Back from vacation with our best podcast ever. Ernest and I discuss why we love companies that have the owner operator mindset and make themselves invincible on the balance sheet. Then we discuss our feature company, the profit machine called Apple. We talk about the current criticisms of the company and why we feel the best days stay lie ahead. Check it out!
Long Term Investing Podcast can also be found on Spotify & Apple.
Podcast Transcript
Barry
Hello, and welcome to the Long-Term Investing Podcast with Baskin Wealth Management. I’m Barry Schwartz, chief investment officer. Baskin Wealth Management is an independently owned investment management firm with almost $2 billion in assets under management, providing customized wealth management solutions and services to families and foundations. In this podcast, we ignore all the noise and have conversations that make sense about the things that matter in today’s markets. It’s what we talk about with each other here in the office, and we want to share those conversations with you. Please stay tuned for our legal disclaimer at the end of the episode.
We are back from a two-week hiatus. The hiatus because, Ernest, I was on vacation. But thank you, Ernest Wong, for joining me on the podcast. Today vacation is over. Back to work. Earnings never stop of course, the market never sleeps, even when you’re on vacation. But when you go to Europe and you’re 8 hours ahead, it’s harder to follow things. Luckily, I had you to follow things. And so as long as you and I both aren’t away for two weeks at the same time, we can pay attention and still chat through Teams. The earnings are coming in fast and furious. I read Ernest that the S&P 500 earnings are beating expectation again, for the S&P 500 companies, it’s all about earnings. And you wanted to talk before we get into our feature company, you wanted to talk about a little bit about how stocks follow earnings.
Ernest
Yes. So. The big fear going into 2023 was that we’re going to have a recession and that everything was going to be terrible.
Barry
Yeah, I remember that.
Ernest
And obviously, we don’t know what the stock market is going to do in the next few months. But what we’ve seen in the most recent quarter’s earnings is that shares the market is expecting things to improve. So, Floor & Decor, for example, is a company that we own, and they’re one of the largest distributors of hardwood flooring in the United States. The stock is up 50% year to date, but their volumes are still falling because the home sales are very poor.
Barry
People aren’t really renovating their flooring, and no one’s selling houses because the inventory is low, interest rates are high, it’s harder to get mortgages. No one wants to move right now. It’s just a weird time.
Ernest
Right. So, a cynic would say, oh, the market’s just being irrational and putting Floor & Decor shares in a bubble. I think a better explanation is that the market is forward looking, anticipating that home sales are probably going to improve from here, and that because of Floor & Decor’s business model, they’re probably likely to gain market share over this time while maintaining profitability. So which one it is? I guess we’ll see. But I think it’s a good reminder that the market is forward-looking, and share price follows in advance of the earnings.
Barry
Bill Miller is one of our favorite investors. We follow a lot of what he says. Sometimes he does some crazy stuff with his portfolio, like putting almost all of it into Amazon and Bitcoin, although I think that’s worked out well for him. He’s a billionaire because of it, but you have to have a certain mindset and stomach to live through it. But he’s always said that the PE ratios and the evaluations tell you about what happened in the past and really the growth is in the future. So, you got to look out, as we always say, out the windshield instead of the rear-view mirror and really study your companies and know them well. And yeah, it can be, as you said, totally mind boggling to see a company that lowers guidance going forward. Its earnings aren’t as good as expected, yet it’s up 50% this year, and that’s only a minor example. There are some extreme examples of some companies that are up 200% or 300% year to date, albeit they probably got destroyed in 2022 and their earnings or their outlooks aren’t as good. Maybe worse news was priced into the stock. But what we want to finish off here and say is last year, when it looked like the world was ending because inflation was nonstop, all of a sudden the market started to pick up in midsummer of 2022, and hard to tell why that was happening, but the anticipation, I guess, was that inflation was going to start to come down. Interest rates would stop going up at some point, although they haven’t yet, in 2023, and earnings would start to recover. And there’s always so much more than one variable when it comes to pricing out the valuation of stock, right? You can say, well, interest rates are going to go up. That’s bad for flooring decor. Well, you just mentioned that there’s other positive things that can happen. They can gain more market share; their business can get better in a tough time. So, I think that’s a very insightful point to make.
Ernest
I think another thing that was pleasantly surprising for Baskin’s strategy of investing in high quality businesses with strong balance sheets is that a lot of the companies that we own tend to carry a lot of cash on their balance sheets. They do this mostly because they want to act conservatively and save money for rainy days or to make deals if the opportunity presents itself. And a side benefit of doing this is that some of them are earning fairly decent yields on the cash that they have today.
