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Good morning. I am an American, and as such a stranger to monarchy. But the late Queen’s grace and fortitude were obvious to everyone. I mourn with my British friends and readers. I hope a little finance chatter serves as a distraction. Email us: email@example.com and firstname.lastname@example.org.
Apple, the ultimate quality stock
Yesterday’s column on quality and value stocks posed a dilemma, summed up as follows. One: quality stocks (strong competitive position, high margins, steady cash flows) outperform during scary times like these. Two: value stocks (cheap price/earnings or price/book, in competitive markets, often cyclical, often leveraged) outperform in the recovery. Three: you do not know when the scary times will end and the recovery will begin.
In the abstract it is easy to say that the right thing to do is snap up value stocks when they are unloved, rather than overpaying for quality when everyone else is. It is harder when confronted with examples. So I posed the question to myself: what is the highest-quality quality stock?
It’s Apple, in my view (happy to hear readers’ candidates). My shorthand quality metric is gross profit divided into total assets, a crude measure of how many profit dollars a company can wring out of the stuff it owns, which can then be invested in the business, employees or customers, or passed on to shareholders. Apple comes in at 50 per cent here, in the top 10 per cent of the S&P 500 and amazing for an asset-intensive business. Margins are high and stable over the long term. Free cash flow gushes year after year.
And what a competitive position: raise your hand if, as an Apple user, you would consider switching brands for your next phone/laptop/watch. Anyone? Anyone? Hence the staggering pricing power on display at the company’s latest product launch — yet another extravaganza of minor innovation. Whatever you think about how Apple will evolve, this business is not going to disappear from under its investors.
So: is Apple too expensive now, despite all this? Are investors overpaying for all that quality?
Here is Apple’s premium to the market. I’ve put the premium of another classic quality stock, Colgate-Palmolive, on the chart to add some context:
Apple shares have pulled off an amazing trick. They outperformed the market like a tech stock when tech stocks were hot. Then, this year, as tech has fallen out of favour, they have slightly outperformed the broad market and crushed other tech stocks. The result of this is that Apple now trades at almost as big a premium to the market as it ever has (contrast Colgate-Palmolive, which has traded near its current premium quite often).
Apple’s widening premium over time can be partly explained by the transformation of the business. In the most recent quarter, a quarter of revenues came from services. In 2016 the figure was 14 per cent. More importantly, Apple has proven that it can sell iPhone fans top-end models on the back of only incremental improvements — and expensive supplemental products, too. Both, again, bind customers to the brand. As tech pundit Ben Thompson sums up:
The end result is that Apple isn’t making $550 per customer, to go back to the iPhone 5c, or $650 in the case of the 5S: they’re making upwards of $2000 — $1,000+ for a top-of-the-line iPhone, $400+ for a Watch, $200+ for AirPods . . .
I was writing about the company back in 2016, when it traded at a discount to the market. There were plenty of people out there then arguing that what happened to Nokia and BlackBerry could happen to Apple. That possibility seems very remote today.
On the other hand, there will always be an analyst out there who says Apple’s market cap will quintuple when it gets into cars, payments, healthcare or fairy dust. Best to ignore them. What Apple does is get even better at the same things it has always done: small, wizzy devices that do cool stuff. Assume that Apple will grow, at best, at the respectable but stately upper-single-digit pace of recent years and, at worst, will become a slow grower that remains super profitable for years to come.
To get that today, you must pay almost the biggest premium anyone has ever paid for Apple. That is, in an extreme form, the quality dilemma.
Unpriced recession risk, credit edition
When the economy gets worse, low-grade debt falters first. The familiar story is playing out now in leveraged loans.
To recap, these are floating-rate bank loans to heavily indebted groups, often to fund buyouts. Higher interest rates and slowing growth squeeze lev-loan issuers from two sides, amping up repayment pressure just when revenue shrinks. Analysts have been saying for months that things will get worse.
Well, this looks worse. Here’s the FT’s Eric Platt:
Bankers on Wall Street have embarked on a high-stakes attempt to offload a $15bn financing package [for the buyout of Citrix, a tech company] to investors in a significant test of whether creditors are willing to lend to risky businesses as the economy slows and interest rates rise . . .
However, to attract those investors, the banks will have to offer the loan at a significant discount. They are hoping to price it at 92 cents on the dollar with an interest rate of 4.5 percentage points above Sofr, the floating interest rate benchmark.
That is a much bigger discount than has been recently typical for a deal like the buyout of Citrix . . .
However, investors are warning the discount could still increase as bankers finalise the deal depending on the level of appetite.
This fire sale is not an isolated event. Some other indicators:
Lev-loan defaults are creeping up and are now at late-2020 levels.
Credit rating downgrades have exceeded upgrades in the past month, according to S&P.
The Fed’s loan officer survey, a leading indicator of credit conditions, is showing sharp tightening in lending standards.
Year to date, we’ve seen just $78bn of financing (new issuance + refinancing) come through, versus $465bn in 2021, according to LCD data. Vanishing financing will weigh down any companies that need to roll over debt.
This feels to us like a smallish flock of canaries saying it’s time to leave the mine. And remember that credit markets are slow-moving beasts. This is true of credit spreads, where the rate of change is more informative than the level. As Marty Fridson, the dean of high yield, put it to us:
It is the norm rather than the exception [that credit] markets have waited until the wolf is at the door until they start to reflect the prospect of higher default rates.
Not everyone shares our anxiety. In its third-quarter credit outlook, Guggenheim argues that credit now looks cheap, especially in leveraged loans, where spreads are somewhat elevated by historical standards (green cells below):
(Spreads, we should note, have risen since Guggenheim published this graphic but are still below mid-July levels, when recession speculation was rampant.)
Yes, there is recession risk involved, but investors are compensated for it and can hunt for quality companies in unpopular cyclical industries. Guggenheim writes:
We believe some companies in out-of-favour categories are positioned to survive a downturn due to their healthy liquidity profiles and sticky cash flows, which often come from long-term contracts in place or issuer bargaining power.
If the US avoids a recession, Guggenheim will look smart. But nothing even resembling a recession is priced into the risky edges of the credit market. [Ethan Wu]
One good read
John Plender on the debt trap.