Fidelity’s new international trading service

A little more than a week ago, Fidelity began a new service that allows qualified clients to trade international stocks online.  Although I haven’t used the service yet, it appears to be a substantial improvement over the company’s previous international equity trading offering, which required a call to the company’s international trading desk.  As far as I’m aware, Fidelity becomes only the second discount broker–after E*Trade–to offer a low commission, online method to buy and sell international stocks and currencies.  (The markets covered include Australia, Hong Kong, Japan, Canada and most of western Europe.)

The big advantages of the new structure are:

commissions, particularly for Hong Kong trades, are a lot lower;

you don’t have to call a trading desk to place orders; and

you can hold foreign currencies in your account.

What investment conclusions can we draw from this?

1.  Fidelity must have been seeing a big increase in client demand for buying individual foreign stocks, for a long enough time and in enough volume to justify making the investment in computer systems to support the service.  Fidelity must also think that this new-found interest won’t go away any time soon.

2.  Many Fidelity customers must want to diversify away from having cash in dollars, since Fidelity is stressing the ability to hold foreign currency balances in accounts.  Of course, meeting clients’ currency needs can be very profitable.    For currency trades under $100,000, for example, Fidelity charges the spot rate +100bp.  For a retail trade, I think this is a decent deal.  But Fidelity, which can aggregate client currency orders, may be able to trade at very close to the spot rate.

3.  Clients must have been really unhappy with the former system, which other brokers still use.  I know I was.  Fidelity used to rely on US-based market makers operating through the pink sheets for trades under $50,000.   There, bid-asked spreads can be as high as 10%–in other words, as much as 10x-20x what they would be in the local markets.  I can’t imagine many clients being thrilled with this sort of execution.  And at least in part, clients would likely blame Fidelity.  (My pet peeve:  older computer systems were set up with the US stock market in mind, and with commissions figured in a certain number of cents–usually around 4¢–per share.  That would be a bargain in a place like Switzerland.  But in Hong Kong, where customs are different and important stocks can trade for the equivalent of US$1-2 per share, Fidelity’s commissions each way for a trade in the local market could amount to 4% of the principal.)

4.  The pink sheets must be vulnerable. The competition, the pink sheets, does a land office business in foreign stocks with a pretty poor product for all but the most highly liquid equities.  The new international service could be a substantial source of new customers and trading revenue for Fidelity, which gets to be a hero at the same time, for offering a far superior trading platform.

Where are people getting their information about foreign stocks?

Fidelity intends at some point to provide information on foreign companies through a third-party service, similar to what it does for the US (good luck in finding someone competent!).  Most major foreign companies have elaborate websites, where the basic facts are available, as well as IR departments able to answer at least some questions.  Local newspapers are available online.  And, of course, there’s the Financial Times.

I’ve been toying for some time with the idea of starting a service that would provide in-depth analysis and recommendations for foreign (and maybe one or two US) stocks I like.  Now that Fidelity is providing an easy way of acting in foreign markets, I’ve got to take the thought more seriously.  I’d appreciate any comments you might have.

Brazil and the “Dutch disease”

In many ways, Brazil can be seen as the premier growth story so far in the new century.  The country has always been blessed with abundant mineral and agricultural resources.  What’s new is that it has finally been able to shake off the legacy of decades of economic mismanagement.  Brazil’s GDP now ranks it as one of the top ten economies in the world.

Brazil’s prosperity, and the resulting inflow of foreign capital, have caused commentators to worry that the country is suffering from “Dutch disease,” an economic challenge named after conditions in the Netherlands after discovery of massive offshore natural gas deposits there.

What is the “Dutch disease”?

It has two elements:

1.  a sharp rise in the exchange rate, as foreign money pours into the country to purchase output from existing mineral deposits and to own and develop new ones;

2.  severe problems in non-resource traded goods industries.   The higher exchange rate makes output more expensive, hence less attractive, to customers abroad, and the booming resource industry attracts capital and workers to it,  raising the cost of both for every domestic company.

