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Apple vs Coke

Great Stock = Great Company + Great Valuation (Apple vs Coke)

Valuation – margin of safety (discount to fair value) – solves a lot of global problems.  Let’s take Apple as an example.

Today Apple is mostly an iPhone company: two-thirds of its profits come from that product.  In 2014 it sold 169 million iPhones, and in 2015 iPhones sales jumped 37% to 231 million.  In 2015 the mobile phone market grew somewhere around 6-10%.  iPhone sales for 2015 were driven by many extraordinary factors. Apple introduced larger-screen iPhones at the end of 2014, and China Mobile – the larger wireless company in the world – started selling the iPhone.

In 2015 the iPhone took market share from Android, but also and more importantly it brought forward some sales from 2016 and maybe even 2017.  In the first two quarters of 2016 iPhone sales are expected to decline about 15-16% from the 2015 level.  In our worst-case scenarios, we are assuming a 16% decline in iPhone sales for both 2016 and 2017.  We are also punishing Apple’s margins by 3% for the cheaper iPhone 5SE it introduced in 2016.  In addition, we are still growing Apple’s R&D expense 25% a year.

After all of this punishment we get earnings per share of $6.50.  If Apple does not come out with any categorically new products this or next year, we get the worst-case 2017 value of around $90 per share (10 times $6.50 worst-case earnings = $65 plus $25 of net cash per share).  Let’s put our $6.50 number in the right context: Apple is followed by 46 Wall Street analysts whose lowest earnings estimate for 2017 is $7.46 per share (the highest is $10.10 per share).

It gets better.  In 2016 Apple will spend $10 billion on R&D.  Let’s put this number into perspective: In 2007, the year Apple introduced the first iPhone, Apple’s R&D stood at $782 million.  The company’s R&D investment over the last three years more than doubled, but outside of increasing iPhone screen size (which required millions not billions of dollars to accomplish) and introducing the Apple Watch, Apple has not introduced any significant new products.

We don’t exactly know which specific products the increase in R&D is flowing to. Our best guess is an electric car and virtual reality technology. Our $6.50 worst-case earnings factors in much, much higher R&D, which is an expense, but no new products from it, thus no additional revenues or profits.

We are going through this exercise to show that at the right price a high-quality company can handle a lot of headwinds – which makes it a great stock.  We are looking for stocks that we or the global economy cannot kill.

Though we have not made a lot buy decisions in your portfolio in 2016, we have made hundreds of decisions – you just didn’t see them because they were decisions “not to buy.”  We looked at looked at hundreds of companies.  Some companies failed the initial quality test, and many of the ones that passed were not cheap enough and went on our watch list – future buys.  In fact, the companies we did buy were on our watch list.

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Vitaliy Katsenelson

I am the CEO at IMA, which is anything but your average investment firm. (Why? Get our company brochure here, or simply visit our website).

In a brief moment of senility, Forbes magazine called me “the new Benjamin Graham.”

I’ve written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. (I’m working on a third - you can read a chapter from it, titled “The 6 Commandments of Value Investing” here).

And if you prefer listening, audio versions of my articles are published weekly at investor.fm.

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