Barry
Yeah, well, T bills and high interest savings paying 5% or more, that’s a decent return on your idle cash. And in some of the cases, it’s actually a fairly material portion of their earnings.
Ernest
So that’s been something that may not be immediately intuitive, but it’s something that is happening so far.
Barry
Well, I saw the headlines about Berkshire Hathaway, which had an incredible move the past couple of days. $140 billion net in cash, and it’s going to earn $7 billion from interest income. That’s no joke. Of course, there are lots of reasons why Berkshire has $140 billion in cash. Some of it has to do with mechanical reasons about being in the insurance business and keeping a large float. And not all that $140 billion could be put to work. But owners have a different mindset, and that rainy day. And living to fight another day means you don’t blow up the balance sheet. You don’t try and risk everything for the short-term earnings pop. And companies like Berkshire and Costco and Constellation Software, that high quality mindset, that owner operated mindset can really do wonders for your portfolio over the long term.
Ernest
Yes. No, definitely.
Barry
Cool. So, on that exciting note, we want to talk about Apple.
Ernest
Talking about a clean balance sheet.
Barry
Cleanest balance sheet. Not as clean as it used to be, of course, but I think we’ll get into it. But our clients have owned Apple, those that have been here since around 2012. Had I listened to my wife who told me to take a look at Apple stock a few years after it launched the iPod – you know it launched the iPod Ernest in 2001 – and if you look at a split adjusted price of Apple in 2001, it’s about twenty seven cents US. That would have been your cost base. Not saying that I would have bought it at, but had I bought it and listened to her a lot earlier, maybe I’d be doing different things than doing this podcast with you, but that’s another story for another day. But, Apple just released its Q2 earnings, and the stock got beat up a little bit. But we have some positive things we want to talk. So, let’s get into our feature company, Apple. Tim Cook. Tim Apple. He’s been doing a great job. Ernest, what do you have to say?
Ernest
So, Apple today is the largest company in the world.
Barry
Is it larger than Saudi Aramco?
Ernest
Well, maybe not. Okay, Saudi Aramco, but they’re the largest publicly traded company in the US. Certainly. Market cap is about 2.8 trillion with a T.
Barry
Wow.
Ernest
Used to be three, but as you mentioned, has sold off a little bit. Just a quick snapshot of what Apple is today. I think that just in raw numbers. Apple is sometimes a little bit underappreciated. They did about $380 billion in sales last year, about $95 billion in profits. Which is, for some for some perspective, that’s about the same as Google and Facebook put together. Amazing. It’s just incredible. There’s big tech and then there’s Apple, really, to break this $380 billion down a little bit more, 80% is from selling products like things like iPhones is most of it, but also Macs, iPads, Air Pods, watches, and the remaining 20% is what Apple calls services. So, this is things like cloud storage, Apple Care, Apple Music, the App store. It’s a bit of a black box, but that’s what it is. Services are generally more profitable for Apple, so about a third of their profits come from services, two thirds comes from product sales.
Barry
The services are really people paying for Apple cloud, right? Which is probably a 95% margin business.
Ernest
Well, yes, like I said, it’s a black box. Nobody really knows exactly what the various contributors are, but they make Apple a lot of money. And they keep growing by double digits every year.
Barry
Well, every time they add a new user. Anyway, we’ll get into that. Go ahead.
Ernest
So, I think even teenagers understand why Apple products are good. They’re easy to use, their design is good. You look cool if you have an iPhone versus an Android Droid.
Barry
Totally. And all the teenagers have their Air pods in their ears 99% of the time of their waking life.
Ernest
Right. But at the very core, I think the reason why Apple is so successful and so profitable is because unlike most of its competitors, like Samsung or Google Pixel or Huawei, they control every aspect of the products that they make. So, this includes the operating system, this includes the App Store, they increasingly design their own chips, they make basically all the software, they even control the sales and servicing of the products that they make through the Apple Store.
Barry
They have both the physical and the Cloud Store.
Ernest
Exactly. And the reason this is important is that it makes Apple products have a better user experience because they design the entire aspect. They know how it all works together. And it also makes you stuck into their ecosystem.
Barry
100%.
Ernest
Because if you for whatever reason, you don’t want to use iPhone anymore, you’re not just getting a new phone, you have to switch your photo storage provider, you lose all your iMessage text, you can’t watch Apple TV Plus anymore, your Air Pods won’t connect to your new phone. It’s just super hard to actually leave.
Barry
It’s your entire life.