Since when is an economic boom a problem?

Two reasons:

1.  the economy of a natural resources-driven country becomes hostage to the booms and busts of demand for its commodities;

2.  the country can end up with no advanced service or manufacturing industries of its own, to offset commodity downturns, or to be there when the deposits eventually run out.

What about Brazil?

The Netherlands is a tiny country.  Brazil has the sixth largest population on earth.  So having all the working-age population pulled into natural resource development isn’t an issue.

But the exchange rate is.  The real is up 36% against the dollar so far this year (the US is Brazil’s largest trading partner), and the country is awash in foreign currency inflows, both foreign direct investment and portfolio capital.

Brazil is concerned, as it should be.  It believes the portfolio inflows are primarily speculative, however, and has just instituted a 2% tax on them.  The tax doesn’t apply to Brazilian ADRs traded in the US, by the way–and will likely not have much effect, other than to set creative minds to work on ways to get around the levy.

The situation bears watching.

For non-resource industries in a “Dutch disease” country, the best solution is government subsidy to encourage increased productivity and innovation in industries hurt by currency appreciation.  Import barriers, which would constitute a return to the bad old days, are unlikely, I think, but still something to be on the alert for.

Should the flows reverse, I imagine Brazil would heave a sigh of relief and wave the money goodbye, even though the departures would cause short-term pain.  The only country in (my) recent memory to stop outflows with capital controls is Malaysia.  As I see it, that action has destroyed the country’s investment appeal to all but the most highly specialized portfolio investors since.

MSFT’s Sept ’09 earnings (ll): MSFT and netbooks

The netbook transformation

1.  The idea

The netbook was invented by the Taiwanese tech manufacturer, Asustek (ASUS), a couple of years ago.  It was designed to be cheap (about $300), compact (8″ screen), light (2 lb.+) and fast (linux OS for quick boot-up and 30MB of flash memory for storage).  It’s very useful for email, web browsing, word processing and simple spreadsheets.

ASUS seems to have envisioned the netbook being used by young children, or perhaps as an upscale alternative to the machines developed by various $100 computer projects for emerging markets.

2.  The reality

Despite initial skepticism, netbooks have been a smash hit.  Sales have gone from zero to become 17% of all laptop purchases worldwide in about two years.  The users haven’t just, or even mostly, been the ones ASUS envisioned.  Netbooks have become a staple for business travelers and university students, as well as functioning as an “extra” computer for home use.

3.  The transformation

It turns out that netbook buyers don’t like linux.  So out that went.  Virtually all netbooks being sold today have a Windows operating system installed.  Initially this was XP; from now on, it will be some version of Windows 7.

But Windows uses up a lot of storage, about 12 MB worth for XP.  So solid-state storage has been replaced with small form factor hard disk drives in the 160 MB range.

Where to from here?

Open questions:

1.  Are netbooks popular because of recession-induced trading down that will disappear as the economy recovers? MSFT’s tone of voice when talking about netbooks makes me think this is what they believe.  There may be some truth to this.  Of course, MSFT also makes much more money selling software in a traditional notebook than in a netbook.  So they certainly would like to think buyers will trade up as the world economy recovers.

Most others–myself included–think netbooks are here to stay, and already comprise a new category that adds to overall laptop computer sales.  My guess is that traditional desktop-substitute laptops will stay as they are, but that the rest will strive harder to emulate the netbook’s portability–a feature consumers clearly want.  But I don’t see how they can adopt the netbook form factor without implicitly inviting potential buyers to expect a netbook price point.

2.  Will netbooks remain Windows machines? Netbook makers would prefer that they don’t.  There’s a strong economic reason for this.  If the manufacturer has to pay, say, $30, to MSFT for a low-end copy of Windows 7 vs. equipping a netbook with linux for free and can charge the same price for either, the profits are much higher if the customer picks linux.  The big problem so far is that linux has proved too hard for the typical netbook user to use.  Although netbooks can be ordered with linux, almost everyone chooses a Windows machine.

