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the AAPL announcement
Yesterday morning, AAPL announced that it will initiate a $2.65/ share quarterly dividend, starting during the July accounting period. The company says it will also repurchase $10 billion in stock over the coming three fiscal years. Together, the two moves will absorb $45 billion in domestic cash.
the stock buyback
The dividend is a more important signal about future earnings. But the description of the stock buyback also says something important, and admirable, about the company’s management.
Most firms try to describe stock buybacks an altruistic move on their part, as “returning cash to shareholders.” They argue that dividend payments create a tax liability for recipients while stock buybacks do not, and intimate that this is the main reason for their action.
The tax stuff is true. But the rest is, at best, nonsense.
Companies pay their employees, and particularly their executives, in two ways: with cash; and with stock options. The latter gradually transfer ownership of the firm from portfolio investors to employees. In fact, many companies in the tech world have target percentages for this transfer in mind when they issue stock options. The main–unspoken–purpose of stock repurchases is to keep the total number of shares outstanding stable, and thereby disguise the change in ownership that is taking place.
APPL is the first company I’ve seen that’s completely honest with shareholders. AAPL says its share repurchases have “the primary objective of neutralizing the impact of dilution from future employee equity grants and employee stock purchase programs.” The asset transfer effect, by the way, is a miniscule .5% or so per year in AAPL’s case.
The initial payment level of $10.60/year implies to me that AAPL management thinks profits will be a lot better than the market now expects. Here’s why:
Two basic rules about dividends are:
–they’re supposed to be paid out of profits, and
–they should be set at a level that’s easily sustainable, and that can rise. Very little is worse for a company than having to cut, or eliminate, a dividend. A prudent firm–and AAPL is one–would have already thought carefully about a pattern of future dividend increases when setting the initial payment amount.
At the end of the December 2011 quarter, AAPL had 932 million shares outstanding. Let’s say that rises to 940 million by the time it begins paying dividends. $2.65/quarter x 4 quarters x 940 million shares = $9.96 billion in annual dividend payments.
AAPL will most likely have chosen the current dividend payment based solely on its estimate of sustainable US earnings. Why? Dividend payments from a US corporation have to use US-domiciled cash. Yes, AAPL has $33 billion in the bank in the US already–enough to pay the current dividend for over three years or supplement a payout that exceeds US-generated funds for far longer than that. But what would AAPL do after the US cash runs out? …cut the payout? No way. …repatriate funds from abroad, losing 35% to federal taxes? Probably not.
Therefore, it’s a reasonable assumption that AAPL considers a recurring $10.60 a share from the US each year as “in the bag.” If it were me making the decision, I wouldn’t want to set the payout at 100% of US earnings. I’d like a cushion. Arguably, the US cash on the balance sheet is enough of a safety margin, but why take the risk? I’m thinking the payout is being set at more like 75% of US earnings–which also leaves room for a dividend increase next year.
doing some arithmetic
Let’s try to use the $10.60 a year to calculate what AAPL must be thinking about its total earnings.
AAPL presently earns a little more than a third of its revenues in the US. As Asia increases in importance to the company, the domestic percentage will likely fall. Assume that the US is 30% of the AAPL total for fiscal 2012 and 28% in fiscal 2013, with overall earnings growing, say, by 15%.
Case 1: low-balling AAPL has decided to pay out 100% of its current US earnings in dividends.
That would imply AAPL earns $35.33 this fiscal year and $43.50 next.
I think this is would be, in AAPL’s view, for all practical purposes the worst possible case.
Case 2: realistic AAPL has decided to pay out 75% of its current US earnings.
That would mean $47 in eps for this fiscal year and $58 next.
This compares with the current analyst consensus eps of $43.14 for fiscal 2012 and $48.44 for fiscal 2013.
AAPL insiders more bullish than Wall Street? I think so
Case 1 yields no useful information, since consensus estimates are already substantially higher. Case 2, which I think is considerably more probable, would imply that AAPL’s board and management are both noticeably more bullish on company prospects than Wall Street. AAPL insiders can be as wrong as anyone else. In this case, however, they have a ton more pertinent information to work with than you and I do.
the home field advantage
No company ever goes into a foreign country expecting a level playing field. There are always going to be rules–written and unwritten–that favor the home team. This is the flip side of the belief that you’re always going to have at least a slight advantage over a foreign company in your domestic market.
