Apple Part 2

Apple Inc. (AAPL) Part 2

In this part of my analysis of Apple I want to show you how I projected Apple’s likely future earnings. I will also put the projected future earnings in relation to 1. the price Apple is trading at today and 2. the price I bought Apple stock at in december 2018. So we will be able to estimate the future returns and see, if Apple is worth buying.

Projection of Future Earnings + Price of the Stock

First of all we calculate the compound annual growth rate of per share equity for the period of 2009 to 2018, which is 16.19%. Using this growth rate we project the future per share equity ten years from now, by compounding the 2018 value for ten years by 16.19%. Per share equity in 2018 was 22.53$ therefore the projected future per share equity is: 22.53$ * (1+0.1619) ^ 10 = 101$. In order to get the projected future earnings per share we multiply the projected future per share equity by the average return on equity of the last ten years, which gives us: 101$ * 0.3555 = 35.90$. The last step is estimating the future price of the stock. The estimated future price is the projected future EPS * average P/E over the last ten years. That gives us a future price of 15.81 * 35.90$ = 567$.

Calculating the Return  

Based on the estimated future price of the stock (future value) and the price at which Apple trades today (present value) we can calculate the return we will likely get if we buy the stock today. At the time of writing (early dec ’19) Apple trades at 264$, which will be the input for present value. The compound annual growth rate is defined as: {(future value / present value) ^ (1/n)} – 1 which in our case will be: {(567 / 264) ^ (1/10)} – 1 = 0.079 = 7.9%. That means if we buy Apple stock today at 264$ our return for the next ten years is likely to be 7.9% p.a.. I bought Apple for my portfolio in december 2018 for 149$ a share. Using the same formula for CAGR with 149$ as input for the present value we will get a result of 14.2% p.a..

Conclusion

Using these simple steps to estimate the likely return of an investment can help a lot with determining the right time to buy and with managing expectations. We have seen that buying Apple at todays prices would only give us a return of 7.9% which is not very attractive. Therefore we can conclude that even if we think Apple is a great business that we would like to own, it is necessary to wait for lower prices. In my personal case these calculations help me with managing my expectations. Apple stock went up tremendously in 2019, but I only expect 14.2% p.a. over ten years. So I know that if a large part of that movement happened early on that I might have to sit trough some sideways action. These calculations help me forming realistic expectations, thereby not getting discouraged over the lifespan of the investment. As I am happy with my expected 14.2% return I will stick with my investment in Apple, however I would not recommend buying Apple at these high prices. 

Apple Part 1

Apple Inc. (AAPL) Part 1

Today I want to share with you my research on Apple. I discovered that Apple could be a good investment according to the principles of Compound Investing, while writing my Bachelor’s Thesis. My topic was to write about the overvaluation of the US stock market, especially analyzing Tesla. While doing research on the big Tech companies that are massively overvalued in relation to their earnings, I found that Apple was different. Their P/E-ratio at the time was around 14 while all the others had P/E-ratios of 100 or more. This gave me the impulse to do further research on Apple.

1.1 Quantitative Analysis

Return on Equity

Apple’s average ROE for the past ten years has been 35.55%. It is also important to mention, that the ROE didn’t fluctuate much and the lowest value during this period was 26.28% in 2009.

Earnings

As you can see in the graphic below the earnings per share over the past ten years show a strong upward trend. Although EPS decreased in the years from 2012 to 2013 and 2015 to 2016 Apple was able to get back quickly and the upward trend in earnings was not broken. Also the EPS are not fluctuating much, which is a good sign of stable and predictable growth. The rate at which EPS have been compounding (CAGR) over the last ten years is 24%, which is an exceptional value and also shows the strength of Apple’s business model.

