Apple (NASDAQ:AAPL) bears are out in force. I even heard an analyst come on TV and say, “Someone should tell the market that Apple is not growing but is priced with a growth multiple,” or something to that effect. Good one! Yes, that must be it. The tens of thousands of discerning institutional investors who feel comfortable with the world’s most prodigious stock must have missed something you uncovered in your tireless spreadsheet work, right? Wrong. Of course, he wasn’t actually short.
The market is always right. In my experience, if you think the market is wrong, you’re often cruising for a bruising, as the kids say. Remember that one participant can only ever ride a wave, not make them. There are a few people who can, but you’re not one of them, and neither am I.
Of course, the stock suffered last week when the Wall Street Journal reported that the Chinese government had banned iPhones for government employees. The Chinese government later denied this report. China’s foreign ministry spokesperson said the nation “did not issue any law, regulation or policy document that bans the purchase and use of cellphones of foreign brands, such as iPhones.” It reminds me of someone saying a diseased coyote is the infamous chupacabra. As with so many shrill deglobalization headlines, this one turned out to quite literally be a myth or rumor.
Wow. I’m sure they’re petrified over in Cupertino. In the worst-case scenario that this was true, Tech analyst Dan Ives estimated it would be a hit of half a million iPhones. Mr. Ives was remarkably prescient in saying this report had “more bark than bite.” Rather than being an actual impediment to Apple’s future earnings, this supposedly dreadful catalyst was more likely posturing by an increasingly desperate Chinese Communist Party to get concessions from the United States towards achieving a pre-COVID-esque economic detente.
It is undoubtedly true that Apple’s growth has slowed, but that elevated valuation all the bears harp on is actually a reason why this is less consequential. There was also a bit of a “puppy through the python” problem in the comps caused by excessive performance during COVID-19.
But let that sink in; the stock is having bad comps because it performed immaculately during the worst economic catastrophe faced by the world in modern history. This is also one of the very reasons it enjoys a premium valuation, but there are many more. There are a lot of reasons why a company can enjoy an elevated valuation compared to peers:
- Superior or dominant competitive position
- Superior margins or growth
- Strong brand and connection with the consumer
- Solid prospects for growth far into the future
- Strong financial position and a lot of cash
Apple benefits from all these characteristics, which puts its valuation in a more sympathetic light, in my opinion. Remember that blind value investing can often end up with a portfolio full of trash, and that quality is rarely cheap. When a company’s valuation is elevated like Apple’s, this effectively means that current earnings (and I’ll include earnings one year out in the definition of ‘current’ for my purpose here) become less and less proportionally important for the total valuation.
The P/E ratio is a multiple of current earnings. So, the higher the P/E, the lower the proportion of the valuation derived from next year’s earnings. Now, if it’s a volatile P/E for a company with little revenue, that’s one thing. But Apple earned its stripes and has delivered on the critical Services story.
It’s like how different risks affect prices across different ends of the yield curve differently. If you’re a high P/E big boy like Apple, next year’s earnings are less important than your long-term prospects. Suppose you’re a small company that hasn’t grown into your valuation. In that case, that’s a different story, but people acting like a 30 P/E for Apple is preposterous are taking a rather juvenile valuation viewpoint, in my opinion.
Thus, the higher the P/E ratio, the less critical the following year’s earnings are for the valuation. A high P/E with high revenue means something different since a nosedive would require tens or hundreds of millions of people to change routine purchasing behavior quickly. However, when you look at Apple compared to peers, its valuation advantage is significant but maybe less so when considering its entrenched competitive position and all the advantages being the world’s largest company entails.
But the fantastic thing about Apple is that you can define its peers in many ways. Apple has a net income that dwarfs the size of all these competitors, but as a massive hardware company, you might expect it to have lower margins. Yet, it is competitive with peers on margins across many different peer groups.
So, it makes a lot of sense to short a company that is highly overvalued and doesn’t have a lot of future prospects to turn ideas, even great ones, into revenue. However, when you’re asking yourself whether a company has prospects of deriving a lot of growth from investing investor capital over the next few decades, I find financial effectiveness most important. In this area, Apple exceeds so exceptionally that I think it suggests the current valuation premium compared to peers is not only justified but might suggest it is currently a bargain.
