Efficient markets, rotten apples - part 1

John Addis examines the lessons of Wall Street getting the world’s biggest company wrong not once, not twice but three times in five years.

There’s no such thing as perfect competition. Whether in the banking sector, fuel, groceries or power, companies make huge monopoly profits. Under perfect competition that can’t happen.

Instead, the model serves as an economist’s reference point, and for wonks at the Productivity Commission or ACCC, something to aspire to. But whilst no market is perfectly competitive, there is one that gets closer to it than any other – the sharemarket.

No one buyer or seller dominates; each (theoretically) has equal access to information; transaction costs are low; and there are a large number of buyers and sellers. These factors make for accurate price discovery.

Key Points

  • If markets are generally efficient, Apple should prove it

  • Analysts repeatedly got the company wrong

  • Irrational pessimism is as common as irrational exuberance

The efficient market hypothesis (EMH) takes it one step further, positing that share prices reflect all publicly available information at all times. Assuming rational buyers and sellers (a big assumption which we’ll get to), prices quickly adjust to new information.

Now comes the kicker. If the EMH holds true no one can make above average market returns. But of course they do, as a glance at Warren Buffett’s track record, or even our model portfolios, suggests. Unlike the theory of gravity, which works all the time, the EMH works only part time. Our job as value investors is to spot those occasions where it’s off-duty.

If you peruse the list of Hold recommendations (about 90) compared with our current Buys (17) one might conclude that the EMH functions most of the time, especially among the larger blue chip companies the subject of most analytical attention.

Institutional failure

But what if there was a company where the market failed to price its stock appropriately not once, not twice, but three times? And what if that company was the world’s most scrutinised, most deeply analysed, obsessed-over stock? What might we learn from such a grand, institutional failure?

The Apple iPhone was launched on 29 June 07. Few realised its game changing status. Two years later, Apple's stock was trading at around the price when the new gadget was launched.

Although only hindsight truly illuminates its revolutionary capacity, professional analysts might have done better. By 2007 Apple had forged a reputation for innovation, successfully launching the iPod, the first iMac, and iTunes.

Most commentators weren’t persuaded. The response of Bloomberg’s Mathew Lynn was typical; the iPhone was ‘nothing more than a luxury bauble that will appeal to a few gadget freaks’. By the end of the 2009 fiscal year Apple had found 27 million gadget freaks to buy one. But the real failure was yet to come.

Between mid-2009 and September 2012 Apple’s stock price quadrupled. iPhone sales were exploding and the iPad was cracking along, too. Not only was the company selling more phones in a quarter than it had in the two previous years combined, the 60% margins were eye-popping.

Professional analysts completely missed the opportunity to buy the company cheaply. In July 2009, Fortune wrote, ‘not only were most caught off guard by the strength of Apple’s record third-quarter results but the men and women who track the company for banks and brokerage houses were bested once again by a bunch of bloggers, day traders and amateur analysts.’

Turley Morley, an unemployed former mortgage analyst with an Apple blog, could knock out earnings estimates far more accurate than anything the massed ranks of professional analysts on The Street could manage.

Two years later Fortune’s Philip Elmer-DeWitt again reviewed amateur and professional forecasts and ‘once again the Street blew it’. In top spot this time wasn’t an unemployed blogger but a Romanian mathematician. Down the bottom were Morgan Stanley and Goldman Sachs. As a group, wrote Elmer-DeWitt, ‘the amateurs were twice as accurate in their predictions as the pros.’

As Apple’s iPhone sales boomed and its cash pile grew there were no mea culpas. Instead, analysts just climbed aboard the rising share price. By November of 2012, of the 57 rated analysts that covered the stock 50 rated it a buy. Only two rated it a sell. Having first missed Apple’s four-fold price increase, they got on board too late to lock in the really big gains. Now they were about to miss the collapse.

Claim chowder

Negative media commentary surrounding the company intensified. Whereas the genius of Amazon’s Jeff Bezos was applauded despite the company never turning a profit, Apple was castigated for making too much money. A new term entered the lexicon. Apple claim chowder was the label applied to ill-conceived criticism that could later be offered as evidence of foolishness. And there was plenty of it.

Three arguments stood out. The first was Apple’s loss of market share to Android, which, until the launch of the iPhone 6, was undeniably true. According to Statistia, in the fourth quarter of 2009 Apple controlled 16.1% of the smartphone market. Samsung’s share was just 3.3%. Four years later Samsung controlled 29% and Apple 17.4%. Apple enjoyed increasing iPhone sales, but at half the rate of overall market growth.

This had long been a concern. ‘Apple’s ability to sustain an innovative edge over Android will be reduced to months – if that,’ said Brian Prentice of Gartner in September 2009. Within a few years, this critique had become widely accepted. In November 2013 former analyst turned journalist Henry Blodget urged Apple fans to ‘admit that the company is blowing it.’

The most popular phone operating system, the argument went, would attract the most application developers. These were the famed network effects. As Microsoft PCs had overwhelmed Macintosh computers in the 1990s, Android would overwhelm iOS. Eventually, popularity would win out.

The second argument flowed from the first. If Apple was to compete more effectively it had to sell its products at more attractive prices. Blodget again: ‘The answer is for Apple to sell some of its gadgets - not the latest, greatest ones, but some - at prices that are highly competitive with local alternatives [Blodget’s emphasis].’

Third time wrong

If Apple failed to do that itself, competition would force it to. Mark Newman of Informa Telecoms and Media in February 2012: ‘Apple is focused on defending the high end of the market, and that is becoming harder to do each year. Competitors, such as the Galaxy from Samsung, are starting to catch up. I think it is inevitable that the margin pressure increases.’

Either way, Apple was ‘dead in the water’. It had to lower margins if it was to avoid the competition doing it for them. Apple had to stop making so much money in order to make more of it.

The third issue was more subtle but just as significant. To the outside world, Apple was Steve Jobs. When he died in October 2011 there were doubts that Apple could remain the innovative force it had become. Even before his death Fortune was asking whether Apple could survive without him. After it, everyone was asking that question.

Coincidentally, Jobs death was followed by a period where Apple merely updated its product ranges rather than announce another game-changing device, thus prompting the likes of The Guardian to ask whether Apple was running out of juice.

These three issues, constantly prompted in the mainstream and business press, scared investors. Eventually, the chatter about Apple’s forthcoming, predictable decline took hold. On 17 Sep 12 Apple reached a split-adjusted high of US$98.75. Within seven months it had fallen 44%. And again, Wall Street analysts had missed it.

In part 2 next week we’ll look at how they managed it, why the explanations for Apple’s forthcoming demise were predictably incorrect, and what we can learn from the brightest brains on Wall Street getting Apple wrong three times in five years.

Disclosure: John Addis owns Apple stock and way too many Apple products.

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