Debt

Up until 2013 Apple didn’t have any long term debt. Since 2013 they have started building up long term debt, but for our analysis we have to look at the ratio of long term debt to net income (displayed in the second graphic). This ratio built up to 2.0 in 2017, but we can see that it has been going down to 1.6 in 2018. Not just the ratio went down, but also the absolute long term debt. This is a good sign and we will see if this development can continue for the year 2019. Normally the threshold for the long term debt to net income ratio would be 1 and all companies with a higher ratio would be eliminated. Because Apple is moving in the right direction I will continue with the analysis. Still it is definitely an important aspect to consider when making the investment decision and we will have to monitor the future development of long term debt closely. 

1.2 Qualitative Analysis

1.2.1 Business Model

In terms of the business model Apple has big changes ahead. They stand at a point of transforming their entire core business. Hence the following analysis will be presented in two separate parts.

Business Model during the last ten years

The last ten years the iPhone has been Apple’s most valuable product making up around 70% of total revenue. Apple had the advantage of inventing the smartphone, so when the iPhone first came out there was no competition at all. When competing products were introduced to the market, Apple was able to profit from having positioned their products in the luxury segment. Because of this positioning and Apple’s strong brand name they were able to realize high profit margins. Additionally, because Apple produces both hardware and software, it is difficult for users to switch to competitors without negative repercussions. For example someone who has bought apps with his Apple account would have to buy them again when switching to android. This ‘digital prison’ strategy together with the iPhone as a new, transformative technology has worked really well for Apple in the past. 

Future Business Model

The saturation of the smartphone market and cheap competing products are a threat to Apple’s business model. Even though they will be able to make lots of money with the iPhone in the future, it is likely that we won’t see any substantial growth in this area. Apple’s strategy, in order to secure future growth, has been to transition to a services business. They have been working on it for many years, but in the recent past it has become more obvious. New services offered by Apple are for example the Apple Credit Card, Apple TV and Apple news. They all have the goal in common to bind customers to the company and generate further revenue. 

1.2.2 Further Qualitative aspects

Type of Business

Apple is definitely a monopoly type business as they have a strong brand name and are positioned in the luxury segment. Customers are willing to pay huge premiums for Apple products.

Capital Requirements

On the one hand Apple has to use a lot of capital for research and development in order to stay competitive. On the other hand they don’t have to maintain factories and their products won’t become obsolete for a long time. Also Apple’s transition to a services business will lead to less capital requirements. 

Retainment of Earnings

In the graphic below you can see how much of the earnings Apple retained each year. With Compound Investing we are looking for a high percentage of retained earnings, because we want to invest in companies that can compound their earnings within the business at high rates of return. First of all we see that Apple started paying a dividend in 2012 and that the percentage of retained earnings since then has been in the mid 70% range. That is definitely a good sign, because it means that Apple still reinvests about three quarters of their earnings back into the business. The other aspect we have to test is, if Apple can reach a high enough rate of return on the retained earnings to justify an investment in them. In order to calculate the rate of return on retained earnings we compare the absolute amount of retained earnings to the growth of EPS over a period of time. In the bottom right of the table below you can see that Apple retained 42.69$ per share from 2009 to 2017. That means this amount per share has been reinvested into the business in order to realize an EPS in 2018 of 12.01$. The growth of EPS therefore is 12.01$ – 1.32$ = 10.69$. The rate of return can be calculated by dividing the growth of EPS by the sum of retained earnings: 10.69$ / 42.69$ = 25%. That means Apple realized a rate of return of 25% by reinvesting their earnings back into the business. This rate of return meets our minimum requirement so that from a standpoint of earnings retainment Apple looks like a good investment.

 

Conclusion

The goal of this article was to look deeper into the financials and the business model of Apple. Before I started this analysis I was convinced that Apple was a great company to invest in. Now I am not so sure. I wasn’t aware of the long term debt Apple has built up over the past years, even though, if the declining trend continues, this factor might not be so important. What will determine the future success is the transition to a services business. On the one hand such a dramatic change in the business model is always risky and more a speculation than an investment. On the other hand the business model of the past ten years is still working at this time and we shouldn’t anticipate a deterioration of it, but just acknowledge the possibility. I did invest in Apple myself on the basis of the old business model, without being fully aware of the future challenges Apple will have to face. However I will stick with the investment for now, as the business model still works and because I was able to get the stock at  a very good price. My strategy with this investment is to be cautious as to how Apple will face the future and only sell if their financials deteriorate. I hope you enjoyed reading!