Google aims to change that, by introducing its Chrome OS in netbooks next year.  Chrome is based on linux and, like other versions of linux, is free.  The big question is whether the Google name or the Chrome performance will be enough to persuade consumers to turn down Windows.  No one knows yet.  If we look at Google’s other products, Google Groups, Picassa and Gmail are great, in my opinion.  But Google Documents are just not good enough.

3.  Will they use Intel processors? Again, it’s not clear.  The OEMs are going to introduce linux notebooks next year that are powered by microprocessors designed by the UK company, ARM.  ARM chips are commonly used in smartphones, so the move introduces a competitor to Intel, enhances the netbook communications capability and allows linux to be used as the OS.

Intel’s response?  It’s modifying its Atom chips so they can run linux machines.  It’s also joining ASUS and Acer in opening apps stores, like Apple has for the iPhone, for linux machines.  In other words, Intel is trying to make its position more secure by making it easier for OEMs to replace MSFT.

3.  Will there be an Apple entry? There have been persistent rumors on Apple-oriented websites for a long time that AAPL will soon offer a large screen, tablet-like, iPhone that will also be an entry into the netbook market.

I don’t understand what AAPL has to gain by doing so.  The company may produce a tablet (again, I don’t know quite why), but a netbook is a low selling price, low profit item made by high volume producers.  This really clashes with AAPL’s image.

An interesting spectator sport

What I find fascinating about netbooks is the battle of industry titans, each looking for a way to enter another’s key product markets.  It’s Google vs. Microsoft, Intel vs. ARM, ASUS and Acer vs. Dell and HP.  So far the field belongs to the Taiwanese and the Wintel alliance.  But for how long?

MSFT’s Sept. ’09 earnings (I): is MSFT a stock for 2010?

MSFT reported September-period earnings (the first quarter of its fiscal 2010) last Thursday, the day after the official introduction of Windows 7.

Earnings were surprisingly good, for two reasons.

X-Box continues to be the major force in this generation of console video game machines.  X-Box Live was up 50% year over year, and the latest installation of MSFT’s Halo has been a very big seller.   Yes, MSFT has been helped to some degree by Sony’s missteps, but the operational improvement at MSFT during this generation is still impressive.

Also, the consumer PC business is picking up again for MSFT, everywhere in the world ex Europe.  Netbooks are a big reason.  They’ve come from zero to 12% of the PC market in a couple of years.  Virtually all netbooks now sport a Windows operating system, although not many users opt for an Office suite.

The case for MSFT as a stock

Two points:

1.  better management The company has known intellectually for a long time that it is no longer a fast-growing company.  I recall vividly at a MSFT analysts’ meeting in Seattle early in this decade a questioner asking Bill Gates and Steve Ballmer when 20% eps growth would resume for MSFT.  The MSFT top managers were stunned.  Their somewhat scornful reply was that it was an heroic achievement just to get a company as big as MSFT to grow at 10%!

It seems to me, however, that MSFT hasn’t until recently accepted this fact emotionally.  That is to say, management continued to act as if MSFT were still a secular growth company and not a cyclical manufacturer of semi-commodity products.  The company hired a veteran of the forest products industry (the ultimate non-grower) as CFO in mid-2005.  Over the past year or so it has begun to tighten its belt.  It is paying increasing attention to costs and has even reduced its workforce by 4%.  It has also backed away from plans to acquire Yahoo, opting for a search joint venture instead.

Bears worry that MSFT will go back to its old free spending ways as recession abates.  For the sake of argument, thought, let’s assume MSFT understands that as a value company it is called to a different standard of management competence than it could get away with when the business was growing rapidly.

2.  strong cyclical recovery MSFT, like most other firms, believes the low point for world economies came (and went) in the June quarter.  The consumer is slowly reviving now.  Businesses, however, are simply adhering to the spartan budgets they developed last December at the height of economic uncertainty.

Large firms are already signally that they will boost their capital spending significantly next year if the recovery, weak though it may be, stays on course.   Their spending on new desktops and laptops may be unusually strong and they are wedded to MSFT products.   How so?

