Should I buy or sell Apple Stock?

Quiz!

What is the impact of Apple’s share buybacks on its P/E, and should you adjust for it?

  1. The share buybacks lowered Apple’s P/E in the past 3 years. At this rate, Apple’s cash will be gone in less than 3 years. Since this is not sustainable, you should adjust for it.
  2. Apple is a highly profitable company with desirable products. Its profits should keep generating cash to support share buybacks for the long run. There is no need for adjustments.

Should I buy or sell Apple Stock?

Apple is a very successful company, with strong demand for their products.  As an investment, I see conflicting messages in their financials:

  1. The Price/Earnings (P/E) of 21 is not extremely high (https://www.macrotrends.net/stocks/charts/AAPL/apple/pe-ratio).
  2. The Price/Book (P/B) of 41 is stratospheric, about x20 higher than the average for the S&P 500 (https://www.macrotrends.net/stocks/charts/AAPL/apple/price-book).

The problem?  Apple did massive share buybacks, reducing its cash on hand by 55% within about 3 years (https://www.macrotrends.net/stocks/charts/AAPL/apple/cash-on-hand).  Share buybacks reduce the number of shares, increasing the earnings per share, and lowering the P/E.  At the current rate, Apple’s excess cash will go down to $0 in less than 3 years.  Assuming continued success, with no change in earnings growth, something has to give within the next 3 years: a drop in the stock price, or a big increase in the P/E, resolving some of the current anomaly.

The solution? You can estimate the annual impact of share buybacks on Apple’s P/E in the past 3 years, and adjust for it, as part of a full analysis of the stock. QAM focuses on value investing based on the more reliable, stable and thoroughly studied P/B, and diversifies stock portfolios into 1,000s of stocks.

Quiz Answer:

What is the impact of Apple’s share buybacks on its P/E, and should you adjust for it?

  1. The share buybacks lowered Apple’s P/E in the past 3 years. At this rate, Apple’s cash will be gone in less than 3 years. Since this is not sustainable, you should adjust for it. [Correct Answer]
  2. Apple is a highly profitable company with desirable products. Its profits should keep generating cash to support share buybacks for the long run. There is no need for adjustments.

Explanations:

  1. Please read this month’s article above for an explanation of this point.
  2. While Apple is profitable, a realistic valuation should reflect a sustainable future, including a stable level of cash. With cash dropping fast in recent years, an adjustment is needed.
Disclosures Including Backtested Performance Data

What is the Impact of High Inflation on Stock Returns?

Quiz!

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations.
  2. Growth stocks.
  3. Value stocks.

What is the Impact of High Inflation on Stock Returns?

We are experiencing very high inflation, last seen in the early 1980’s. What is the Impact of High Inflation on Stock Returns?

  1. Negative: It hurts stocks, by reducing stock valuations (Price/Book) to reflect a lower value of future earnings. It hurts growth stocks with high valuations especially hard. Examples are S&P 500 and Nasdaq.
  2. Positive: It ultimately helps stocks, because high inflation = higher prices => higher earnings for the companies.

The bigger the spike in inflation, the more stocks are likely to decline in the short run, because the negative forces can be greater than the positive ones. Once stock valuations adjust to higher inflation and higher interest rates (that are used to combat inflation), the positive impact tends to be much stronger, especially for value stocks.

Key takeaways:

  1. When inflation spikes, you should be especially cautious of stocks with very high valuations. Now the largest tech stocks are priced extremely high, something familiar from past cycles. In the 1970’s, we had the nifty-fifty, also called “one-decision” stocks. Counter to expectations at the time, they crashed badly despite being the most prominent of US stocks (https://en.wikipedia.org/wiki/Nifty_Fifty). Stock returns adhere to the formula, price = book value x (price / book value). If the valuations (price / book value) are very high, even the best company in the world can see its stock price drop.
  2. Value stocks (with low valuations, or price / book-value) are better positioned for high inflation, for 2 reasons: (1) Immediate: there is no big correction necessary to valuations; (2) Ongoing: more of their earnings are from the near-term, with a smaller needed discount to future earnings.
  3. Even value stocks can be expensive at times. For example, US Large Value stocks are currently very expensive (but still less than the S&P 500 and Nasdaq). In stark contrast, non-US Value stocks are priced low.

Quiz Answer:

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations. [Correct Answer]
  2. Growth stocks. [Correct Answer]
  3. Value stocks.

Explanation:

  1. While value stocks tend to have low Price/Book, sometimes an entire collection of stocks becomes expensive, including value stocks. A current example is US Large stocks.
  2. Growth stocks tend to have earnings far into the future, that need to be discounted by high interest rates (the tool used to combat high inflation).
  3. Value stocks are priced lower and have nearer-term earnings that not impacted as much by higher interest rates. The increase in income (along with inflation) can become the dominant force.

