The investment thesis
The thesis of this article is really simple – under the current conditions, Apple (AAPL) provides far superior returns for long-term investors than the overall market. The key argument is built on the following chart. This chart is also the roadmap that we use in our marketplace service to pick our tactical holdings. Having a coherent investing roadmap keeps us clear-headed, especially under challenging times like this.
You will see from the following chart, AAPL is projected to provide about 11% annual return (“ROI”) in the long term, while the overall market is only about 6.5%. The fundamental reason is AAPL’s far superior ROCE (return on capital employed) over the market average, which gives it the ability to grow without the need for too much capital and subsequently can return most of the earnings to shareholders (either as dividends or share buybacks).
The key is to think like a business owner, not a stock trader. The long-term ROI for a business owner is simply determined by two things: A) the price paid to buy the business and B) the quality of the business. More specifically, part A is determined by the owner’s earnings yield (“OEY”) when we purchased the business. And that is why PE is the first dimension in our roadmap. Part B is determined by the quality of the business and that is why ROCE, the most important metric for profitability, is the second dimension in our roadmap.
Now, the long-term growth rate is governed by ROCE and the Reinvestment Rate. These are the two most important growth engines, and they mutually enhance each other. High ROCE means every $1 reinvested can lead to a higher growth rate, which leads to more future profits and more flexible capital allocation to fuel further growth, and so on. So to summarize:
Longer-Term ROI = valuation + quality = OEY + Growth Rate = OEY + ROCE*Reinvestment Rate
The remainder of this article will show how the above roadmap applies to AAPL.
How did our roadmap perform?
Before going into further details, you must be wondering if our above roadmap really works. So let me provide a bit of background of our investment philosophy and history. My family is in the final stage toward retirement (after about 15 years of work). We have been applying this method consistently since 2012 (we started developing it around 2007 and it took us a few years to mature it). We hold a rather concentrated portfolio with about a dozen tickers diversified across different asset classes. Our own journey has shown that A) having a coherent investing roadmap keeps us clear-headed, especially under extreme market junctures, and B) sticking to FEWER but well-understood holdings not only generated higher returns but also at LOWER risks despite the fact that we consistently applied leverage.
Currently, our stock portfolio holdings are shown in the next chart. Using the date I first published it on 5/31/2021 as the inception date, its performance relative to the S&P 500 (represented by SPY) is shown below, and also plotted on a weekly basis in the second chart. The chart plots a really short timeframe compared to our horizon, and there is no need to read too much into the specific numbers. At their current level (plus and minus a few %), they can all change within a few days of random market fluctuations. Note that AAPL has been a legacy holding, and its returns are not included in these charts (otherwise, it will completely dominate the picture).
And cells highlighted in blue put these holdings on the roadmap. As you can see, they all tend to be stocks with a good combination of quality and valuation – and that is how we have achieved healthy returns in a consistent, and equally importantly, relaxed way with only a handful of holdings.
AAPL’s owners’ earnings yield
Now, with the above background, let’s see how our roadmap is applied to AAPL.
First, we need to analyze AAPL’s owner earnings. The owners’ earnings are different from the accounting earnings because of the CAPEX expenses. The CAPEX expenses for a business are the sum of two parts: the maintenance CAPEX and growth CAPEX. Maintenance CAPEX is the mandatory part to keep the business running and should be deducted from owners’ earnings. However, the growth part is optional. It should be considered part of the owners’ earnings because it can be returned to the owners if the owners decide not to grow the business anymore – a key insight that investors like Buffett have been promoting for decades.
With this understanding, the following table shows my analysis of AAPL’s maintenance CAPEX, growth CAPEX, and owners’ earnings. This analysis is performed by Bruce Greenwald’s method. Readers interested in more details could take a look at my earlier article and are highly recommended to take a look at Greenwald’s book entitled Value Investing. As shown, AAPL’s owners’ earnings are about $5.8 per share. And it is higher than both its free cash flow and its accounting EPS.
Now, with the owners’ earnings of $5.8 per share and its current share price as of this writing, the OEY is about 3.8%.
AAPL’s return on capital employed (“ROCE”)
The next issue is profitability. As aforementioned, the most important profitability metric in my opinion is ROCE because it measures the return of capital ACTUALLY employed in a business. Details of AAPL’s ROCE analysis have been provided in my early article already and here, I will just directly quote the result.
It maintains a remarkably high level of ROCE, on average about 100% in recent years. And this calculation considers the following items capital employed A) Working capital, including payables, receivables, inventory, B) Gross Property, Plant, and Equipment, and C) Research and development expenses are also capitalized. The next chart helps to put things under perspective. You can see that AAPL’s ROCE is not only spectacular on an absolute basis, it is also the highest among this group of overachievers.