 

What nobody told you about ETF’s

What nobody told you about ETF’s 

Today I want to talk about Exchange Traded Funds. ETF’s are an ever increasing industry with a total market capitalization reaching well over 4$ trillion in 2019. They are also becoming more and more important for the small investor as they offer a low cost option to participate in the stock market. However there are some risks associated with ETF’s that in my experience many small investors are not aware of. During times like these, where all assets are rising, ETF’s seem like the perfect investment. However during times of crisis the hidden risks could cause a lot of devastation, especially when you are not aware of them. In this article I want to discuss what I think are some important aspects to consider when investing in ETF’s and the hidden risks. I will also talk about positive aspects of ETF’s.

Pro

ETF’s are a great tool especially for the small investor. Before their invention you had to buy mutual funds, if you wanted to invest in the stock market but didn’t have enough capital to create a diversified portfolio yourself. The problem with mutual funds however is that they are associated with high costs of around 1% to 2% p.a. and these are just management fees. Additionally some funds have a performance fee, which usually applies to the gains the fund makes above a certain level. Even though 2% might not sound so much, as you can see in my article on compound interest, even a small difference in the interest rate can make a huge difference in the return you will get, especially over long periods of time. The second big issue with mutual funds is their performance. According to an article on CNBC.com well above over 80% of mutual funds underperform the S&P 500 over long time periods (10+ years). Further a study from UCLA found good performance is mostly present in funds that apply growth strategies or have small net asset values. However the authors conclude that these types of funds typically have the highest expenses so that their performance diminishes net of fees (see below for sources). ETF’s are a promising low cost alternative. If you can’t get better returns than the index make sure to at least get the same return at much lower cost. 

Contra

In the first part of this article I discussed the advantages that ETF’s offer (or rather the disadvantages of classic mutual funds). Now I want to talk about some lesser known negative aspects and maybe help you to become aware of the risks associated with ETF’s.

1. Physical versus Synthetic Replication

The first aspect is the method of replication used by the fund. In my opinion this is one of the most important aspects to consider, as it allows you to reduce your risk tremendously with almost no work at all. The two methods to distinguish are physical replication and swap based replication. When a fund uses the physical method of replication it means the fund actually buys all the stocks in the index and holds them in their accounts. On the other hand swap based replication means the fund doesn’t own the stocks, but uses derivatives, in this case swaps, to get the same exposure to the market as if it would own the stocks. In my opinion the swap based method is not suited for the long term investor and makes only sense when you use the ETF for short term trading purposes. Even though ETF’s that use swaps to replicate an index usually have lower fees, there is a huge risk of total loss during a crisis. The reason for this is, that the counterparty to a swap usually is a bank and when the bank goes broke in times of financial crisis you lose your investment. Swaps were also the product that caused the financial crisis of 2008/2009 to spread globally. It is imperative for investors to know this difference, take a little time to read the prospectus and then go for a fund that uses physical replication.

2. Crowding out Effects

The next aspect is the possibility of crowding out effects occurring in a future crisis. When many ETF owners want to sell at the same time, the funds have to liquidate stocks in order to raise capital. As most of the money in ETF’s goes into the S&P 500, in a time of crisis a lot of funds would have to sell stocks that are listed in the S&P 500, thereby pushing down the stock’s prices. This could lead to more selling from investors and create a self-reinforcing cycle. Contrary to that, mutual funds don’t all have the same stocks so even if all funds have to sell, the wouldn’t sell the same stocks. 