One exception–if you’re hoping that the foreigner will buy your domestic business. Chances are he’d be willing to pay over the odds. But it’s equally likely the government will force a sale to a domestic competitor. Around the world, that’s just the way it is.
We see this all the time in sports.
Your favorite baseball team plays an away game. You can be sure the field will be manicured to minimize the home team’s weaknesses and your strengths. The visitor’s dugout in San Francisco is, unusually, on the first-base side of the field? Why? It faces right into the frigid wind off the bay.
The home town timekeeper will make the game clock in basketball or hockey run fast or slow, as the home team requires.
Even the referees will exhibit a home-town bias, perhaps influenced by crowd noise.
what’s not cricket
Some actions are beyond the pale, however. One such appears to be happening right now in India.
In 2004, when Vodafone was still intent on ruling the world, it entered the Indian cellphone market by buying an interest in an existing player from Hutchison Whampoa. Aware that if the transaction were done in India it would trigger a capital gains tax of around $2.9 billion, the parties did the deal offshore.
The Indian Tax Department ruled that the tax was still due. Vodafone refused to pay and lengthy litigation ensued.
Two months ago, the Indian Supreme Court ruled in Vodafone’s favor–that no tax was due.
proposed retroactive tax law change
On Saturday, the Financial Times reported that in its annual budget the Indian government proposes to change the tax law, retroactive to April 1962, to make offshore transactions involving multinationals and Indian subsidiaries subject to domestic capital gains tax.
Although the proposed change, if implemented, will have much wider implications than for Vodafone alone, it is being widely seen as aimed directly at the UK telecoms company.
The issue of course, is that Vodafone has played on the home field and won–but the losing side is trying to change the basic ground rules five years after the fact, in a way that turns victory into defeat.
I think it’s ironic that this situation is arising just as the Indian government has decided to try to woo foreign portfolio investors for the first time. If the budget documents are not just bluster and parliament makes the retroactive tax law change, that would seem to me to dim substantially the appeal to foreign investors of India’s large domestic population. The negative effect could last for many years. For emerging markets investors, then, I think the Vodafone situation bears close watching.
On Wednesday, the New York Times published the resignation letter of Greg Smith, a (former) derivatives salesman at Goldman Sachs. Smith, a 12-year employee, says he’s leaving because the GS work environment has become “toxic and destructive.”
My first reaction: plus ça change…
In 1989, Michael Lewis, of later Moneyball fame, wrote Liar’s Poker, an expose of the culture of cutthroat competition and macho banality of Salomon Brothers while he was a bond salesman there. Salomon, you may recall, had to be rescued by Warren Buffett after top executives colluded to illegally manipulate prices in the US government bond market. What’s left of the firm now resides inside Citigroup.
Yes, Moneyball shows that Lewis is sometimes reluctant to let facts stand in the way of a good read. Nevertheless, I think Liar’s Poker is an important book. In fact, I’ve asked all the securities analysts and portfolio managers I’ve trained since its publication to read it.
Three points from the Lewis account still stand out to me:
–the strong internal pressure for salesmen to get unattractive, illiquid bonds off the company’s books by persuading some gullible customer to buy them
–a sketch of the growing dismay of a certain client as the realization dawns that he has been sold a toxic security that he can’t resell and which will get him fired when his bosses figure out what he’s done (why they don’t already know is beyond me)
–the feverish rush to unload dud bonds on a client the brokerage community figures is so unskilled that he’ll soon be fired. Like blood in the water to sharks.
Welcome to Wall Street.
an adversarial relationship
What the Michael Lewis book and the Greg Smith letter bring out most strongly, to my mind, is the simple truth that the relationship between broker and client is a commercial one where the interests of the two sides are not aligned.
–Every time you trade, you think you know more than the other party. You think any security you buy is undervalued and that the other side of the trade will give up future profits by selling it to you at today’s price. You expect anyone you sell to to lose money by taking your offer. You also expect the broker to act as the counterparty if he can;t find someone else. It’s like baseball. You take the field expecting to beat the other side. You’ll win; they’ll lose.