AAPL’s capital allocation flexibility and reinvestment rate
Next, let’s see the reinvestment part. In recent years, the following is how AAPL has been allocating its operation cash (“OPC”). AAPL has been using on average ~33% of the OPC as maintenance CAPEX and dividends. So these two “mandatory” have been on average costing only 1/3 of AAPL’s operation cash in recent years. The quotation mark means even though the dividend is usually considered an optional cost. But for a stock with AAPL’s status, management probably won’t cut it unless they really have to.
For the remaining 2/3, the company does have a choice. It can use it for a variety of things: reinvest to fuel further growth, retain it to strengthen the balance sheet, pay an extra special dividend, pay down debt, buy back shares, et al. It obviously makes total sense to reinvest all of it to fuel further growth, given its 100% ROCE. At this ROCE, $1 reinvested would be fuel $1 of additional earnings! But the problem is that for businesses at this scale, there are just not that many opportunities to reinvest the earnings. As a result, AAPL has been allocating a part of the remaining earnings, on average 70% in recent years, to buy back shares. Such repurchases, besides reflecting the good problem of having too much cash, again also signal the lack of good reinvestment opportunities.
All told, AAPL has been reinvesting “only” about 7.5% of its earnings to expand the capital employed in recent years. So it could maintain a 7.5% long-term growth rate (PGR = ROCE * fraction of earnings reinvested = 150% * 5% = 7.5%). This is a reason that AAPL can afford to return pretty much all the OPC to shareholders (either via dividend and/or share repurchase) after covering its maintenance CAPEX.
Now we have all pieces of the puzzle in place, and we can go back to the roadmap again.
Back to the roadmap
At its current price levels, the OEY is ~3.8% as aforementioned. The growth rate is about 7.5% as estimated above, resulting in more than 11% ROI already! This is a key insight that we’ve learned from Buffett – when you think like a business owner, you do not need a 10% growth rate to achieve a 10% return.
The road map below shows the ROI based on an assumption of a 10% reinvestment rate, which is the average rate for the large and mature businesses in the S&P 500 index. Admittedly, AAPL’s reinvestment rate is not as high as 10% for the reasons mentioned above. So the total ROI would be a bit lower than what is shown in the roadmap below. However, note that AAPL’s strong cash generation capability does provide the optionality to crank up reinvestment rates or to boost growth through acquisitions.
In contrast, the overall market is currently valued at about 26.5x PE, resulting in an OEY of about 3.8%. However, the overall market’s ROCE is on the order of 20% or so. And with a 10% reinvestment rate, the growth rate would be about 2%, leading to a long-term ROI of about 6% per year.
Our approach has its own risks and limitations. First, not all the stocks on our roadmap picks are winners and some of them suffered quite large losses (like BABA). Second, this approach won’t be too useful to pick early-stage growth stocks. The approach relies on A) evaluating the profitability and B) pricing the stock based on its profitability. Growth stocks in their earlier stage typically have no profitability and hence provide no basis for either A or B.
As to the risks specific to AAPL, first and foremost, I do not see any structural risk associated with AAPL at this moment. Remotely, there might be an anti-trust regulatory risk. But even if it comes to that, I am not entirely certain if it will be bad for AAPL investors for sure. If it really comes to that and the company has to be broken up, the market would be forced to value each of its business segments separately. And such a complete and transparent valuation may or may not result in a lower valuation.
There can be significant short-term volatility risks too. Regardless of AAPL’s scale and business model, the valuation is at a high level, and the overall market itself is also near a historical record valuation. There are several large macroeconomic and geopolitical uncertainties unfolding right now, including the pandemic, Ukraine conflicts, global logistic chain interruptions, and Fed’s interest rate decisions. Such a combination of high valuation and high volatility certainly could cause short-terms risks – but are irrelevant for the long term.
Conclusion and final thought
When we invest like a business owner, not a stock trader, our long-term ROI is simply the sum of two things: A) the price paid to buy the business and B) the quality of the business. In AAPL’s case, it will provide a far superior return for long-term investors than the overall market because of its far superior ROCE over the market average. Such high ROCE gives it the ability to grow without the need for too much capital and subsequently can return most of the earnings to shareholders (either as dividends or share buybacks).
At its current price levels and reinvestment rate, the OEY is about ~3.8% and the organic growth rate is about 7.5%, resulting in more than 11% ROI already. Furthermore, AAPL’s strong cash generation capability also provides the optionality to crank up reinvestment rates if it sees the need or to boost growth through acquisitions.
And as a final note, this might be the most valuable insight that I’ve learned by studying Warren Buffett’s – we do not need a business with double-digit growth to generate double-digit returns. A business that offers reliable growth at a boring rate of a few percent (say ~5%) can already provide double-digit returns with good certainty as long as A) they are purchased at a reasonable valuation, and B) they have ROCE sufficiently high so that the growth can be driven by reinvesting a small fraction of the income. In the long run, assuming a growth rate substantially above 5% probably is a dangerous assumption to start with anyway.