It’s not Apple’s fault, it’s ours

January 24, 2013

By James Saft

(Reuters) – The problem, investors, lies not in Apple but in ourselves.

Apple’s disappointing earnings report and its subsequent 10 percent-plus stock market fall on Thursday are a timely reminder that there are a lot of idiots out there.

The issue – and your source of risk as an investor – isn’t just Apple, but rather the panting hoard of trend following investors who drove its stock price so far above a reasonable valuation.

Apple is a great company making great products, and has an outstanding record of creating new markets. It enjoys margins closer to those of a software company than a consumer giant, has more than $130 billion in cash and a historically unique franchise, one it has been able to expand time and again.

That’s a great company, but, word to investors, not one that can be counted on to grow and profit in the future at similar rates to the past.

Apple isn’t expensive on a price/earnings basis, it is phenomenal, and phenomena often don’t sustain themselves over time.

That’s clear from its gross margins, which fell to a still very high 38.6 percent compared to 44.7 percent in the year-ago quarter, and which are expected to range between 37.5 and 38.5 percent in Apple’s second quarter of fiscal 2013. Those are astounding numbers, but likely ones which, even in an innovative, well run and healthy business, will head downwards over time.

To justify the pricing on Apple at its peak, the company would have had to be able to create new categories of goods consumers were willing to pay up for, or open new markets. That’s possible, but you don’t pay for that in advance.

And this isn’t about the death of Steve Jobs. Steve Jobs, great as he was, was over-rated by investors, who projected on to him a superhuman ability to will reality to change. Jobs’ habit of refusing to accept reality did allow those around him to do great things – more than they would have imagined – but exceeding expectations is a lot harder when you are the biggest and most highly regarded.

RISK IS OTHER PEOPLE

Yet investors continued to drive Apple shares up, counting on it to bend reality to its will over and over. The saga of Apple is actually a great lesson in a fundamental truth of investing – most of your problems, and opportunities, come courtesy of other investors. Though we spend most of our time studying company fundamentals, or economics or even politics, we are likely to make our biggest mistakes when we play the ball and not the man.

“Much (perhaps most) of the risk in investing comes not from companies, institutions or securities involved,” famed hedge fund manager Howard Marks of Oaktree Capital Management wrote in his most recent client letter. here “It comes from the behavior of other investors.”

Marks remembers the fad for the “Nifty Fifty,” a group of standout corporations whose performance was fantastic in the late 1960s and early 70s. They were well managed, but also overpriced. Investors, lemming like, piled in. Many of the Nifty Fifty fell by as much as 90 percent from their in-vogue peaks.

Investors, Marks understands, set the price at which you can get access to the stream of income a given security represents. They can set it too high, like Apple recently, or too low, like junk bonds in the 1970s.

The Apple phenomenon is as much about crowds and fund manager benchmarking as it is about expensive gadgets and the affinity of affluent older people for iPads. First Apple was an innovation phenomenon, but then it became a financial markets one. As it worked towards becoming the most valuable company on the planet, fund managers saw their own performance lag the benchmark if they sat the party out.

Performance against a benchmark drives fund flows, compensation and job security, so doubtless many professionals got on the bandwagon despite themselves.

So it is with Apple, so it was with subprime, so it will be in the future.

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns atblogs.reuters.com/james-saft)

(Editing by Chizu Nomiyama)

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