I certainly understand the bearish arguments on Apple. Indeed, I think I can state and articulate them better than most. Yes, friends, I understand the allure of shooting at the Death Star, as shorting Apple is sometimes colloquially called on Wall Street. This, of course, is not to denote Apple as an evil empire but rather to suggest a stock with the properties Apple has, and its unprecedented track record also can be a nearly indefatigable foe for reasons of thick derivatives markets and prodigious liquidity. Throw in a world-class buyback program, and you can see why shorting Cupertino can seem more like a suicide mission to those who have already tried.
Here’s another thing, though, and I think many analysts miss this. Apple not only has excellent profitability, but it also has a vast network with a lot of reliability. It’s the whole package: beauty and brains. That’s why the valuation is justified. If you look at some of the peers by revenue, you can see that Apple is in the leagues with companies with far lower margins. But Apple still has a lot of room for growth, and the high-margin services segment will likely contribute far more to earnings in five and ten years. The other companies on this list don’t have such a growth driver.
As you can see, Apple’s revenue is comparable to some massive companies with their roots planted firmly in the American economy. Yet, it still has the opportunity to find growth, both domestically and internationally. I think Apple and Tim Cook have deserved the benefit of the doubt on capital allocation, too. At the end of 2022, the Zhengzhou riots presented Cupertino with its most significant risk in years, and Mr. Cook and his world-class team have navigated that risk admirably.
Compared to this shock last December, the recent headlines about an iPhone ban for Chinese government workers have turned out untrue. If you want to view the light the Chinese Communist Party really views Apple in, consider that they put soldiers from the Chinese military on the line to plug interruptions from the riots in late 2022.
One of the reasons Apple has been able to keep costs lower than many peers is because the Chinese government gave them effective subsidization. I don’t think that subsidization will be eliminated now that the Chinese economy is relatively more dependent on Apple compared with ten months ago when riots threatened production in a big way.
This speaks louder about reality than what has likely been some recent posturing by Xi to try to coax America into an economic detente that most of the consensus thinks is unreachable. On the other hand, I think detente is inevitable. And even if the status quo remains, Apple is projected to grow significantly over the next five years. However, cooling tensions would likely help the firm outperform consensus expectations.
The Myth of Deglobalization: Why Apple Can Experience Multiple Expansion Despite Low Growth
What has become clear is that the first quarter of 2020, which saw the onset of COVID, was a point of no return for Chinese economic behavior, which began shifting in 2015, when the state extended its control: since then, bank deposits as a share of GDP have risen by an enormous 50 percent and are staying at that high level. Private-sector consumption of durable goods is down by around a third versus early 2015, continuing to decline since reopening rather than reflecting pent-up demand. Private investment is even weaker, down by a historic two-thirds since the first quarter of 2015, including a decrease of 25 percent since the pandemic started. And both these key forms of private-sector investment continue to trend still further downward.
-Adam Posen, The End of China’s Economic Miracle
We all know about China’s prolific rise, right? An economic miracle that guaranteed it would soon eclipse the United States has been in the American psyche for years. One of the few things that increasingly polarized and estranged political parties agree on is that we must rise to meet the China threat. Yet, it looks like Xi Jinping has already taken care of that for us, and in a way, this is simultaneously helping the Fed’s fight against inflation. Thanks, Xi!
One thing the bears are certainly right about is that Apple is dependent on China. This fact is beyond debate, and recent efforts to shift some production to India will take years to be meaningful. But this fact is a double-edged sword; China is also deeply dependent on Apple in many ways. And that dependence has grown since the expected economic recovery after zero-COVID (which was ended by defacto popular sovereignty) remained elusive.
Aside from the prodigious direct economic impact of the firm’s massive footprint in the country, it is and should be a great source of national pride that China has been at the center of Apple’s success, a fact which the firm’s management openly admits with pride. But facing economic and demographic headwinds, the relationship with Apple takes on an even more practical concern for the besieged Chinese Communist Party.
