This is the second segment in an 8-part series on Unlocking the Value in AAPL.
- The Irrational Market Theory
- The Law of Large Numbers
- Market Share
- Apple's History
- Business Model
- A Dollar A Day
*Disclosure: The author owns AAPL.
I believe that over the very long term markets are rational and arrive at fair value for financial assets, however I am not a believer in the efficient-market hypothesis (which states that market value always reflects all publicly available information in a rational manner). The path markets take to arrive at a fair value is neither smooth nor efficient1. There is lots of noise and often irrational excess2. As John Maynard Keynes famously said, “Markets can stay irrational longer than you can stay solvent.”
Apple's stock has been no stranger to apparently irrational and wild swings in market sentiment over the course of the last decade. During it's 1000% climb the stock experienced several declines of 40%, including one of about 60% during the financial crisis of 2008-2009. These declines happened despite no apparent underlying changes for the worse in Apple's business, which always grew quicker than expected3.
The last year has been a tough one for owners of AAPL as the stock experienced another 40% decline. Although it has subsequently regained some of this ground it is still down about 30% since last year's peak. There are clearly some underlying fundamental factors which made year over year growth difficult and thus contributed to a peak in the stock:
- The smartphone market is maturing. While plenty of growth remains it will not be as rapid as it was in the beginning and will come mostly at the lower end of the market.
- The holiday quarter in 2011 was 13 weeks long. In 2012 it was a normal 12-week quarter. Apple had 8.3% more time to sell products in their most critical quarter during 2011.
- Shifts in Apple's product cycle made year over year comparisons difficult:
- Opening week iPhone sales were in the holiday quarter in 2011, but not in 2012
- The iPad moved from spring release to fall release impacting spring and summer year over year growth numbers.
- Apple's most important products were all early in their life cycle and acheiving correspondingly lower margins (iPhone 5 and iPad mini) than they do later in their product lifecycle (iPhone 5 margins were lower than the iPhone 4s margins were or iPhone 5c margins will be).
While most of this should not have surprised anybody it certainly explains why the rise in Apple's took a pause. Markets being what they are, some degree of correction was also inevitable. However, I don't believe these factors are adequate to explain a 40% decline. Until recently I believed the extreme nature of the decline was best attributed to classic irrational market excess4 and over-reaction. Apple's business may no longer be growing by 50% or more annually but there is no concrete evidence of it being in danger of decline.5
If Apple's current valuation is not due to irrational market excess it will have a rational explanation. The Law of Large Numbers is perhaps the most commonly heard rational explanation. In the next segment I explore how that may (or may not) apply to Apple.
Warren Buffet argues against the efficient-market hypothesis in The Superinvestors of Graham-and-Doddsville. The investors he discusses have exploited roughness, inefficiency, and temporary irrationality in the markets to capture superior and more reliable returns than the efficient-market hypothesis says is possible. I find the argument very compelling.
Irrational excess in financial markets is a phenomena that has been documented for a very long time. If you are interested in the topic you may be interested in reading the following books:
Apple's business grew so quickly that many of us came to expect Apple to beat consensus earnings estimates every quarter by a wide margin despite constant upward revisions by analysts. These upside surprises can be partially explained by Apple executives carefully under-promising with earnings guidance. Yet they continued to happen well past the time when analysts knew Apple was under-promising and accounted for that in their estimates.
I occasionally see bloggers complaining that Wall Street doesn't “like” Apple and attribute their frequent undervaluation to this dislike. While there may be many on Wall Street and in the financial community that do not understand or even do not like Apple because they are so different from most corporations I do not believe dislike plays an important role in how the market values Apple.
Analysts and pundits may sometimes enjoy criticizing Apple for these differences but those who make large investment decisions are focused on financial gain and loss. Avoiding an opportunity for financial gain because of sentiment could be considered a form of conscious irrationality (from a financial perspective) and is not a common behavior in the financial markets. The irrationality at work in the markets is usually a much more subtle group irrationality where each individual player consciously believes they are behaving in a rational manner that will maximize their financial gain.
Many would argue that Apple's declining market share in tablets and smartphones is concrete evidence that their business is in danger of decline. I address both of these concerns later in the series.