3. ETF Bubble?

The last aspect I want to talk about is something I have found very little in while researching. It is just an idea that I had, which is that ETF’s could be the next big bubble. A key characteristic of assets that develop into a bubble its that everyone and especially small investors are euphoric about it. Today the only asset class that could match this description are ETF’s. Every small investor buys ETF’s and everyone that has nothing to do with finance knows about them. On the other hand one aspect that is missing is the expectation of huge returns as people are aware that they will only get the return of the index. Further the huge inflow of capital into ETF’s over the past years leads to inflated prices. This is especially the case with bad companies that get bought just because they are part of the index. Could it really be that prices across the board are artificially high because of the influence of ETF’s and that we will see huge losses in the future, especially in stocks that are part of the big indices?

Conclusion

As we have seen ETF’s also have some risk factors inherent in them. In my opinion these risks are not the biggest problem. The big issue is that most people are not fully aware of them. I think ETF’s can still be a great investment vehicle especially for small investors, but investors need to get familiar with what they buy and learn about all the risks. This will enable them to plan for these risks in their security selection, i.e. select an ETF that uses physical replication. Also I think, whenever it is possible from a cost perspective, you should hold your investments directly in your accounts and not use a middleman like an ETF or a mutual fund. 

Sources: 1. https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html 2. Mutual Fund Performance: An Analysis of Quarterly Portfolio Holdings; Mark Grinblatt and Sheridan Titman; The Journal of BusinessVol. 62, No. 3 (Jul., 1989), pp. 393-416

Monster Beverage Part 2

Monster Beverage Corporation (MNST) Part 2 

In this second part of my analysis of Monster Beverage we will estimate at what range of price Monster’s stock is likely to be at ten years from now. Normally these types of estimation don’t hold much value. However in our case it is different, because we are focusing on a special kind of company. As we have seen in part one of the analysis, Monster has very a stable earnings growth as well as a solid monopoly type business model. Under such circumstances an estimation of future prices, based on the earnings development, has a much higher predictive value.

Projection of future stock price

First of all we will calculate the future per share equity value of the stock. Therefore we need the present per share equity value and the rate at which Monster was able to grow their equity in the past. The average growth rate of per share equity over the last ten years was 19.96% and the present per share equity is 6.64$. In order to calculate the expected future per share equity value we simply have to compound 6.64$ for ten years with an interest rate of 19.96%. That gives us a future per share equity value of 6.64*(1+0.1996)^10 = 40.97$. The next step is to calculate the future earnings per share, by multiplying the future per share equity by the return on equity. As we do not know what the ROE will be exactly in the future, we use the average ROE of the last ten years, which in this case is 31%. So the future EPS are 40.97$ * 0.31 = 12.7$. Now we can multiply the future EPS and the average P/E-ratio of the last ten years (33) to calculate the future stock price. The future stock price is 12.7$ * 33 = 419$.

Conclusion 

So what does this calculation tell us about the valuation of the stock today? At the time of writing the Monster stock is traded at 58.70$. That means, if we buy the stock today at 58.70$ and expect the price in ten years to be at 419$ then our compound annual growth rate will be 21.71% p.a.. Now we are able to compare this rate of return to alternatives and then make a decision. It is important to remember that Monster Beverage also met our requirements in the first part of the analysis. A stock that offers a return of 20% or more according these calculations, but does not meet the quantitative and qualitative requirements would not be interesting to us. That is the case, because the above calculation only has predictive value for monopoly type businesses with stable earnings growth and the ability to compound their earnings.

All in all we can conclude that Monster Beverage definitely is great opportunity and that a price around 58$ would give us a return of approximately 21% over the next years. I hope you enjoyed reading. If you have any questions or criticism feel free to leave a comment or use the contact form. 

Monster Beverage Part 1

Monster Beverage Corporation (MNST) Part 1

 

This post is part one of the research I have done on Monster Beverage. After reading about Monster in an online article I got interested and had to do my own research to see if the company was a good investment according to the principles of Compound Investing. In Part 1 of my analysis we will go through the quantitative and qualitative analysis.  

 

1.1 Quantitative Analysis:

 

In this first step, based on three simple metrics, we will very quickly check if Monster is worth analyzing further.