See article for more explanations.

Disclosures Including Backtested Performance Data

The Anatomy of a Lost Decade

Quiz!

What leads to lost decades? (There may be multiple answers.)

  1. Wars.
  2. Pandemics.
  3. High valuations, as measured by price/book or price/earnings.
  4. Extreme economic distress.
  5. Euphoria.

The Anatomy of a Lost Decade

In the 2000’s, the S&P 500 experienced a 10-year decline, on a total return basis (including dividends), and much worse after counting the negative effect of inflation. This was not the first time – the decade ending in 1974 had +1.2% return per year, while inflation averaged 5.2% per year. This article describes what may lead to such long declines, and how they look.

What led to lost decades? A diversified portfolio of companies that produces products and services for entire countries is not likely to shrink its production for 10 years. What led to the 2 recent lost decades was high valuations (high price relative to the earnings of the companies or book values) of the companies. During the decade, the valuations declined by more than 50%, to correct (and typically overcorrect) the unusual pricing.

How did they look? The two most recent lost decades involved a series of gain periods followed by big declines, erasing substantial gains.

Can you avoid lost decades? There is no way to perfectly time the market, since turning points vary between cycles, with highs sometimes (but not always) leading to higher levels. There are various approaches with varying levels of success, involving getting out of diversified investments that did far above average for 10 years, or selling when valuations reach extremes. The easiest one is to diversify and include investments with lower average growth. While it involves a sacrifice to the returns, it gets around so many strategies that fail.

Why most people fail at timing? Once you find a strategy that stood the test of time, and has sound logic to it, you still have a major obstacle to overcome. Selling high and buying low involves going against the grain. It involves selling the most loved investment of the time, that people believe will just keep going up, and buying battered investments that underperformed for many years.

Can you avoid lost decades? While it is very difficult to time the market, or at least soften the blow of tough stretches, there are several principles that can improve your odds:

  1. When you hear gloomy news, along with scary predictions, and the investments are very low (low valuations / low 10 year returns), get excited about the investment.
  2. When you see euphoria all around you, with the most positive news, and the investments are sky high (high valuations / high 10 year returns), have the ability pull the trigger and sell and switch to an investment that most people hate.
  3. Whatever strategy you choose, make sure that it passed 2 tests: the test of time & the test of logic. While these are not enough, I would not move forward without these in place.
  4. Don’t expect to successfully time within one day, week, month or even year. Short-term timing strategies are far more difficult than long-term ones.
  5. Have a very robust risk plan, accounting for cases much worse than experienced in the past, allowing you to stick with the plan in some of the toughest times.

Quiz Answer:

What leads to lost decades? (There may be multiple answers.)

  1. Wars.
  2. Pandemics.
  3. High valuations, as measured by price/book or price/earnings. [Correct Answer]
  4. Extreme economic distress.
  5. Euphoria. [Correct Answer]

Explanations:

  1. Wars end up leading to increased economic activity. Declines tend to be far shorter than a decade.
  2. Pandemics tended to create short-term shocks, not very long lasting.
  3. High valuations typically get corrected. When valuations reach extremes, such as x2 the typical or more, it takes a prolonged period of poor performance to correct those.
  4. Extreme economic distress can lead to declines, but without high valuations, they tend to get resolved in far less than 10 years.
  5. Euphoria tends to lead to very high valuations – see #3 above.
Disclosures Including Backtested Performance Data

Can You Make Money Buying Stocks that Declined?

Quiz!

Can You Make Money Buying Stocks that Declined?

  1. No
  2. Yes, with a combination of a diversified stock portfolio along with very low valuations.
  3. Yes, after a careful analysis of buying near the bottom.
  4. Yes, with diversified stock investments.

Can You Make Money Buying Stocks that Declined?

When you see your stock portfolio decline, is your instinct to double down and invest more, or sell and wait on the sidelines until the sky clears? Knowing whether a recovery at a reasonable timeframe is likely depends on multiple factors. Here are cases that could lead to disappointment:

  1. If your portfolio includes only one or a few stocks, it may never recover. Many companies go bankrupt every year.
  2. If your portfolio reached extremely high valuations, as measured by price relative to book value (or liquidation value), you could make money by holding on until past the recovery, but the recovery could be many years away.