Ernest
Exactly. And increasingly, so that’s one thing. Another thing that comes from Apple controlling the entire ecosystem is that it allows Apple to capture the vast majority of the profitability that comes from its ecosystem. So, there’s a few examples of this. First is that Apple can sell things like Air Pods and watches to the existing iPhone base, and those are the products that work best with iPhone because they’re designed and made to work together with the iPhone. That’s not true if you’re buying a Samsung, because those are Android based and they just don’t control every aspect of the user experience. Another example is that every time you are buying gems or something when you’re playing Candy Crush, Apple gets a large cut of that.
Barry
I was wondering where you’re going with buying gems, but you’re talking Candy Crush.
Ernest
Every time you spend money on the App Store, apple gets a 30% cut of that.
Barry
My wife was totally addicted to Candy Crush. I think she stopped or I’ve stopped looking at the credit card, how much money we’re spending on Apple every month. So, 30% of the $2, $3 that one would spend to upgrade to the next level when they can’t finish it or to move forward right to Apple. And is that all margin?
Ernest
Yeah, 100% margin.
Barry
Amazing.
Ernest
This has gotten a little bit controversial, of course, in recent years, but it’s another way Apple is flexing its ecosystem to make money. Another way they do that is by charging. Google pays them over $10 billion a year just so that when you open Safari, the browser, they’re the first ones that you see for search.
Barry
And that’s totally worth it to Google because it gets access to a billion iPhone users every day to be the default search engine. Why wouldn’t they, it should be paying more, right?
Ernest
And so, you put these together, and that’s why Apple is the most profitable company in the world.
Barry
Yeah. So, it’s the most profitable company in the world. And every time you talk about Apple and people talk about it in the media, everybody says the growth is over, the valuation is too high. They’re not innovative. I think I’ve heard they haven’t been innovative every year since the unfortunate passing of Steve Jobs, you know, well over a decade ago. And had you bought the stock on his passing, you would have made an absolute fortune. So, Ernest, why don’t you get into a little bit about the criticisms about Apple and maybe refute some of them about valuation, about it’s not innovative, it’s not growing anymore. The stocks shouldn’t be trading at a premium multiple. I think people will be really interested to see what we see over the next three to five years with Apple.
Ernest
Yeah, like you said, a lot of common criticism about Apple is that it’s something like, Apple is just the next BlackBerry or it’s the next GE, or like in history, if you look through history, every time there’s a big and successful tech company that becomes the largest company in the world, it ends up inevitably failing BlackBerry, IBM, Polaroid, Hewlett Packard, you name it. And this has especially been true for hardware device makers such as Apple. I think this is a very lazy comparison because it doesn’t really, at the end of the day, have anything to do with Apple. It’s just making an equivalence between something that did happen in the past and something that may or may not happen in the future and doesn’t really say anything about what Apple is doing today or what their strategy is …
Barry
or their eco system or the type of product that it’s created that the consumer product flywheel that it’s created versus maybe a more business-oriented product and the fact that it’s probably created the most addictive product the world has ever seen.
Ernest
Right. And as you said to me and you have heard this objection basically every year since we’ve owned Apple, Apple’s best days are over. They’ve totally saturated their growth opportunity. And you could have said that in 2018, for example. And since then, they’ve added $130 billion worth of sales. So, they clearly have found some way to grow profits. And so, I think there is a lot of opportunity for growth with Apple going forward. They are growing quite quickly in the enterprise market by selling things like Macs and iPhones into what has traditionally been a Windows based market.
Barry
Totally.
Ernest
And I think that they’re getting there because of their focus on privacy and security, which is something that a lot of organizations are thinking about right now.
Barry
As well as connecting other devices. Right. So, if everybody in your office has an iPhone and yet you’re working on PCs, there’s a latency issue there.
Ernest
Exactly. So that’s one thing I think there’s a lot of opportunity for new services. I think things like payment, things like health services, things like ads, or even things that don’t even exist yet. I think those are all opportunities for them to make more money and also increase the stickiness of the product. Make it harder for you to switch away. I think there’s also more opportunity for them to launch more very expensive widgets like the Air Pods or the pencil. And these are all things that my wife is definitely going to buy when they come out.
Barry
What’s the goggle thing that they are working on?
Ernest
Yeah. And so, the Vision Pro. I think there’s opportunity long term for new platforms like I don’t know what’s going to happen with that.
Barry
No one does. I mean, it came out and everybody made fun of it, of course, but we just don’t know the future, and I would trust Apple to be able to figure out the right product. Not necessarily Facebook or a Google Android Pixel product.
Ernest
And then lastly, I think there’s a lot of opportunity in emerging markets.
