Apple vs. Correlation fatigue and the ETF bubble

Recent commentary in financial press (e.g. FT Alphaville » Lost in correlation fatigue and The Herd Instinct Takes OverAmber Waves of Pain)  points out how the markets have become insensitive to fundamentals or valuation itself.

Symptoms of this are:

  • Global markets trading in lock-step.  In an apparent blindness to any local differences, markets from emerging economies to Japan and to London trade in perfect correlation.
  • Crude oil and other commodities are mis-priced due to HFT or algorithmic trading which ignores underlying supply and demand fundamentals.
  • Value investors find that there is lack of dispersion among stocks.
  • Component stocks’ correlation to the S&P 500 is at highest level since ’87 crash, reaching a high of 83% vs. average of 44% since 1980.
  • ETFs (exchange traded funds) maintain (or freeze) over- and under-valuations.

Structural changes such as the proliferation of exchange-traded funds and super-rapid computer-based bloc trading, activities that are totally unconcerned with valuation metrics and/or long-term trends, are still taking place and there is little or no prospect of this development coming to an early end.

  • Adam Smith’s invisible hand has for the time being, been handcuffed.

It means you can’t trust any valuation. I could have valued a subprime CDO better on May 6 than any equity. And it’s almost the same thing all day long. Valuations and prices have been divorced for a while. Just look at the volatility. It’s not like traditional trading. No wonder there are such increased correlations.

What this has to do with mobile computing?  Interestingly, I find that Apple is not just a victim of this de-coupling of fundamentals from valuation. I hold out hope that the stark facts of its performance might actually pop this correlation bubble.
The hope comes from the fact that trading strategies have finite lives.  As soon as a strategy develops to a point of being widely used, it makes sense for a contrarian to “short” or bet on the reverse of that trend, taking advantage of the tendency to overshoot. I don’t have a strong handle on this phenomenon, but the chances are that value/fundamental investment will be back with a vengeance and Apple might just be the leader, by sheer weight of numbers.

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  • Lee Penick

    What am I missing? Why doesn't apple use some of that cash that is wasting away at <1% and buy back shares when the price periodically drops?

    They have the money to be the "Federal Reserve" of their own shares. Practice some Open Market Operations and buy back shares to support the price.

    • Here's the problem with returning retained earnings to shareholders:

      Most people assume that the management is there to look out for the shareholders' interests. They really aren't. They can't because those interests vary. The only interest that matters is the value of the shares. So the assumption becomes that management's responsibility is to increase the value of AAPL shares. But that's like saying that Apple management should worry about what Wall St. thinks. I can assure you that they don't.

      Why am I so sure? Because Wall St. has shown complete incompetence in valuing the company. Management knows that. So playing a game that pleases Wall St. is futile and actually counter productive. As soon as Wall St. knows it's being stroked they'll find a way to discount the stroking.

      For example, concentrating shares through a buyback may be completely undermined by an unsubstantiated rumor that wipes 20% off the value of the stock. These rumors can be easily fabricated. So you have to justify blowing $billions of precious leverage to satisfy a market that can't/won't price the underlying asset. The market has easily taken Apple down 40% without any consideration of the fundamentals and it's clear that it will do it again. Apple's Beta used to be 3, meaning it was three times more volatile than the overall market–something the predictability of its results belies.

      The cash may not be productive at present, but it offers unprecedented leverage and option value to the company that I believe will be put to work.

  • Lee Penick

    I agree, the companies financial responsibility is to maximize the wealth of the owners.

    But if the stock is truly undervalued. That won't last forever. Efficient markets, some big value investor, etc will pop the fallacy if there is money to be made.

    But while it is undervalued, Apple could be supporting the stock, and un-deluting earnings, and spanking the shorts, buy doing buybacks when the stock is periodically dipping. Not saying they need to use all 40 some billion, but using some would send a message that they believe with their wallet that their stock is undervalued.

    It's hard for me to imaging they could use all that cash, plus the billions of new $ that are streaming in every quarter.

    My money is much more productive invested in Apple shares than in apples short term cash instruments. But Apple is unleveraging me by holding my cash! I can reverse this by using leverage with my broker, and say buy 20% more shares using margin, but the irony is I would be borrowing at the margin rate which is much higher than what they are getting on their cash.

    In this case, they are NOT maximizing the value of the shareholder. They put a shareholder in the situation of lending at a low rate and borrowing at a high rate. (I put this forward as a bigger sin than a small antenna issue) With this in mind, I think well Apple must have some pretty nifty plans for all that money. Yet it goes on year after year.

