What Did Buffett See in AAPL in 2016? Coca-Cola
How Buffett Stole AAPL at 8.8x Ex-Cash Trailing P/E in 2016 + A Financial Analysis of 2016 AAPL
In early-2016, AAPL 0.00%↑ was just coming off from the highs of their “iPhone supercycle” — having just achieved a record-breaking 13 million iPhone 6S & 6S Plus units sold (its first Plus model) within its first weekend of launch.
However, I still recall that its stock was trading at a low 11-12x trailing PE at the time — as there was a genuine concern that their future growth then was fleeting. AAPL had already saturated its China TAM by then, and markets perceived that their incremental China TAM was plateauing. While India did represent another equally sizable market for AAPL, it didn’t have the same levels of income per capita or flagship smartphone market share amongst its local population.
As a result, markets opined that AAPL’s future growth would weep, as there were no more worlds for it to conquer.
Oh how wrong they would be.
As shown in the chart above, Buffett acquired his first AAPL 0.00%↑ stake in 1Q16. Much like his OXY purchases today, his early AAPL purchases were large & gaping — like a hungry toddler. We can see how by 4Q16, Berkshire was entertaining stock purchases of 100-200 million shares per quarter.
While I do not presume to be Buffett, I also felt that AAPL was ridiculously undervalued at the time. For context, I came from a tech background and was an avid user of Apple’s suite of products by then — and had been following its muted share price trajectory very closely for awhile. While I wasn’t a financial analyst then, the product guy in me simply could not fathom how the incredible Apple brand could possibly be on the table for a measly ex-cash trailing PE ratio of just 8.8x — I would have frictionlessly paid that much just for the privilege of owning the Apple brand alone.
Even then, most tech people would have been intimately familiar with the incredible power of the Apple brand. Few today remember that AAPL had already decimated two decades-old software industry standards by 2015 — Java in favor of HTML5 (web) and MP4 (video); and the closed ecosystem which had been the staple of both Windows and Android, in favor of the tightly locked-down walled-garden ecosystem which ‘just works’. AAPL had also pretty much stolen the entire global tablet market from under the nose of other flagship smartphone brands by 2016, with iPad having achieved a 77% global market share by then.
Finally, markets in 2016 seemed to be completely remiss of the incredible standardization capabilities of the Apple brand — with its ability to instantaneously introduce hundreds of millions of new devices to a captive fanboy market overnight. The reason why this is amazing is because it instantly solves the dreaded chicken-and-egg problem of ‘developer vs customers’ that all new tech product categories have to face overnight — customers won’t switch to a new platform with no apps, while developers won’t write apps for a platform with no customers. The Apple brand’s ability to create standardization (literally overnight) would enable Apple to later introduce new successful product categories, e.g. the M1 Macbooks or Airtags — we can especially see proof of such powerful network effects in the Airtag, which relies on the global ubiquity of the iPhone in order to enable low-powered location tracking.
Keep in mind that at this point, we’re not even considering the value of Apple’s revolutionary M1 chip yet (link below) — since it was unlikely that even Warren Buffett would have been aware that AAPL had already begun R&D on them. But even discounting that phenomenal product line completely, the fanboy in me could not conceive how the colossal AAPL brand was being offered on the market for an ex-cash trailing PE ratio of just 8.8x in 2016.
And while Buffett is famously not a tech guy, he basically saw the same thing that I did in AAPL 0.00%↑ — the incredible latent power lying dormant behind the Apple retail brand. Buffett is well-known for liking companies in the Branded Retail sector, and the rest is history.
A Financial Analysis of AAPL in 2016
However, just because AAPL 0.00%↑ was perceived by the Oracle of Omaha as a Branded Retail champion in 2016 — and was trading at an ex-cash trailing PE of 8.8x —that didn’t automatically justify it as the largest stock holding in Berkshire’s stable of moaty businesses.
What else could Buffett have seen in AAPL at the time? The following quote from this excellent interview with Todd Combs sheds some light onto the matter:
Combs goes to Buffett’s house on many Saturdays to talk, and here’s a litmus test they frequently use. Warren asks “How many names in the S&P are going to be 15x earnings in the next 12 months? How many are going to earn more in five years (using a 90% confidence interval), and how many will compound at 7% (using a 50% confidence interval)?” In this exercise, you are solving for cyclicality, compounding, and initial price. Combs said that this rubric was used to find Apple, since at the time the same 3-5 names kept coming up.