Barry
Totally. Places like India, where they just opened their first Apple store. I was looking to, sorry to interrupt, but I was looking at there’s still not a lot of Apple stores around even in Latin America, and obviously in India and just other places, some of them only have one or two. Just the opportunity is huge.
Ernest
Right. And because Apple is a premium product, to the extent that you think emerging markets and people entering the middle class are getting wealthier, I think they’re more likely to switch from a cheap Chinese Android phone to an iPhone.
Barry
So, Ernest, 2023 Apple is on a different fiscal year than a calendar year. I think it just finished its third quarter earnings, so its fourth quarter earnings is coming up. It’s going to be a year of down revenues. I think that part of it has to do with FX, part of it has to do with the fact of when they released the iPhone last year versus this year. And a lot of people are comment, and the earnings are probably not up very much as a result, even though they’re buying back a lot of stock. So as a result, people are saying, well, there’s no growth left in the stock, and you’re paying 26 times earnings or 30 times earnings for a no growth company. Why should I be paying that kind of multiple?
Ernest
Well, before I say that, before I answer that part, I just want to make one last point.
Barry
Yeah, of course.
Ernest
I think that’s a little bit underappreciated and kind of helps explain why Apple’s shares have held up a bit better than a lot of the other tech companies over the last year is that Apple is extremely careful with how they spend money. Not to say that other companies aren’t, but if you compare Apple to a lot of other megatech companies, they’re very careful about managing operating expenses and headcount, which is one reason why they haven’t conducted large layoffs. Unlike a lot of their peers, there was nothing to recover from.
Barry
Right. Amazon and Google Meta laid off a ton of employees. And I think Apple just said, we’re going to slow hiring in some areas.
Ernest
Right. And part of the reason is because Apple, they don’t spend money on what I would call moonshot projects. They’re not spending money on Internet balloons in Africa or driverless taxis or stuff that might be profitable in 15 years.
Barry
No question, they’re spending, I don’t know, $12 or $15 billion on R & D. It’s going somewhere. And there’s got to be always secret projects that they’re working on, but they seem to be very disciplined about throwing money out the window.
Ernest
Right. It’s not that they’re not making cool stuff. It’s that they’re not spending on pet projects of the CEO. So, that’s one thing. Another thing is that Apple basically doesn’t do M&A. The largest acquisition they ever did was Beats, which was $3 billion.
Barry
Those are the specialty headphones from Dr. Dre.
Ernest
Right. In 2014
Barry
That probably wasn’t a very good acquisition. I don’t know.
Ernest
No. And it turned out to be totally immaterial. It doesn’t matter. So, most of the cash that they make ends up going back to shareholders through buybacks and dividends. Warren Buffett loves that. And so, Apple’s earnings, even in a bit of a rough year, they’ve been remarkably stable. If you compare that to even Google, which we still own and love, their earnings are down quite a bit because they didn’t do as good of a job of managing headcount.
Barry
Also, Google’s in a much more cyclical industry, which is all based on advertising spending, where if you lose your iPhone or your Air Pod, you got to replace it. You just can’t live without it. So, it’s pretty exciting. Okay, go ahead.
Ernest
Back to valuation. I think shares are trading at about 28 times earnings today. They have about $50 billion in net cash. Although, most of their debt is basically zero or 1% rate debt that they issued in Europe to help bring their cash back in a tax efficient way. So, they’re buying back a lot of stock.
Barry
Every share that they’ve bought back over the last decade has been brilliant because they bought them back at much lower prices.
Ernest
I think certainly earnings, especially in North America, there’s a bit of a consumer slowdown because the consumer is a little bit more challenged, and a lot of people bought new phones over the last couple of years.
Barry
Yeah, I mean, the consumer is pinched, there’s no question. Inflation and higher interest rates and a slowdown in the economy, it’s going to pinch everyone. But you talked about the company Floor & Decor. You don’t have to redo your floors, but you’re probably still going to buy that new iPhone or new Air Pods.
Earnets
No, my phone broke like two months ago and I had to buy a new one the next day.
Barry
Of course. The next day, yeah. I mean, my wife thought she lost her phone in the car and like five minutes later, she was ready to drive and go get a new one. And luckily, she found it.
Ernest
And if you look at 28 times, certainly not like deep value stock, but if you look at high quality companies anywhere, it certainly looks like a very reasonable price to me.
Barry
Luxury brand companies like Ferrari and Hermes and LVMH trade at 40, 50 times earnings. Right?
Ernest
Exactly. Yeah. So, like. It’s not cheap, but certainly not the bubble that I think everybody makes it out to be.
