PMC 30 Spotlight - Apple Inc.

This is the second post in our series of the PMC 30 Spotlight, where we provide an in depth look at an individual stock and explain how it fits into our investment thesis. The PMC 30 can be seen on the right of the blog. Inclusion in the PMC 30 does not mean that we would buy the stocks at their current valuations.

Apple Inc., together with subsidiaries, designs, manufactures, and markets personal computers, mobile communication devices, and portable digital music and video players, as well as sells various related software, services, peripherals, and networking solutions. The company sells its products worldwide through its online stores, retail stores, direct sales force, third-party wholesalers, resellers, and value-added resellers. In addition, it sells various third-party Macintosh, iPhone, and iPod compatible products, including application software, printers, storage devices, speakers, headphones, and various other accessories and peripherals through its online and retail stores, and digital content and applications through the iTunes Store. The company sells its products to consumer, small and mid-sized business, education, enterprise, government, and creative customers. As of September 26, 2009, it had 273 retail stores, including 217 stores in the United States and 56 stores internationally. The company, formerly known as Apple Computer, Inc., was founded in 1976 and is headquartered in Cupertino, California.

- source Yahoo Finance

During the quarter Apple elected retrospective adoption of the Financial Accounting Standards Board’s amended accounting standards* related to certain revenue recognition. Adoption of the new accounting standards significantly changes how the Company accounts for certain items, particularly sales of iPhone® and Apple TV®. “If you annualize our quarterly revenue, it’s surprising that Apple is now a $50+ billion company,” said Steve Jobs, Apple’s CEO. “The new products we are planning to release this year are very strong, starting this week with a major new product that we’re really excited about.” “We are very pleased to have generated $5.8 billion in cash during the quarter,” said Peter Oppenheimer, Apple’s CFO.

-source Apple's Q1 Earnings Release

We at Panoptic Management Consultants, Inc. are huge believers in the technology sector. The fundamentals of tech companies are some of the strongest across all of the S&P 500 sectors. In the case of Apple, Inc., they have almost $40 billion in cash and short-term equivalents, and no long term debt. With this amount of cash, they could literally buy Morgan Stanley! Instead, Apple decides to focus all their efforts on innovation and incremental updates of their already existing products.

They have their hands in many of the fastest growing sub-sectors of technology. iPhone has revolutionized the smartphone market, iPod continues to dominate mp3 players, and the Mac computer line continues its comeback story. Macintosh computers have not broken 8% of the US PC market share in over a decade. This in my opinion is the real growth story going on at Apple. Macs are no longer shunned by enterprise users, and the ability to use Windows via BootCamp or Parellels allows PC users to easily transition to the Mac ecosystem. Apple has a virtuous "halo effect" going for them as well. A customer will buy an iPhone, an iMac a year later, etc. Their newest creation, the iPad, launches April 3, 2010. Its aggressive pricing will make it Apple's entrant into the ultramobile computing space.

I was lucky enough to attend the Apple, Inc. Shareholders Meeting on February, 25, 2010. There were a few interesting moments during the shareholder proposed votes on sustainability. At the first opportunity for audience participation just several minutes into the proceeding, a longtime and well-known Apple shareholder--some would say gadfly--who introduced himself as Shelton Ehrlich, stood at the microphone and urged against Al Gore's re-election to the board. Gore "has become a laughingstock. The glaciers have not melted," Ehrlich said, referring to Gore's views on global warming. "If his advice he gives to Apple is as faulty as his views on the environment then he doesn't need to be re-elected." - source CNET What CNET doesn't mention is that the glacier comment drew large amounts of laughter.

After the shareholder votes were cast, there was a question and answer session. CEO Steve Jobs, COO Tim Cook, and CFO Peter Oppenheimer came to the stage. I immediately got in line. I proceeded to hear questions from other shareholders mainly about what to do with the $40 billion in cash on the balance sheet. Dividends, buybacks, and even buying Tesla Motors were suggested. Mr. Jobs had a better idea, TOGA PARTY!

After 6 other shareholders, I got to talk to Mr. Jobs. I told him I had two questions on video gaming:

Why does Apple not have a 1st party developer studio for video games? (Microsoft, Sony and Nintendo all do)

I had an interesting back and forth with Mr. Jobs about this topic. He responded that the thousands of games made by 3rd party developers on the App Store were great, and he didn't see any reason for Apple to compete. I mentioned that "I hear Apple is good at making innovative products, and maybe they could bring something to gaming that other developers hadn't thought of." This even got a laugh from Mr. Jobs.

Would Apple be open to a strategic alliance to bring iTunes content to a video game system?

Netflix has been assaulting Apple on all three video game consoles on the downloadable video front. I broke down the market analysis: Microsoft has the Zune Marketplace, Sony has a load of content. but Nintendo is sitting there not doing much about selling media. I asked if a strategic alliance with Nintendo is something worth doing. He responded that "strategic alliances are tricky, but if they are profitable they are always worth doing."

It was truly a great honor to speak with the 3 top executives at Apple, Inc.