 

Return on Equity

At first we will look at the return on equity (ROE). The ROE of Monster Beverage over the past ten years has been at 31% on average. Except for two years during this period it even has been consistently over 20%.

 

Earnings

The next step of our analysis is looking at the earnings. Aspects that are important to us at this stage are the consistency and the 10 year compound annual growth rate (CAGR) of the earnings.

The CAGR of the last 10 years is 16.39%. To determine the consistency of earnings it is best to look at a graph. As you see in the picture titled Earnings Growth of MNST, earnings grew very consistently. Monster Beverage was actually able to increase their earnings each year during the entire ten year period. Also the earnings show a strong upward trend.

 

Debt

It is also necessary to look into the debt burden of a company. The long term debt is the most important metric to consider. In the case of Monster Beverage there is no long term debt at all, which is very good. Actually the company hadn’t had any debt since 2010 and no long term debt since 2006.

 

As Monster Beverage meets all our requirements in the quantitative section of the analysis, we can now move on to look into the business model.

 

1.2 Qualitative Analysis:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Type of Business

The most important aspect in this part of the analysis is to identify the type of business of Monster Beverage. We are looking for a monopoly type business. That means the company has some measures to shield themselves from competition, so that they don’t have to compete by lowering their prices. In the case of Monster Beverage the strong brand definitely acts as a shield against competition. Monster is very active as a sponsor, especially in extreme sports, to further strengthen their brand. Another aspect that came to my attention when I was buying different tastes of their drinks to try them for myself, was the placement of their products. In the supermarket their drinks were exactly on the height of my eyes, while all the other brands (except Red Bull) were placed in the lower shelves. In some stores Monster drinks even had their own fridge which was formed in the shape of a big can branded with the Monster logo. These findings further strengthen my conclusion, that Monster has a strong brand name product and is therefore to be categorized as a monopoly type business.

 

Capital Requirements

The capital requirements of a company are also a key determinant of the profitability. If a company has to allocate most of their earnings to the maintenance of factories and equipment or to expensive and ongoing research and development that doesn’t produce secure outcomes, they lose the ability to reinvest their earnings into new business opportunities or the expansion of their operations. In our case the capital requirements are extremely low, because Monster has outsourced the entire manufacturing process to third-party bottlers and co-packers. They don’t have to maintain factories of their own and are able to reinvest the earnings into the expansion of the business. Also there is no need for expansive research and development, as energy drinks are a fairly simple product.  

 

Retainment of Earnings

Monster was able to reinvest their entire earnings back into the expansion of the business, because they never paid a dividend (which is a good thing). When talking about the retainment of earnings, it is also important to test If the retained earnings have been employed in a profitable manner and if the price of the stock responds to the value added to the business. The stock price definitely responded well to the increased value of the company as it has increased steadily over the past years. To see how profitably the retained earnings have been employed by the management we will put the total retained earnings per share in relation to the increase in earnings per share over the last ten years. First of all we have to calculate the total EPS for the last ten years, which are 9.03$. In this case there is no need to differentiate between retained earnings and earnings paid out, as there was no dividend. Otherwise it would be necessary to subtract from the total EPS the part of the EPS which was paid out over the years. The increase in EPS over the same period has been 2.17$. This means Monster Beverage invested 9.03$ a share to gain an increase of 2.17$ a share, which means they invested their retained earnings at a return of 24% (2.17$ / 9.03$ = 0.24 = 24%) So we can conclude, that the management definitely has the ability to profitably employ retained earnings as a return of 24% is exceptional and difficult to get elsewhere.

 

Conclusion

Monster Beverage is a great company, that met all the requirements in both sections of the analysis. Their product is used up quickly, very simple to produce and never goes obsolete. These properties coupled with the low competition and their strong financial situation make for a great investment. In part 2 of the research on Monster Beverage we will see at what price the stock is a good buy. Feel free to leave a comment and I hope you enjoyed reading!

What is Compound Investing?