In the spirit of Yefei Lu’s book, I actually went back and performed a cursory financial analysis of AAPL in 2016 — the way Buffett might have saw it. As a reminder, AAPL’s iPhone business at the time was perceived as being at the tail-end of their growth “supercycle”; and their iPhone business in China was also seen as hitting a glass ceiling of growth, with no immediate replacement market. This perhaps explains why AAPL was only sporting a Market Cap of $600B and an Enterprise Value of $460B by end-2015 — despite posting an FY15 Net Income of $53B. (ex-cash PE ratio of 8.8x)
Now let’s take a look at AAPL’s FY10-16 balance sheet in the chart above, i.e. what Buffett might have seen at the time. As we can see, their historical Net Cash balance had regularly exceeded their Total Equity since 2012 — implying that the company’s solvency was never in question. Furthermore, they were spending significant amounts annually on Repurchase of Common Stock relative to their equity base — which made sense when you consider that the earnings yield obtained on those share buybacks was simply the inverse of their PE ratio of between 10x - 12x (i.e. 8% - 10% earnings yield) when Buffett initiated his AAPL stake:
In my previous P/B ratio article, we saw how the P/B ratio had a direct relationship with ROE — i.e. Earnings Yield x P/B = ROE. Given that AAPL was regularly sporting 30% - 40% ROE at the time, even their P/B ratio of 4-5x at the time could still result in a shareholder’s Earnings Yield of 8% - 10%. Imagine if you were Buffett — wouldn’t that be enough?
Is the P/B Ratio Still Relevant in the Modern Day?
Bottomless Resemblances with KO
So the question remains… what did Buffett See in AAPL in 2016? The unexpected answer: COCA-COLA!
As I’ve described before in this tweet, there are a startling number of parallels between Buffett’s investment in KO 0.00%↑ & his investment in AAPL 0.00%↑:
AAPL had by then become a one-product moat business with an identically outsized ROIC as Coca-Cola;
AAPL’s Net Cash position was higher than its Total Equity by FY15 — which meant that it could theoretically recreate KO’s negative Total Equity balance via share buybacks overnight. (Figure 1 below)
Its iPhone business was sporting a very similarly lucrative ROE/ROIC profile as Coca-Cola; and so were its margins. (Figure 2 below) For context, most retail businesses tend to sport Net Margins of 10% or below.
By 2016, AAPL was already showing signs of prioritizing shareholder returns, via taking on debt and channeling its practically unlimited FCF towards dividends & share buybacks (of its undervalued stock) — alá The Outsider CEOs:
Long-time value investors will understand why Buffett prioritizes this quality so much in his investments.
This enormously simplified AAPL’s cash flow model, dramatically improving future earnings visibility and reducing uncertainty (and therefore risk). Coincidentally, this is also exactly how I described Buffett’s current investment in OXY! (link below)
AAPL occupied an entrenched position in the highly moaty Branded Retail sector:
This gave AAPL pricing power, Buffett’s favorite business characteristic.
Its iPhone business also adequately fulfilled Buffett’s quote below:
Hence, going back to the Todd Combs’ quote above, how did AAPL fare in 2016 based on Todd’s investment requirements above?
How many names in the S&P are going to be 15x earnings in the next 12 months?
Answer: AAPL was already trading at below 15x earnings in 1Q16, and even consensus at the time agreed that its earnings would still post positive growth going forward (albeit slightly muted). It was highly likely then that AAPL would remain at >15x earnings within the next 12 months (i.e. 1Q17).
How many are going to earn more in five years (using a 90% confidence interval)?
Answer: Even without any incremental TAM growth from China going forward, it would be highly unlikely that an investor in 2016 would have imagined AAPL posting negative cumulative earnings growth over the next 5 years.
How many will compound at 7% (using a 50% confidence interval)?
Answer: The valuation exercise above has adequately demonstrated how an investor in AAPL in 2016 could have estimated a LT total shareholder return of 10% quite conservatively.
Todd goes on to say that, “In this exercise, you are solving for cyclicality, compounding, and initial price.” Maybe Berkshire was special since it had the privilege of entertaining LT yields of 10% while still considering it satisfactory — nonetheless, we can see how AAPL in 2016 could quite easily cleared all of Buffett’s hurdles, and therefore justify its top dog status in Berkshire’s already legendary stock portfolio.
But wait, there’s more! There’s a notable elephant in the room here — none of the investment requirements above imply that Buffett had bought AAPL 0.00%↑ knowing in advance that it could clear +30% CAGR over the next 7 years! In contrast to the popular narrative, it seems far more likely that he had made his investment decision into AAPL thinking that there was simply no way he could possibly lose money on it — and he was perfectly fine with the 10% yield or whatever that he could get out of it. If true, this would align magnificently with Ben Graham’s following quote:
Now do you believe that I have value investing blood flowing in my veins? 😉
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Great write-up. Just one 1uick question on the following statement -- isn't dividend yield already captured in the 8-10% earnings yield?
"Finally, AAPL was also paying a juicy ~2% dividend yield, further raising its total shareholder return to between 10% - 12%."
This was a great post! I love to check what companies looked like when great investors bought them so we little guys can replicate on small or mid-caps with our little money. ROE/ROIC is the first thing I look for when researching new companies.