–Investment managers earn higher fees by having superior performance, which helps attract new assets; brokers get paid in direct relationship with the amount of trading the client does. Experience shows, however, that for most managers superior performance and the amount of trading are inversely related. So, what’s good for the manager isn’t particularly good for the broker, and vice versa.
In addition, each side markets itself to the other. That is, each tries to replace the cold commercial structure of the relationship with a warmer “like me, trust me” one. That’s partly because we’re all decent people. It’s partly so the other side will continue to do business with you after you’ve traded them into the dust. And it’s also partly because it’s a way of gaining a competitive advantage, of tilting the ratio of compensation to services in your favor. In my experience, brokers are much more successful in getting clients to deliver excess compensation than clients are in getting excess services without payment.
the business has changed
A generation ago, the principal business of investment banks was providing comprehensive financial services and advice to companies of all sizes–everything from working capital finance to strategy to mergers and acquisitions. For small- and medium-sized firms, its investment banker may well have held a seat on the board of directors.
Not any more. In today’s world, however, most firms have an in-house staff of financial professionals who do most of this.
At the same time as businesses based on building long-term relationships of trust have eroded, the trading business, which focuses on rapid-fire, reflex-action, individual transactions, has exploded in size and scope.
As the composition of company profits for brokers has changed, so too has the character of those who rise to positions of control. The traditional investment bankers, whose temperament is to focus on long-term relationships, are out. High skilled traders, who focus on short-term profits, are in.
playing hardball vs. cheating
Where to from here?
The huge profits that trading businesses have generated during the past decade are already spurring changes. Institutions are already shifting to electronic crossing networks, where fees are much smaller and where the activity won’t be seen by a broker’s proprietary trading desk. Retail investors are doing more business with discount brokers. They’re increasingly shifting, I think, to passive products like ETFs as well.
Institutions have long memories. In cases where they believe a broker has crossed the line between aggressively competing and cheating, they simply won’t do business with them anymore.
there’s something about Europe, too
Did it really take Greg Smith 12 years to figure out what brokers do for a living? …or was it his final year, in Europe, that changed his mind? Why is it that the losing end in all the toxic credit default swaps was a European bank?
business has changed away from long term repationships—now cos do for selves, change of control toward traders in brokerage firms
Yesterday’s Wall Street Journal has an article in which it looks at the investment vehicles that hold AAPL shares. A third of equity mutual funds sold in the US hold AAPL; 20% of hedge funds claim it as one of their top ten long positions (given the sketchy nature of hedge fund disclosure, I wouldn’t bet the farm that this is figure is entirely accurate, though).
what Apple is
Just to be clear,
–Apple is a US-based company.
–It’s incorporated in California, where its headquarters is located.
–Primary trading is on NASDAQ.
–AAPL doesn’t pay a dividend.
–AAPL isn’t just a large-cap stock. It’s a MEGA-cap stock.
The median market cap for members of the S&P 500, the large-cap index, is a touch under $12 billion. AAPL, in contrast, has a market cap of close to $550 billion, or 45x the median. The company has no debt and over $100 billion in cash on its balance sheet.
what funds hold AAPL shares
Despite this description, according to the WSJ the following kinds of funds hold AAPL shares:
–40 funds that focus on dividends in selecting stocks
–50 funds that specialize in small- or mid-cap stocks
–3 Fidelity funds that specialize in Europe
—international funds, including the Ivy International Growth and the Waddell & Reed Advisors International Growth
–the BlackRock High Yield Bond Fund, a $5.9 billion junk bond fund that held $8.3 million in AAPL shares at 12/31/11.
how can these funds do this?
In one sense, it’s crazy. How can you trust a manager who says he’s going to buy small, fast-growing stocks with market caps below the S&P 500 median for you, after you see his outperformance is coming from a half-trillion dollar stock? In this regard, the BlackRock High Yield position that the Journal reports is extremely hard for me to understand. Ignore the fact that it’s a bond fund owning stocks. The AAPL position size is so small, at 0.14% of assets, that it’s immaterial to fund performance. There has to be more to that story. One guess is that the position is much larger today.
In another, narrowly technical, sense–even though the fund name, and presumably its marketing materials, don’t give the slightest hint that this may be going on–fund rules doubtless permit the purchases.
