“AAPL is the best investment of all stocks since 1926. Only 4% of all publicly traded stocks account for all of the net wealth earned by investors in the stock market since 1926….A mere 30 stocks account for 30% of the net wealth generated by stocks in that long period, and 50 stocks account for 40% of the net wealth.”
- New York Times analysis, “The Best Investment since 1926? Apple”, September 22, 2017“
An interesting 3Q17 factoid was that Apple surpassed Exxon as the company which has created the most shareholder value since 1926, as noted above, creating nearly $1 Trillion of shareholder value. If you own AAPL, you are an owner of the most successful stock of all time. Most of this value has been created since the June 2007 iPhone introduction 1, as opposed to the 90+ years it took Exxon to create shareholder value, accounting for all the spinoffs and splits of its original name, Standard Oil of New Jersey. Apple’s shareholder value creation was greater than that created by General Electric, IBM, Philip Morris (Altria), Coca-Cola, DuPont, General Motors, and Johnson & Johnson!
One reason for such an accelerated value creation is the superior returns of capital of emerging disruptors vs. legacy companies. Higher returns on capital means that a company can grow faster without tapping equity and debt markets for financing. Hence the current excitement in Technology, Social Media, and the digital economy.
LEADERS AND LAGGARDS IN 3Q17
Broad rally. In 3Q, the market had a broad rally as 10 of the 11 sectors were up 2, but the performance in each sector was concentrated amidst a number of names,consistent with the long-term performance of equities in the study cited above. For instance, the “Materials” sector was up 5.5% but most of the performance was driven by specialty chemical company “Albemarle Corporation”, ticker ALB. Albemarle has a rapidly growing Lithium division, with lithium used for the manufacture of batteries, and the market is excited about the use of lithium for battery-powered autos.
Energy and Oil Improving. In 3Q16, we were bullish on oil ($44/ barrel) as we wrote “….the current oil supply/ demand picture is unsustainable for global budgets, and bodes well for higher oil prices over the next few years.” At the end of 2016, there was optimism as OPEC announced that it would limit production. Fast forward one year and a combination of production declines and global demand growth has caused oil prices to trade above $51/ barrel, with many oil analysts believing $70 oil is possible within the next year. The energy sector was up 6% in the quarter, benefitting names like Apache, Methanex, and ConocoPhillips, which have underperformed the last two years. We believe the risk/ reward characteristics of some of these companies are favorable and will create shareholder value for those with a slightly longer time horizon.
Technology Lifting off. Technology shares continued to top the market in 3Q, being up 8.3%. Names like Google, Apple, PayPal, and Red Hat all produced excellent earnings and more importantly, high growth, which is being rewarded by the market in the current environment of low interest rates. While some of the valuations in the tech sector appear stretched vs. historical multiples, we continue to find value in the sector. Technology is disruptive by definition, and demand for specific technological innovation is increasing as companies retool their legacy businesses. For example, software infrastructure company Red Hat is benefitting as companies move their IT operations to the cloud, disrupting the likes of IBM and even Microsoft.
Consumer Staples. The one sector that produced a loss in 3Q was that of Consumer Staples, with names like Campbell Soup, Molson Coors, and J.M. Smucker each losing more than 10%, despite Smucker’s tag line of “with a name like Smucker’s it has to be good.”
The market is concerned about a few things with these companies, which are generally mature, cash cows operating in no-growth markets. Some of these markets even have no growth, with declining revenue due to deflation. Unit sales declines coupled with pricing declines often translates to a reduction in earnings and stock values.
CAPITAL ALLOCATION & VALUE INVESTING
“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.”
- Warren Buffet, 1992, paraphrase of John Burr Williams’ 1938 seminal book, “The Theory of Investment Value”
One of the primary roles that we undertake as your investment advisor is to monitor the strategic initiatives and capital allocation activities of the companies in which we own stock. Typically, when a company is in “high growth mode”, it is committing significant capital to new initiatives to try to expand its business. Think of Google, Apple, Facebook. These companies have done extremely well the last few years as they have allocated large amounts of capital at high rates of return, coupled with significant scalability of their business models.
On the contrary, mature businesses (ie Coke, Cisco Systems, DowDuPont) often find themselves unable to deploy significant cash flow being produced, given constraints on new markets and new products. So they turn to one of three places to deploy said cash: paying dividends, buying back stock, or making an acquisition to show growth, albeit inorganic growth. We generally prefer the first two activities for use of free cash flow, as mature companies frequently pursue a “growth-at-any-price” acquisition strategy and overpay for acquisitions simply in order to show revenue and earnings growth.
Since 2007, the stock values of companies with ample growth opportunities (often termed “growth”) have outperformed those of companies that have limited growth opportunities but are producing high cash flows (often termed “value”). We believe two scenarios could change this and that investment accounts should have a mix of both “growth” and “value” names.
Interest rates may raise. When interest rates increase, financing growth becomes much more difficult. Those companies with ample cash flow, however, have a competitive advantage against lesser financed, more nimble competitors. The Federal Reserve has hiked rates marginally over the last year, but the cost of corporate borrowing has not been affected yet. However, stay tuned for a Fed that appears to want to hike rates further.
Tax code changes are afoot. Congress is currently constructing a tax package and one of the outstanding items is that of the capital gains rate, currently 15% to 20% depending on one’s tax bracket. If an investor is sitting on a significant gain (“growth”), and may have a lower capital gains tax rate beginning January 2018, what is their incentive to sell? Alternatively, those with losses in stocks and need tax losses will sell their losers (“value”). We believe that some allocation to “value’ names is prudent.
We are cognizant that the current bull market began in 2009 and may appear “long in the tooth.” However, corporate earnings in 3Q17 were generally strong and the FOMC stated that the U.S. economy is improving. The FOMC is committed to higher interest rates, yet we remain bullish on equities, particularly in light of equity valuations vs. bonds, improved growth in the global economy, stimulative effects of lower US tax rates, and belief that marginally higher interest rates will not choke growth within the US.
David H. Cunningham
Scot Labin, CFA
Director of Research
1 “So we’re gonna reinvent the phone….with a revolutionary interface. Why do we need a revolutionary interface? What’s wrong with the Motorola Q, Blackberry, Palm Treo, and Nokia E62? They don’t work because the buttons and controls can’t change down the road if you think of another great idea you want to add to this product……”
- Steve Jobs, 2007 iPhone introduction
2 The S&P500 is broken into 11 “GICS” sectors. Google the term “GICS sectors” for a list of this breakout.