Barry
Absolutely, I don’t think it’s a bubble. So how do things pick up for Apple from here? They just announced that in September they’re coming out with the iPhone 15. So that should reignite sales, I assume. Apple is very good with pricing, so there should be some margin growth going forward. You mentioned emerging markets, new opportunities there, new products. So, I guess you put all those things together and you can get a pretty nice clip of revenue and earnings growth, plus share buybacks.
Ernest
It’s also hard to predict Apple’s exact trajectory of revenue growth because they are very tight lipped about what new products they’re going to release and when they’re going to release them. So, you do have stretches where revenue kind of goes nowhere for a few years and then it suddenly jumps like 20%. And so, I think you’re probably going to see that going forward.
Barry
So Apple, I think, is going to generate around $100 billion of free cash flow. They have a small dividend. The dividend maybe is $10 or $15 billion of that cash flow. So, there’s $70 to $80 billion left over every year for buybacks.
Ernest
Exactly.
Barry
Yeah. I mean, Apple could buy whatever it wants, but I guess why is buying back its shares the smart thing for Apple at the moment?
Ernest
Well, I think they have first of all, they have way more money than they know what to do with. You can’t spend $100 billion if you wanted to. And probably even harder today, given the antitrust regulatory regime that exists. And the nature of research is not that you just pour money at it and out comes a new product. These things take time. Right. So, I think you could say, what else would they do? As we talked about, if you think that Apple’s best days are still ahead of it, which I think it is, then why not buy back stock at what doesn’t look like an unreasonable multiple?
Barry
Especially when you’re generating that much cash flow? And because they’re buying back so much stock, the free cash flow per share growth, which really interests us, should reignite to double digits from here.
Ernest
Yes.
Barry
And if that’s the case, the stock is mildly attractive at this valuation. Maybe if they run up close to $200 a share, maybe it got a little bit ahead of itself. But even in these earnings, where the guidance, I think, disappointed the street a little bit, I still saw that analysts were raising their estimates for 2023 and 2024. And, of course, every time the stock goes down, Apple can buy more shares back at a cheaper valuation which, for long term investors, is what you want.
Ernest
Exactly. And I think in the earnings call, obviously, quarter to quarter, or even year to year phone sales are going to be quite volatile. But I think the key phrase that they said is that two key phrases, actually. Number one is, we had a high level of switchers to iPhone, which basically means they’re gaining share over Android.
Barry
Amazing.
Ernest
And number two is that, the exact phrasing sometimes varies, but something like over half of sales of Macs and iPads were to new customers. So, people who’ve never owned one before.
Barry
So that’s someone who either has never used an Apple product or someone who has an iPhone and Air Pods and decided to buy a Mac as their new computer.
Ernest
Exactly. And so, when both of these things are true, what this just ends up meaning is that at some point, all of these new customers are going to be buying services, they’re going to be buying accessories, and Apple is becoming more powerful and a bigger company.
Barry
We also have to remember that Apple got a huge COVID bump like a lot of big tech companies. Everybody was scrambling to get their kids new iPads for home, new computers. And so those sales have tailed off, but eventually those things will break, and they will need to be replaced. So, I think people are focusing a little bit too much on the short term and not enough on the long term. And Ernest, we could see Apple generating $120 and $130 billion of free cash flow a year from here. That’s a lot more money for buybacks, no M & A, so more money for buybacks and dividends for one of the greatest businesses the world has ever seen and has now come back to really a more reasonable valuation, so, we’re excited to buy more. It’s our largest holding for clients because we’ve held it the longest and it’s done very well. We have trimmed it in the past, every time I trim, I cry a little bit, but it’s the prudent thing to do to diversify portfolios and make sure that we don’t have gigantic overweight positions in any one stock. These are first world problems to have. Any last final words on Apple?
Ernest
No, not really.
Barry
Okay, cool. Well, thank you all for joining us today. I hope you learned a lot about Apple a little bit more, and I certainly did, and appreciate Ernest, all your wisdom on Apple. And we’ve held Apple for over a decade and hope to hold it for another decade going forward. So, thanks, everybody, and we’ll see you back here real soon.
Disclaimer:
This podcast is for informational purposes only, and any forecasts on the economy, markets, or individual securities should not be viewed as investment advice, a recommendation, or an offer or solicitation to buy or sell any securities. Clients of Baskin Wealth Management and the speakers on this podcast may own shares of the companies discussed. Information on this podcast is current as of the time of production and is subject to change. If you have any questions or would like to subscribe to these podcasts, visit our website at baskinwealth.com.