The PCs businesses are now using are on average about five years old.  Maintenance costs are too high.  According to Intel at least, firms are unhappy with the level of support available for the XP operating systems they’re using.  They would have upgraded long ago, except for two things:  recession; and Vista, the operating system no one wants.  But cash flows should be substantially stronger next year.  And Vista has been replaced by Windows 7, which reviewers have reported to be far superior to Vista.

Unlike netbooks owners, business PC buyers will doubtless also buy large amounts of the new Windows 2010 Office products.

So the second half of the current fiscal year, and all of fiscal 2011, could be unusually profitable.

By the way, MSFT has almost no debt and around $2.60 a share in working capital.  The stock yields 1.9%.  It has performed about in line with the market since the lows in March.

My conclusion:

I’m not sure this is an overwhelmingly convincing positive case.  On the other hand, the company’s strong cash generation and its near-monopoly with businesses seem to me to limit the stock’s downside.  If the market becomes convinced that the company has two years of 15%+ annual growth ahead of it, I think the stock will go significantly higher.  It may also benefit from the facts that:  as a multinational, it gains from dollar weakness; and, although consumers may not spend on luxury goods, they clearly have not lost their appetite for technology gizmos.  And, having followed MSFT since the late Eighties, this is the most positive I’ve been for almost a decade.

Tomorrow:  MSFT and netbooks

When something is going wrong…(lll) growth stock problems

The main idea behind investing in a growth stock is that the company whose equity you’re buying will show earnings growth that’s much higher than the stock market consensus expects, for much longer than the market expects.

AAPL, MON or COH are recent examples of successful growth companies.  In their day, WMT, CSCO, MSFT, ORCL, even IBM were growth stocks.

Examples of companies that had seemingly good ideas that failed to experience a multi-year period of strong earnings growth also abound.  No one remembers their names, though.

Consensus data less useful for growth stocks

Maybe the most important characteristic of growth companies in my opening sentence is the assumption that the consensus is wrong and has materially underestimated how rapidly the company in question will grow, and for how long.

One practical, straightforward consequence of this is that the kind of computer screening that a value investor routinely uses to find undervalued securities, which uses historical data plus consensus estimates, is of little use.

In consequence, although the growth investor does use historical data and may find the germ of an idea from an industry expert, he most often has to rely on his own research.  Sometimes this comes from his own experience. For example, Peter Lynch of the Fidelity Magellan fund, perhaps the most famous stock investor of the late Seventies and early Eighties, wrote that he became interested in Dunkin’ Donuts, once a growth stock, because he used to buy his coffee there on the way to work.

Qualitative research is important

All research has, in my opinion, a qualitative and a quantitative element.  For value investors, the latter is more important.  For growth investors, though, I think the qualitative description is always the key.  Yes, you have to have spreadsheets that have point estimates of what future revenues and earnings will be.  But for the best growth stocks, there’s always a sense of–the earnings will be up at least 30%, but they could be a lot more than that.  In contrast, the qualitative story–what unique attributes of the company allow it to grow so fast–remain constant.

Rules of thumb for growth investors

There are some historical rules of thumb that you can use in growth investing, however:

1.  the process of establishing itself as a fast grower normally takes several years.   This is a combination of the company developing its operations and of Wall Street gradually coming to recognize the firm for what it is;

2.  as stock market outperformers, growth stocks rarely last more than five years;

3.  the truly great companies, like WMT or MSFT, are able to reinvest themselves and extend the growth period for much longer periods;

4.  growth stocks typically reach their peak of stock market popularity and their highest relative P/E multiple just as growth is beginning to slow;

5.  because of this, when they go ex growth, these stocks often face a protracted period of underperformance;

6.  signs of trouble always, always surface in the qualitative analysis before they make themselves evident in earnings.

