End game for growth stocks: nasty, brutish but not very short. How does AAPL fit the mold?

the growth stock life cycle, in brief

The Wall Street cliché is that the key to successful growth investing is how skillfully you sell the stock (as opposed to value investing, where the key is how you buy it).

The idea is that most growth stocks have a very short life in the stock market sun–five or so years.  The best growth companies continue to reinvent themselves and create new lines of business–as WMT or MSFT did.  But most aren’t able to.

As the company demonstrates surprisingly strong earnings growth, the stock market attitude gradually changes from one of disbelief to fandom–extrapolating the period of superior profit expansion much farther into the future than will likely pan out.  This tendency shows itself in a huge price earnings multiple–both absolute and relative to the rest of the market.

Normally, the seeds of future earnings disappointment–and consequent price earning multiple contraction–are already being sown in a qualitative sense at least.  But many investors ignore, or explain away, these early warning signs even when they begin to be evident in reported earnings.  At some point, disillusionment, and subsequent underperformance, begins.

MSFT as an example

MSFT is a good example of this phenomenon.  In the four years from 1995 to 2000, MSFT’s reported profits per share grew at a 40% annual rate,  meaning they quadrupled over that span.  The price earnings multiple expanded from 29 to 53, and advance of 83%, over the same period.  Therefore, more than two fifths of the total 10x stock gain came from p/e expansion.

Over the subsequent decade, MSFT’s eps grew at a little more than a 10% clip–and the stock’s p/e contracted steadily from 53 to 13 (or 3.5x the market average multiple to .9x currently).  Despite the doubling in earnings the  stock price has been cut in half, more than all of which is due to p/e contraction.

If we look at MSFT in general conceptual terms, the stock was first driven by the acceptance of the MS-DOS operating system, then by the Office suite, and finally by successive iterations of the Windows graphical user interface–all in an expanding PC market.  Then the market for its products matured, MSFT came late to the Internet, its diversifications earned little money and…  Nevertheless, it’s important to note that MSFT lasted as a growth stock for such an unusually long period because of its successive waves of innovation from MS-DOS on, not just because the PC market was growing quickly.

How does AAPL fit this model?

Looking in the most general terms, AAPL was a moribund personal computer firm with a cult-like following among individuals using PCs that had a change of management.  New leadership introduced a portable music player, the iPod, that was so successful it quickly doubled the size of the company.  AAPL subsequently introduced a revolutionary smartphone, the iPhone, which again doubled the size of the company.  Now it’s introducing a third product, the iPad in a hope of doing the same trick again.

What AAPL has done over the past decade is truly remarkable.  Earnings per share have grown at a 60%+ annual rate, and are now 10x what they were in 2005. The company is now one part PCs, one part iPod, and two parts iPhone, three of which weren’t there five years ago.

Two potential questions about AAPL’s future performance have emerged:

–One is the “concept” observation that to have the same positive effect on the overall company as the iPhone has had, the next product, presumably the iPad, has to be twice the size of the iPhone.  This is just a fact of the company’s recent growth.

–Android phones are emerging as a potential competitor to the iPhone; iPod unit sales are slipping; Chrome-based tablets are potentially going to be on the market for this year’s holiday season.  Wall Street is presumably thinking that Chrome products will end up being a case of the Zune redux.

one big difference

In 2005, AAPL’s stock was trading at 26x earnings per share.  Today, after a period of extraordinary earnings growth, AAPL’s stock is trading at under 17x eps, a pe multiple contraction of 30%.  AAPL’s relative pe was 1.4 in 2005.  It’s 1.1 now.

Unlike the typical growth stock, more than 100% of AAPL’s stock performance has been driven by earnings growth.  The pe contraction means investors have been increasingly forcefully betting that the company can’t continue its present rate of expansion.  In fact, one might argue that a pe multiple of 17- means the market thinks AAPL won’t grow earnings by more than 15% from now on.

my thoughts

Personally, I think tablets will create a new revolution in computer usage.  I’m not sure the AAPL will get the market share with the iPad that it has been able to achieve with the iPhone or the iPod.  Still, if my reading of the stock price dynamics is correct, I think Wall Street is being much too pessimistic about AAPL’s prospects.  Hard as this is to say about a stock that has had 15x the market return over the past five years, that’s what the numbers tell me.

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