At the time of this post, Apple, Inc. is trading very near its all-time high. It is on the verge of surpassing Walmart for the 4th largest market capitalization in the S&P 500, and has Microsoft in their sights! Not bad for a small company started in a garage in Northern California.

Full Disclosure:

Our CEO, Asif A. Khan, CPA (or his family members) is:

Long Apple, Inc. Common Stock.

Short Apple, Inc. Put Options

Long Nintendo Common Stock

Long Microsoft Common Stock

Long Walmart Common Stock

Long Morgan Stanley Common Stock

Long Morgan Stanley Call Options

Short Morgan Stanley Put Options

A Supplemental Note on MACD

This note is a supplement to the one below it. I felt it may be useful to show how MACD can be an effective tool on more than just a daily chart of a stock. MACD can be used on any time scale chart and works with indexes in addition to individual stocks. Below is a monthly chart of the S&P 500. The chart covers the period from late 1996 until the present. During that period, the S&P has crashed twice. One was the .com bubble burst that lasted from 2000 until 2003 and the other was the mortgage crisis crash that took place mostly during 2008.

Remember, usually the MACD histogram bar chart and the stock price chart move in the same direction. That is, if the stock price is going up the MACD histogram is going up and vice-versa. If they are moving in opposite directions, this is a signal that the a directional change may occur in the stock so that it will again be moving in the same direction as the MACD histogram. In those situations, the MACD histogram is a leading indicator. It gives you an idea of what the price of the stock or the index may do in the future.

Sadly, the MACD histogram did not call the bottom of the 2008 market crash. There was no divergence in the MACD histogram and the S&P price to give a signal. The MACD line crossing the signal line did serve as a useful indicator, but it was a lagging indicator. There was already a substantial recovery occurring in the S&P before MACD gave any signal of it. However, MACD divergence did make an accurate and timely prediction of the market top in 2000, the turnaround in 2003, and the market top in 2007. I'm going to discuss the 2003 turnaround and the market top in 2007 because they are the easiest to see.

The first market top occurred in 2000. From that point you can see that the S&P fell from about 1550 to roughly 765 (a downtrend) between the years 2000 and 2003. During that period, the MACD histogram had a pretty deliberate trend moving from the negative to the positive (an uptrend). In early 2003, the MACD line crossed over the gray signal line and the histogram turned positive. From that point, the market continued its trend upward until late 2007. However, the MACD histogram had been trending down towards the negative and finally went negative with the MACD line crossing below the gray signal line in late 2007.

In both situations, people paying close attention to the MACD on the monthly S&P 500 chart would have had a pretty good chance of catching both the bottoms and the tops of the market. Technical investors like to see confirmation of a signal. In the case of the 2007 market top, not only was the MACD signaling that things were going to make a turn for the worse, there was also a "double top". Do you see how the market basically topped out in 2007 at the same point it did in 2000? This is a very common chart pattern that technicians look for, but I'll save further discussion on that topic for another time.

A Note about Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence (MACD) is one of the most popular technical indicators used by investors. MACD is a trend-following and momentum indicator. In theory, trend following should not work. If the market were totally efficient there would be no trend to follow. However, in practice research has shown that trend following can produce average beating returns. There are of course many caveats. Trend following can result in "whipsaws" or false trends that do the opposite of what an investor anticipates. For this reason, PMC only uses trend following technical analysis for stocks that we already see value in. We use value investing for strategic stock selection and trend following mechanisms like MACD for tactical investment decisions. We believe that by only using technical indicators like MACD on stocks that we think are already mispriced, we lesson our chances of downside and increase our chances of upside.

MACD is composed of two lines. One is a signal line that is a 9-day exponential moving average. An exponential moving average is a moving average where more weight is given to the latest data. The other line is the MACD line which is determined by subtracting the 26-day exponential moving average from the 12-day exponential moving average. When the signal line crosses over the MACD line, this is a bullish indicator. when the MACD line drops below the signal line, it is a bearish indicator.

One of the most effective uses of the MACD is to look for stock price and MACD or MACD histogram divergence. A MACD histogram is simply a bar chart where each bar shows the difference between the MACD line and the signal line.

The above picture is an example using a recent daily stock chart from Nvidia Corporation. Please click on the chart to see a large version. In this chart there are two divergences between the stock price and the MACD histogram. The first is where the stock is trending down during the months of October and November while the histogram is trending up (the histogram is moving up towards 0 from higher negatives). Notice when the MACD blue line crosses the silver signal line, there is a jump in the stock price. Careful watchers of the MACD histogram divergence could have predicted this upward move. The second divergence is during the month of December and January. The stock price makes an unrelenting upward move while the MACD histogram is trending down towards 0. Once the MACD line crosses under the signal line, there is a long downtrend. I have also marked the support level of the stock given that support was discussed in a previous note.

As you can see, MACD can be an effective tool in predicting trends and momentum in a stock. Combining divergence in the histogram with the signal line improves the probabilities of the MACD's accuracy. PMC does not recommend that you solely rely on MACD to make investment decisions. We feel it is not accurate enough for those purposes. It should only be used as a supplemental tool to determine an entry or exit from an equity position.