Common growth stock errors

1.  selling too soon.  The average yearly return of stocks over very long periods of time is about 10%.  Compared with that, a 30% or 50% return looks good.  Also, from a value stock mindset, 50% may be all that you can expect.  Not so with growth stocks, however.  The key question should be whether the basis growth story for the company is still intact (surprisingly strong growth for a surprisingly long period).  If so, don’t sell.  Remember, too, that good growth stocks don’t come around that often and aren’t that easy to identify.

AAPL is a good recent example.  The qualitative story has been simple:  the iPod would be more successful than most thought;  the retail stores would provide a new, profitable distribution system; and there would be a “halo effect” that would spark new interest in AAPL’s computer offerings.  In the four years from late 2003 to late 2007, the stock rose almost 20x.

2.  missing the signs of “reinvention”. Many–make that: most–growth companies are one-trick ponies.  They have one, admittedly, exceptionally good, idea, but once that is executed, the company has nothing left.  The truly great ones, though, have strong management that recognizes this issue and is actively planning far in advance for what comes next.  AAPL, for example, has the iPhone, which on some measures makes up almost half its current earnings.  AMZN now sells an awful lot more than books, and is a leader in the emerging field of “cloud” computing.  MSFT went from personal computer operating systems, to spreadsheet and word processing software, to the Windows user interface.

3.  missing the signs that the party is ending (the reverse of #2)

a.  focussing solely on earnings. Emphasizing the quantitative over the qualitative can get you into trouble in another way.  Strong earnings growth can be sustained for a number of quarters even as the market for a company’s offerings is nearing saturation or as new competition is preparing to enter the market.  Scanning the competitive environment for threats, or looking a company-specific metrics, like the rate of growth of new orders, or sales growth experience with recently-opened stores, will likely turn up signs of slowing growth before they turn up in reported results.

b.  accepting a stratospheric (30x+) price/earnings multiple as normal. In the early years of a company’s life as a fast grower, a very high multiple is typical and usually well-justified.  But a high multiple  means higher investor expectations, which require high, and accelerating, earnings performance to be maintained.  In, say, year four of rapid expansion, surprisingly high earnings growth becomes more difficult to achieve.

Why?  Any firm (not run by crazy people) attacks its best growth opportunities first.  As it expands, those get used up and the company has to turn to progressively less lucrative possibilities.  At the same time, the increasing size of the company means that a lot of work has to be done just to achieve higher profits than the year before.

At some point, a market reaches saturation–that is, no new customers want or need a product.  A one-idea company shifts from the situation of having more customers than it can service, to dealing only with replacement demand.  Look at the pattern of AAPL’s iPod sales, for example, or SIRI’s satellite radio experience.

A very high P/E isn’t by itself a sell signal.  But it is a warning sign to check growth assumptions extremely carefully.  And the highest multiple often comes just as earnings performance is set to flag.


When something is going wrong…(ll) value stock problems

As I’ve written in other posts, I’m a growth stock investor.

My initial training and close to my first decade of work were as a value investor, though, and I’ve worked for long periods in organizations where the majority of the senior portfolio managers had a value orientation.  So I do know something about how value works.  Still, I have a much more intimate acquaintance with how growth stock investors go wrong by making the mistakes myself.  In contrast, I’ve learned at least some of how value can go wrong at second hand, by watching others make them.

Having warned you about the state of my knowledge of value, here goes:

Having an investment plan for each stock is important

When you buy any stock, value or growth, you should have a plan for what you expect to achieve from owning it.  Ideally, you will have

–a concept, backed by

–an earnings model that incorporates information that you’ve gotten by researching the company, its products and its industry (10-k filings and annual reports are key here) that give you

–the expectation of substantial gain.

Your plan should give you a catalog of your major assumptions, as well as a roadmap to what good things you expect to happen, in what sequence, and what effect (at least qualitatively) they will have on the stock.

It’s your checklist to diagnose what may be going wrong

The plan will give you your ultimate exit strategy if things go right.  It gives you a checklist to go over–and decide if your assumptions are still valid–if the stock doesn’t perform the way you want.

In my experience, it may take a year or more before you’ve filled in all the details of your plan and feel comfortable that you know a company’s management, be satisfied that it is competent, and are able to anticipate how it will act.