Suppose you think China was invested in Apple’s success last November when it rushed in Chinese military personnel to ensure production didn’t fall too far behind. In that case, they must be even more invested in their success now that they face a growing list of pernicious economic problems. And prosperity has been at the very heart of the Chinese social contract. Without it, the CCP’s grasp is likely much more tenuous than we would ever imagine from the outside.
China is increasingly looking like the “Sick Man of Asia” economically, and popular perceptions have yet to grasp this profound fact. The government’s intervention in the economy and retro embrace of dialectical materialism has spooked citizens and companies, and they’ve started preferring liquid assets like bank deposits instead of longer-term investments that require trust in the rule of law and protection from the whims of the state.
While it’s possible that Xi is emboldened and made more volatile by this fact, I think it is increasingly likely that China has little choice but to cozy up the United States and the community of nations. Of course, detente would benefit the US and global economies as well. Economic openness and a return to something resembling the pre-COVID economic status quo are now greatly in the party’s interest, which is always tinged with a heavy emphasis on self-preservation.
Risks and Where I Could Be Wrong
While I have focused on diminishing very attention-grabbing headline risks for Apple, that doesn’t mean other risks don’t exist. While there are advantages to being the world’s largest stock in terms of liquidity and derivatives markets, there are also downsides to being huge. Furthermore, suppose I’m wrong about deglobalization, and China really is a malevolent rising power bent on world domination. In that case, Apple and any other company heavily dependent on a Chinese presence will have perpetual problems.
While there have been some favorable resolutions on anti-trust issues, namely in a critical App Store case, there was recently a high-profile meeting on Artificial Intelligence in Washington DC, and Tim Cook was notably absent. If there is any truth to the building claim that Cupertino is dramatically behind its peers on AI, then the firm could have lackluster performance in more ways than one, given the rising importance of the trend. However, I don’t think this is the case. Apple is known for playing its cards meticulously and conservatively, and Mr. Cook’s prowess so far should give investors confidence.
However, Great Power standoffs are tricky matters, and despite leaders’ best intentions, sometimes subordinates can screw the pooch in bigger ways than we could ever imagine. Let’s flash back a few months to a meeting discussing a potential detente that was derailed by a spy balloon that China’s Xi Jinping apparently didn’t know about.
Apple is the world’s largest stock; like a massive wildfire, this gives it its own climate. A massive economy, bigger than many nations, exists in the options volume of this prodigious stock alone. There are certainly a lot of risks for the world’s largest company, and the days of its highest growth are likely behind it. But there is also a risk that China’s economic strength (which underpins the party’s political legitimacy) is slipping. This situation benefits Apple in the delicate balance of power between it and the Chinese Communist Party.
However, Apple has many amazing assets and strengths, including a world-class team that continues to shatter expectations and prove the doubters wrong. If you’ve ever known people who actually work in Silicon Valley, you might meet some people who have hopped around between Meta (META), Amazon (AMZN), and Google (GOOGL). But Apple is a different breed.
It’s a strict meritocracy where secrecy and compartmentalization are so extreme that playing company politics is almost impossible in the traditional sense we all know. One differentiating factor is that Apple was a maven of globalization and was always known to flourish in it. If globalization isn’t receding like consensus seems to think it is, then expectations are too low for Cupertino.
Daniel Ellsberg passed away a few weeks back. Before his fame from leaking the Pentagon Papers that likely helped shorten the Vietnam War, he was an analyst at RAND Corporation. One of his duties was re-working the cumbersome and obscene 1950s US nuclear strike plan. In this capacity, he gained access to the highest security clearances in the US government, including the Corona Spy Satellite Program, which revealed, despite Khrushchev’s claims to be turning out ICBMs “like sausages,” that the Soviets were at a severe disadvantage.
Of course, this didn’t prevent the Air Force from conducting an unnecessary nuclear buildup on the supposition that Soviet claims likely indicated a massive “missile gap.” It was a bluff, though. And like this past period of Great Power standoff, we are overestimating our adversary. But one thing is different. We were not economically enmeshed with the Soviet Union. American and Chinese businesses want to transact with each other, and ultimately, a more cordial economic posture between the US and China benefits both great nations.