Friday, March 30, 2012

Apple: Another Cisco?

Apple is undoubtedly one of the world’s great companies.  Its succession of unique products has customers lining up out the door when new products become available.  In addition, the company is just beginning to penetrate the huge Chinese market.  What’s not to like as a consumer and as an investor?

It is indeed a great story with superior products, esteemed management, and seemingly unbounded prospects for continued growth.  It has become 4% of the S & P 500 stock index and is considered a “must own” stock by individuals and professional investors alike.  With the stock up 49% in the past three months, and 537% in the past five years, competitive pressures and career risk concerns have led fund managers to load up on the stock to avoid being left behind benchmark indexes and peers.  Similarly, Wall Street analysts have embraced the juggernaut, with 46 “buy” ratings, 5 “hold” ratings, and one “sell” rating.  When a stock has seemingly everything going for it, there is too much career risk for investment professionals to be skeptical.

Apple now has a total stock market value of more than $550 billion, making it only the sixth U.S. company on record to be valued at more than $500 billion.  This reminds me of a similar phenomenon in the technology sector more than a decade ago. 

At the peak of the Internet mania in the late 1990’s, Cisco was also valued at more than $500 billion in the stock market.  As the leading producer of networking equipment for the Internet, its revenues and profits soared, along with its shares. 

The top performing funds at the time had large stakes in Cisco.  The soaring stock helped those investment funds produce superior returns, which led investors to pour more and more money into the mutual funds.  The mutual fund managers then bought more Cisco, driving its price up, which lead to even better returns, and so on, producing a “virtuous circle” for Cisco stock.  Early in 2000, the company reported sales growth of 53% and earnings growth of 47%.   With the stock then at $80 per share (split adjusted), it was hard to see what could stop the virtuous circle.

But the virtuous circle did stop.  Today Cisco is a $21 stock, down 75% over the past twelve years.  It’s not that the company prospects collapsed.  Sales tripled and earnings grew approximately 150% during that time.  It’s just that at $500 billion, expectations and valuations were extremely high, and a number that large makes sustaining large percentage gains increasingly difficult.   In early 2000, one could have taken the $500 billion invested in Cisco stock and bought the entire outstanding stock of two dozen of the world’s leading companies.

With Apple stock valued today at more than $550 billion, does Apple face a similar risk?  Yes and no. Yes, since once again the $550 billion invested in Apple could be used to buy the entire outstanding stock of more than 20 leading companies.

No, in that the main difference in Apple’s favor is its valuation compared to Cisco in 2000.  Cisco had a price/earnings ratio of 130, and a price/sales ratio of 30.  Apple sells for 14 times earnings (about average for the S & P 500) and 4 times sales. 

This is a crucial difference, since valuation is the most important determinant of long-term stock market returns.  With Apple fairly valued—if not undervalued—it seems unlikely to face the problems for its investors that Cisco experienced.

But, with the stock up so sharply and with almost unanimous enthusiasm among professional and individual investors alike, it would be prudent to trim holdings.

Steven Lehman

Apple:  600

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