By the way, no professional I’m aware of waits until the plan is completed before buying the stock.  Professionals, myself included, may do a week of research to get the plan structure right and spend the rest of the time putting flesh on the bones.  With a good stock, evidence mounts that you’ve made the right decision.  With a bad stock, the opposite (hopefully) happens.

What makes a value stock

Value investors argue that their stocks are attractive because the stock market does not fully appreciate the value of the underlying companies as they exist today.  (This is in contrast to growth investors, who believe their companies are attractive because the market underestimates the extent or duration of the firms’ future profit growth.)

Why should value stocks be misunderstood?

–Often, investors have an excessive negative emotional reaction to temporary difficulties.  A company may be highly exposed to the business cycle, for example, and investors rush to sell as the cycle turns down, without any thought to the possibility that conditions will someday get better.  We don’t have to go that far back in history–just to last March– to see this idea in action.

–A company may have good products, a great brand name and state-of-the-art production facilities, but weak management that fails to earn the profits the company should make.

–Or the industry it’s in may be hard to understand.

–Or it may be overlooked because it is only growing slowly.

–Or a firm may have had a damaging product recall or made a tactical marketing mistake that Wall Street has overreacted to.

Buy assets at 30¢ on the dollar and sell them at 70¢

The four essential elements of a value plan are:

–calculation of the “true” or “intrinsic” value of a firm,

–determining that the current price is at a steep discount to that number, and

–fixing a target price, and target timeframe, to sell the stock at.

Some deep value investors stop there.  They typically run computer screens to find the cheapest stocks based on price/cash flow or price/book value and buy them.   They argue that the moments of greatest despair are the ultimate buying points for stocks, both individually and as an asset class (think March 2009 again).  They also think that incompetently managed companies that refuse to change will be taken over.

Others want to identify a fourth factor–a catalyst for change–that will start the process of reevaluation along–anything from an uptick in the business cycle to a change in company management.  Personally, I’m much more comfortable with this approach.

Typical problems

a.  getting the intrinsic value wrong

This happens less often than you’d think.  This comes primarily (in my limited experience) from  non-specialists getting involved in industries that are highly regulated, like utilities, or that have no growth prospects, like traditional airlines.  In these instances, the cash flow the firms currently generate is immediately consumed in spending that’s necessary for the firm to survive.  Relying solely on book value as a measure of worth can also be dangerous, since auditors are not always as diligent as they should be in getting their clients to write down assets to true market value.

b.  the catalyst doesn’t catalyze

Think GM.  At one time the company had an unbelievable market position.  It was an American icon and a bellwether of the overall US economy.  It began to steadily lose market share when foreign competition arrived in the US auto market.  Managers developed internally were unable to reverse the company’s fortunes.  The board of directors was equally inept, and also stubbornly resisted advances from outside parties trying to (for a profit of course) be agents of change.

HPQ is another interesting case.  Here the board realized that a once high-tech company had slipped into mid-tech and decided to bring in a high-profile outside manager to turn things around.  Unfortunately, the company chose a marketing executive from ATT, Carly Fiorina, whose greatest talent, from where I sit, lay in marketing herself.  She was fired after several unproductive years and replaced by another outsider, Mark Hurd, who had a strong reputation as an operating manager and cost-cutter at NCR.

Under Hurd, HPQ became an illustration of a value stock that worked, far outpacing the market performance as he reorganized the company.

c.  staying after the party’s over

Value stocks are by and large, mediocre companies behaving badly.  While a turnaround is underway, a firm’s profits may skyrocket and its reputation on Wall Street may soar as well.   But there’s only so much that even the best managers can do.  Once margins have improved to industry-leading standards, growth may decelerate to not much faster than overall GDP.  Once the market realizes this, the stock may being to languish.