    And it's very hard to see them entering the manufacturing space because thats not where the value creation is for their products. I read an excellent article several years ago about the value creation of an iPod. For instance, for a $100 iPod, the manufacturing portion was only several dollars.

    Manufacturing isn't a method for Apple to maintain it's great GM's. Unless there is some other unique aspect to it like incredible new technology that can't leak out by using other manufactures, fear of product leaks that have very large negative consequences, etc.

    Your thoughts?

    • Finance can clearly show that capital would be better employed if returned to shareholders, but I'm arguing here that Apple is not managed with financial theory. It's managed as a technology company which means things get hairy, ugly and random, fast. Financial theory is fine and may be correct even in this respect, but I will defer judgement on the best use of capital in this case.

      The point about manufacturing is again something where the theory gets in the way of clear thinking. I am aware that the manufacturing cost to a device is usually <5% of its bill of materials, however here we are also not seeing the forest for the trees.

      The manufacturing part of the value chain should not be evaluated independent of the value chain. I'm sure a similar analysis of the retail end of the value chain would also show that it would be foolish for Apple to be in retail.

      No, the right analysis framework is to look at the whole value chain and see whether it needs to be integrated or modular. If the modular approach means lower flexibility in production ramps, or longer cycle times for product development at a time when you need the opposite then it's time to throw away the separation and integrate.

      Apple sees this whereas most other companies don't. Apple's DNA is in building the whole widget and that means understanding the "system" not just the components. Systems thinking is essential to analyzing not just products but value chains and the whole business.

      Which brings me back to cash. System analysis about the value of that cash might lead one to use it differently than modular thinking. I don't have access to Apple's mountain of knowledge about their operations so I can't second guess what they will do, but I assume that Tim Cook and team are looking at this from all the angles. This is why Apple continues to surprise. Their thinking is on another level than conventional wisdom. It leads first to surprise, then ridicule then admiration.

  • Lee Penick

    you wrote, "Why am I so sure? Because Wall St. has shown complete incompetence in valuing the company. Management knows that. So playing a game that pleases Wall St. is futile and actually counter productive. As soon as Wall St. knows it’s being stroked they’ll find a way to discount the stroking."

    But many analysts have given Apple a price target that is significantly higher than it's current price. They may lowball the quarterly earnings estimates a bit, because embarrassing a company isn't a good way to get investment banking business, but their price targets are significantly higher than it's current price. So they haven't shown incompetence there.

    And have you seen Mary Meeker's "mobile internet" presentation? She's from Morgan Stanley I believe. Excellent information with much forward thinking, showing the potential growth of the mobile internet and Apple. I also don't think she has shown incompetence.

    I believe the question is more, why are investors not heeding the numbers, logic, forecasts, and presentations that show the future growth and future share price?

    Changing topics a bit, I agree with you that paying a dividend has the negative effect of double taxation…once at the corporate level and then at the individual level. However, there is a positive effect too. Some income related mutuals funds, etc can't invest in a stock unless it pays a dividend. If Apple paid a dividend, even a small one, it would open the stock up to those institutions that can't buy it unless it does. This adds that much more analysts attention to the stock and that many more potential buyers to help ensure an efficient market/price. If undervalued as we both believe, this, to some unknown extent, would help rectify the undervaluation.

    And I disagree with you. Apple does need to care how Wall Street views the company. They can't maximize the value for shareholders without considering this. And executives are well compensated with stock options. They themselves are getting rich from stock appreciation. Even if they didn't care about you and I holding stock, self interest says they care about the stock value. (and I do believe they take their fiduciary responsibility seriously)

    Long shot here….maybe Apple is undervalued because of their financial structure. They don't magnify earnings to shareholders by having some reasonable level of debt. they go the other way and (as I discussed in another post) unleverage the shareholder with their large cash holdings. Thus reducing the return on the shareholders invested dollars.

    What's the optimum financial structure for a CE firm with high growth rates and a steady stream of cash each quarter? I doubt Apple has achieved it. I imagine lots of people would love to have an 8% bond with Apple backing it and making the interest payments. The after tax cost to apple would be more like 6%. This money is used to buy back shares and the earnings are increased in remaining shares. Then we have a company growing like a weed at 5-10 times the after tax borrowing cost.

    If you have a current model in Excel showing income, cost, and flowing through to earnings, I'll try to adjust the numbers to show what effect a 20 Billion debt and share buyback would have on EPS.

    take care,

    • I did read Meeker's work and it is better than the usual, but the sell side of the house only uses that material when it suits them. Mary Meeker works for the same organization that employs Katy Huberty. She put a target on Apple of $100 in April of 2009 (a 14% decline from the level it was then).