If your portfolio is diversified and has very low valuations, you may enjoy seeing a recovery within a reasonable timeframe, making you money. This is far from guaranteed. Here are steps to increase your chances:

  1. You need a robust risk plan, that accounts for a significant amount of additional declines, with a prolonged timeframe to recovery.
  2. With the right risk plan in place, you need to be 100% committed to your plan. When additional declines occur, you are not likely to see headlines saying “don’t worry, everything will be fine, this is a temporary dip”. The headlines are likely to be between negative and terrifying. Sticking with the plan requires putting all emotions aside, focusing on your risk plan, and following it mechanically – not for the faint of heart!
  3. Buying after declines requires a great deal of humility. You may have strong gut feelings on the “obvious” next move for stocks. Avoid setting any short-term expectations – the next move is mostly influenced by information that is not available at the moment.
  4. Start by having your normal allocation. Then, given the uncertainty, it helps to have a multi-step plan, with incremental small investing with every material additional decline. Allow for more declines than you can imagine. This can empower you knowing that you are proactive with additional declines.
  5. An incremental investing plan is smart in theory, but can be tough to execute. On the way down, you are likely to feel increasingly wrong. Remember that your goal is not to call the bottom – a very tough thing to do, but to emphasize extra investing when the odds are stacked more strongly in your favor, and the risks are lower.
  6. If you don’t have long-term valuation data for your investment, one alternative is comparing the 10-year performance relative to the long run. 10-year outperformance relative to the long run could mean high valuations and high risk.
    1. For example, the S&P 500 had far above average returns in the past 10 years, leading it to reach near record valuations. Buying on the dip beyond your normal allocation in such cases can be very risky.
    2. On the other hand, Emerging Markets Value investments had unusually low returns in the past 10-years, leading to below average valuations. Buying on the dip beyond your normal allocation in such cases may be profitable, subject to all the precautions described above.

Quiz Answer:

Can You Make Money Buying Stocks that Declined?

  1. No
  2. Yes, with a combination of a diversified stock portfolio along with very low valuations. [Correct Answer]
  3. Yes, after a careful analysis of buying near the bottom.
  4. Yes, with diversified stock investments.

Explanations:

  1. While there are no guarantees, with the right plan, you can make money buying stocks that declined – read on.
  2. Diversified stock investments tend to recover after declines. As long as you hold onto the investments until they hit a bottom, fully recovered and reached new peaks, you can make money. The low valuations help avoid some of the longest declines of stocks.
  3. A careful analysis may or may not be successful at identifying the bottom. In addition, a concentrated portfolio of one stock may never recover.
  4. While diversified stock investments tend to recover after declines, if the valuations are extremely high, it may take many years to enjoy a gain.
Disclosures Including Backtested Performance Data

S&P 500 10-Year Returns if The Past Repeats

Quiz!

Question 1: In the past 10 years, how much did the S&P 500 companies grow their book values (change in price divided by change in price/book)?

  1. 16.2%
  2. 6%
  3. -6%

Question 2: Last time the S&P 500 had approximately today’s valuations, what was its average annual performance in the following 10 years?

  1. 16.2%
  2. 10%
  3. -1%

S&P 500 10-Year Returns if The Past Repeats

The S&P 500 enjoyed strong returns averaging 16.2% per year in the past 10 years. 10 years look like a long track record, enough to entice investing in the S&P 500 today, based on this data. Let’s evaluate this theory:

1. Actual book-value growth calculated at a mere 6%: What was the growth in the book value of the S&P 500 companies in the past 10 years? We can calculate it as the difference between compounding the 16.2% price increase per year and about 9.6% price/book increase per year (x2.5 going from under 2 to nearly 5), which is 6% per year. It turns out that the past 10 years were not very exciting for the S&P 500 companies.

2. Valuations declined 9.6% per year: From the most recent cycle when valuations reached today’s valuations (year 2000), they declined from about 5 to about 2 in 10 years, which is equal to -9.6% per year.

3. If the past repeats itself, we can get -3.3% annual decline for 10 years = -28% total: If the companies do as well as the past 10 years = 6% per year, and valuations revert to normal as happened last time we reached today’s valuations = -9.6% per year, we get an annual decline of -3.3% per year, and a total decline of -28%.

We don’t know what the future will actually be. But, if you are projecting the past to the future, you should prepare for material declines for the S&P 500 over the next 10 years.

Quiz Answer:

Question 1: In the past 10 years, how much did the S&P 500 companies grow their book values (change in price divided by change in price/book)?

  1. 16.2%
  2. 6% [Correct Answer]
  3. -6%

Question 2: Last time the S&P 500 had approximately today’s valuations, what was its average annual performance in the following 10 years?

  1. 16.2%
  2. 10%
  3. -1% [Correct Answer]

See article for more explanations.

Disclosures Including Backtested Performance Data