By that time, however, the value investor should be long gone.  His calculation is probably something like:  this company is earning $2 a share and trading at 10x eps.  If the company could raise its operating margins to the level of the best firms in the industry, it could be earning $5 a share on the same revenue base and with the existing plant and equipment–and trading at 12x eps.  In other words, if the favorable case plays out, the stock will rise from $20 to $60.

If the $60 price, or some other high value occurs, it will likely happen in year two of a three-year turnaround program–in other words, far in advance of the actual $5 earnings number.  By that time, the market will likely be realizing that the period of earnings acceleration is over and the stock may actually be going down.

Business cycle-sensitive stocks tend to exhibit this pattern.  The value investor judges, based on past cycles, that the stock will peak at, say 10x, peak earnings for the cycle.  Even though the earnings peak may be in year three of the cycle, the stock price peak can occur a year or more earlier.

In this cycle, though, commodity stocks may be an exception to this rule.  Demand from emerging markets and dollar decline may give them more life than an analysis of past cycles would suggest.

An aside:  mechanical rules

Some investors use rules like, “If the stock drops 15% below my purchase price, I’ll automatically sell it.”  or, “If the stock rises 50% above my cost, I’ll take a partial profit.”  Personally, I don’t like rules like this. If the stock’s price action is unfavorable, implicitly telling me I’m making a mistake, I’d prefer to be able to identify the mistake I’m making before acting.

This is at least partly because I’m a growth investor, looking for the next GOOG or AAPL.  My performance tends to be determined by having a small number of very good stocks, so I worry about being shaken out of a long-term winner by a bumpy ride along the way.

Value investors, on the other hand, tend to operate with much clearer, and shorter, timeframes, and with much more easily definable price targets.  So these kinds of rules tend to work better.  As with everything else, you should experiment to see what works for you.

AAPL’s Sept ’09 earnings: what they mean for the market

All or nothing

The short answer:  AAPL’s just-reported earnings mean either a lot, or nothing, depending on your perspective.

First, the nothing.

Even though the September was an exceptionally good one for AAPL, and it was joined by good overnight results from TXN and CAT, the US stock market went down yesterday.

How so?  None of the companies added anything to the picture of the global economy that has already emerged in the earnings announcements of the many companies which have already reported:

the worst of the general economic downturn is over;

consumer-oriented technology is recovering;

Asia is stronger than Europe ex the UK, which is stronger than the UK and US (for AAPL, though, international sales are strong all over).

Of the three firms, AAPL had by far the best report, filled with eye-popping numbers.  I also suspect that AAPL’s near-term prospects are better than the consensus thinks.  But it’s clear that a large part of the company’s performance comes from taking market share from competitors, not from over all economic strength.

What AAPL said

The company reported record sales of Macs and iphones during the quarter.  Sales were $9.9 billion, up 25% from $7.9 billion in the comparable quarter of 2008.  Fully diluted EPS were $1.82, 44% higher than the $.126  earned in the year-ago period.

In looking at the numbers, it’s important to distinguish between “sell in” and “sell through.”  The first is when a product leaves the factory and enters the distribution channel, much of which, in AAPL’s case is done by third parties.  Typically, a company recognizes sales revenue and profits when its manufactured products enter the distribution channel.  “Sell through,” on the other hand, is when the product is purchased by the final consumer.  Any difference between the two numbers represents changes in inventories in the warehouses of firms in the distribution chain.

The difference between sell in and sell through is most important for understanding what is happening with iPhone sales.  AAPL sold a record 7.4 million of them to phone companies during the quarter.  That was up 7% year over year.  Telcos sold 38% more iPhones to customers than in the comparable period of 2008–at a time when overall industry sales were only up 5%.  This last figure is of interest not only to show AAPL’s share gains in the phone market, but because AAPL makes much more money from sharing in subscription revenues than from handset sales.  More about this later.

Macs were also good for AAPL.  Units were up 17% year on year.  Laptops, which comprised about three quarters of sales, were up 35%.  This compares with industry growth of 9%, a healthier number than cellphone growth but again showing that AAPL is making most of its money by taking share away from competitors.  Europe ex the UK was up about 40%, Asia Pacific a little better than that.  AAPL had its best back to school sales ever.