Today we will briefly talk about what the term Compound Investing stands for, so that together with my first article on compound interest we will have a framework for the coming content. First of all I would like to think that I have coined the term Compound Investing myself as various searches on Google and Youtube have only come up with websites or videos that either talk about investing or compound interest, but not their combination in one single investment strategy. However I am not sure if that is really the case and provided you have heard it somewhere else please leave a comment correcting me on that. What I do know for sure is that I did not come up with the content of the strategy myself, but that it is a synthesis of what I have read about and learnt over the past years.
 

The Goal

At first let us talk about the goal of Compound Investing and the time horizon over which the strategy unfolds its power. The goal is finding companies to invest in that are able to deliver superior returns to the investor by compounding their earnings within the company. Basically this means they are using the exponential nature of compound interest to their advantage by adding their earnings back to the equity base so that given the same return on equity their earnings in the following period will be greater than before. This process makes a huge difference that will also show in the price of the company’s stock, but as we have seen in my previous article, the magic of compound interest needs time to work best. The biggest growth happens in the later phases. That is why we will look at a time horizon of around ten years. If possible we will hold the company even longer (given they still fulfill our requirements) and in some cases it might be necessary to sell after a shorter period of time.
 

The three Steps

Compound Investing consists of three separate steps. At first there will be a quantitative and qualitative analysis of a prospective investment. These steps will determine if a company meets our requirements. If that is the case the third step will be a projection of future earnings. The first step, the quantitative analysis, also acts as a filter, because if a company doesn’t fulfill our requirements in this section we will not look any further into it. This also allows us to quickly sort out most of the companies and therefore save a tremendous amount of time that we can then use to thoroughly research the companies that have a high likelihood of being a good investment. During this first step, the focal point will be looking at what the company earns and finding out if they have the ability to compound their earnings over long periods of time and at high rates of return. After that, in the qualitative analysis, we will take our time to really understand and get familiar with the company’s business model. At this point it will be important to determine if the company has a competitive advantage and some measures to shield themselves against possible future competition (i.e. a strong brand). Based on the results from these two steps we will be able to determine if we want to buy the company’s stock. In the last step we will estimate a price at which the stock becomes interesting to us. In order to do that we will be projecting the future earnings for the next ten years. 

 
This was meant to be an overview about Compound Investing. The exact process will be shown over the course of the following articles. I hope you enjoyed reading. See you soon!
 

What is compound interest?

In this first article we will discover what compound interest is and why it is very important for your investment success. We will also look at some examples to grasp the real power of compound interest and see which factors determine it.

The definition of compound interest

Basically compound interest is the term for additional interest you earn when you add the interest from one period to your principal investment in the next period instead of opting for a payout. So for example you start with 100$ at 5% interest rate and receive 5$ interest. In the next period your principal investment grows to 105$, so your interest at 5% would be 5.25$ (instead of 5$). The compound interest would be the 0.25$ that you only earnt because of adding your interest from the beginning back to the principal.
The key variables that determine compound interest are the principal investment, the interest rate, the compounding frequency and time. With interest rate and time being the most important ones.

This concept is one of the most important in finance, because it allows you to grow your investments exponentially (without having to do extra work). Even though exponential phenomena are difficult to comprehend for the human mind, there are multiple examples from other areas for example the growth of bacteria and nuclear chain reactions.

Visualization of the power of compound interest

In the graphic The Power of Compound Interest 1 you can see the exponential character of compound interest. You can also see how it unfolds over time and for different interest rates. Note the huge difference between an interest rate of 15% and 20% and that it is several times bigger than the same percentage difference between 10% and 15% interest. This means a small difference in interest rates can make a huge difference over a longer period of time. A return of 20% over the course many years was actually achieved by the world’s best investors and is not impossible. In the graphic The Power of Compound Interest 2 I zoomed in so you can better see the differences in interest rates and I also included the return of the S&P 500 for comparison.

The concept of compound interest is difficult to really understand, not intellectually, but to really get a feeling for its power and meaning. Hopefully I could convey its importance to you. If you liked the article or have some criticism feel free to leave a comment. Thank you for reading!