Yesterday, Warren Buffett’s Berkshire Hathaway (NYSE: BRK/B) disclosed a $1 billion stake in Apple (NASDAQ: AAPL). As typically happens when Berkshire makes such a new disclosure, this sent the stock rallying by 4%. It is an interesting move given Buffett’s long-held stance against investing in information technology companies. So the question is, why did Berkshire make this investment?
Well, putting aside the high quality of Apple’s smartphone business and broader ecosystem, we believe a primary reason for Berkshire making the acquisition was Apple’s implied “margin of safety”. The concept of margin of safety can be read about here, but in summary, it is the idea of buying one dollar for fifty cents. Then even if you are wrong about the dollar, you still probably won’t lose money because you have only paid fifty cents.
You see, at $90/share – price of Apple’s shares prior to the Berkshire announcement, the market was implying a pretty draconian future profit trajectory, as shown below. That is, to break-even on your investment at $90/share, Apple needed only deliver future profit growth of around negative 5% per annum. The market was saying: Apple will be in structural decline forever.
We thought this market-implied expectation was unreasonably conservative. Apple customers cannot live without their iPhones and are unlikely to switch to a new ecosystem, in our view. Yes, the replacement cycle might be expanding slightly; and yes, average-selling-prices may come under pressure (though this will be offset by an increased total addressable market). But to believe Apple will shrink by more than 5% every year was simply not credible, in our view. Indeed, services revenues (iTunes, Apple TV, Apple Pay, Apps) already account for 10% of total revenue – and are growing at a rate of more than 20% per annum.
Buying with a margin of safety is by far the most important aspect of investing. With Montaka’s investment in Apple, like Berkshire’s, we know that if Apple simply maintains its current level of earnings and never grows again, there is more than 40% upside in the stock. This is a nice position to be in, on behalf of our clients.
Montaka owns shares in Apple.
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.