors beginning to catch up, the big question is: how does Apple maintain its competitive advantage?  Is it an elegant solution to home entertainment (whether it be a next-generation smart TV, an upgraded Apple TV that replaces existing cable boxes, a tablet that functions as a universal remote for the home or any of the other speculations over the past couple of years)?  While incremental improvements that make the current product line faster, thinner, cheaper and more functional will keep the business growing, significant outperformance of the market and success against the competition from this point forward requires a catalyst to power the next wave of growth at Apple.  The difficult part of this is that we don't know what it will be.  And even if we did, it took the market a long time to appreciate the disruptiveness of the iPod, and the iPad was initially received with negative reviews by the investment community.  Meanwhile, competitors aren't standing still.  Google's acquisition of Motorola Mobility and its Google Fiber experiment show very clearly that the company wants to gain control of consumers' home entertainment.  Can Apple keep pace?  There's more at stake than simply the sale of a new type of consumer device; the halo effect that drives Apple's success depends on there being a full suite of seamlessly integrated products.  Failing to successfully compete in a market that Google enters puts this effect at risk as consumers might opt to convert to an entirely Google electronics ecosystem.
     
  3. Execution - Part of what has created the hype around Apple's products is quality.  This quality is both physical (in terms of device materials and appearence) and functional (in terms of system stability, features, etc.).  Some of the issues like "Antennagate" or "Mapgate" have been little more than trumped up headlines, but the recent executive shakeup certainly leaves a few questions whether Apple's execution is as flawless as some had come to expect.
I'm Comfortable With Apple as My Largest Holding
 
There are risks facing every company, especially those at the frontier of technology.  Just look at Palm (remember them?  sadly, I do... it was one of my largest holdings during the peak of the dot-com bubble), or even Research in Motion; it doesn't take long for a first mover in an area to lose its relevancy.  However, I think the positives continue to significantly outweigh the risks for Apple.  From an operational perspective, the company is delivering tremendous results worldwide and there is really no sign of that changing anytime soon.  There is certainly competition, but my personal opinion as a user of a number of devices is that Apple continues to offer the best products.  Plus, the growing markets for smart phones and tablets worldwide provide significant room for the success of multiple companies; I expect Google to outperform the market over the foreseeable future as well, so this is not necessarily a binary decision of picking a single winner.
 
In addition to making best-in-class devices, Apple provides the unique opportunity to invest in a mega cap with substantial growth opportunities at a bargain valuation.  As noted above, the current valuation is cheap by pretty much any metric.  This provides a significant margin of safety for potential investors just in case the investment thesis doesn't quite play out like Apple's recent performance would suggest.


BrewCrewFool owns shares of Amazon.com, Google, and Apple. The Motley Fool owns shares of Apple, Amazon.com, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Amazon.com, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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