To no one’s surprise, iPods were down, despite 100% year on year growth in the iTouch.

We have to remember that outside factors, and product introduction timing, influenced AAPL’s results in a positive way.  Recession has meant that component and transportation costs have been unusually low.  Continuing manufacturing and service issues at DELL and the failure of MSFT’s Vista have left the laptop door wide open for Macs.  In addition, the fast-selling Snow Leopard OS upgrade came out during the quarter.  And laptop and iPhone 3G shortages may have shifted sales from the June quarter into the September period.

Also, I’m not conversant enough in AAPL-speak to know for sure, but I think I heard management say (nothing like these words though) during the earnings conference call that it is pricing new products aggressively to continue to gain market share, even if margins were a bit lower than they have been historically.

These last two paragraphs might start one worrying that the September quarter marks a kind of high-water mark for earnings.  I don’t think so, however.  Despite management’s famous conservatism in giving earnings guidance, their comment that air transport costs would be unusually high in the December quarter (as AAPL pulls out all the stops to put products into the hands of retailers) suggests AAPL is expecting a blowout holiday sales season.

Why this is everything

In a booming economy, there is enough demand that no one firm can satisfy it.  So the market separates out into big winners and bigger winners.  Rather than wait a month for the product you really want to buy, you may take a competitor’s not-quite-as-good substitute that’s on the shelves today.

In a bad economy, you don’t buy.

In a slowly expanding economy, like the US had in the second half of the Seventies, products from the #1 company in an industry are almost always available, so the “overflow” sales to #2 or #3 don’t happen.  So the stock market separates into big winners and big losers in what might otherwise be a trendless, or only slowly uptrending, market.

As a stock, AAPL has already regained all the ground it lost during the recession.  Whether it outperforms from this point on or not, I think its emblematic of the formula for success in the stock market we’ll have over the next few years:  find the truly great companies.  One caveat:  I’m a died-in-the-wool growth stock investor and I’m describing growth stock Nirvana.

What’s up next for AAPL

As I mentioned above, I think the December quarter will be exceptionally good.

There’s another positive factor at play that may attract new attention to AAPL in the coming year.   It’s subscription accounting for iPhone profits.  I’m going to sketch the broad outlines of the issue here.  The actual details are mind-numbing and of interest to AAPL, me and probably no one else.  Here goes:

1.  The average selling price of an iPhone–AAPL to a telco–is about $600.  Let’s say (I’m making up these numbers, but I think they’re directionally correct) AAPL makes a profit of $35 on the hardware sale.

2.  The telco then sells the iPhone on to a consumer, who pays $200, and agrees to a 24-month contract at $125/month, or $3000 over the two years.

3.  AAPL gets a percentage of that revenue.  Let’s say it amounts to $215 (this number comes from AAPL’s press release).

4.  So AAPL’s total profit from an iPhone sale is $250.

Under accounting rules that prevailed until recently, in its income statements AAPL had to spread that $250 equally over the two-year contract term, or about $31.35 per quarter.

A recent change in accounting standards, however, allows AAPL to recognize most, if not all, of the contract revenue during the quarter when the contract is signed.  AAPL has been providing an alternate calculation of eps under the new standard, which it will adopt sometime in the coming fiscal year.  The eps number for the September quarter is $1.30 a share higher than the figure under GAAP (Generally Accepted Accounting Procedures), at $3.12.

In other words, reported earnings in the coming year could end up being close to twice what they would be on the current accounting standard.  The price earnings multiple for AAPL at today’s price might be about 15–less than that of the average stock.

You may say that the market sees through accounting changes and has already factored this one into the current AAPL price.  My experience is that markets hate subscription accounting and never give the company involved any benefit for using a very conservative way of reporting profits.

This change will, however, bring out much more clearly how highly leveraged AAPL is to the success of the iPhone.  This becomes a two-edged sword, if iPhone sales ever flag.  But my guess is that the change will at least initially bring a groundswell of new interest into AAPL.