If you read the prospectus carefully, it will surely say something like the fund will achieve its objective (of buying small-cap, or foreign stocks…) by having at least, say, 65% of the fund assets invested in the specified kind of securities. It will go on to state that the fund reserves the right to invest the rest of the fund in other stuff. (By the way, the prospectus may also say that for temporary defensive purposes, the fund has the right to redeploy its assets entirely to cash or to Treasury bonds, or some other presumably safer form.)
why do they do this?
I think the obvious answer is the correct one. The portfolios in question want to achieve a performance advantage, either over the other funds in the same category or against their benchmark index, by buying securities that are outside their normal investment universe.
Is this illegal? No, because of the prospectus disclosure.
Is it unethical? In my view, yes. An international manager might try to argue that because APPL manufactures and sell products abroad, it’s actually a foreign stock. Someone might buy that explanation. It certainly wouldn’t fly in the institutional pension management world, however. And small-cap managers, who typically charge higher fees to compensate for the extra work involved in small-cap, don’t have an ethical leg to stand on.
what to do
Figure out how much AAPL you actually own and ask yourself if you’re comfortable.
Remember that any S&P 500 index vehicle you hold is about 4.5% AAPL. AAPL may also be 20+% of any tech fund you own. And, as the WSJ article suggests to me, it might be wise to take a quick look at all your mutual funds or ETFs to see how much AAPL is in them. You can get the information from the management company website, the SEC Edgar site, or to the latest report you’ve gotten from the fund itself.
yesterday’s Hong Kong trading
In Hong Kong trading Tuesday, the major Macau gambling stocks moved sharply upward. Wynn Macau, a recent market laggard, was the star, gaining 8.6%. But even China Sands, which is up by over 40% since the Hang Seng peaked last August, rose by almost 6%.
the Karen Tang effect
According to Bloomberg, Karen Tang, a prominent Hong Kong-based leisure analyst who works at Deutsche Bank, reversed her relatively negative view on casinos in the SAR after meeting with company managements.
Ms. Tang sent these same stocks into a tailspin last August. That’s when she issued a report arguing that a falloff in demand for high-end luxury cars that was then being experienced in China presaged an almost complete evaporation of growth in the VIP baccarat market in Macau. Since high-stakes baccarat is the mainstay of the casinos there, this was an especially dire forecast.
Her idea was that the market would begin to slow in the autumn. Economizing high rollers would make trips already planned–and possibly paid for–but wouldn’t book further visits. The market wouldn’t contract. But growth would nosedive, troughing late in the first half of 2012 at a year-on-year rate of, say, +15%, before beginning to rebound.
I didn’t see the Tang report. But it was extensively covered in the Asian press. From those accounts, it seemed the evidence was flimsy and the conclusion much too pessimistic. As it turns out, Ms. Tang was wrong. That’s not the important thing (although I’ve been unable to refrain from inserting this conclusion in this post).
What is important is that after a mild slowdown to a “mere” 25% growth rate last December, Chinese high roller gambling in Macau is beginning to accelerate again. That’s what Ms.Tang found out on her research trip to Macau and published in a note yesterday.
While I was looking at yesterday’s stock prices in Hong Kong while writing this post, I noticed an article from Forbes.com. It reports the results of a research trip to Macau by a Citibank (never to be mistaken for a research powerhouse) analyst, who says the casinos indicate gambling in the SAR grew by about 40% year on year during the first 11 days of March. That’s substantially ahead of the 28% year on year growth of the market during January-February. And it’s not that far below the 42% gain the market put up for full-year 2011.
According to Forbes, Nomura Securities (which makes Citi look good) thinks March gaming win will be up by about the same rate as the average of January/February (a two month average corrects for variable timing of the New Year holiday).
The bottom line, though, is that the market is a lot better than the consensus had thought–and is looking up.
stock market implications
Given all the lawsuits flying around, this may not be the time to load up on the Las Vegas gambling companies. Personally, the litigation bothers me enough that I won’t buy more, but not enough to sell what I have. It seems to me that the Macau subsidiaries are relatively insulated. I like Steve Wynn. And Las Vegas Sands is still cheap.
…or indirect plays?
The most important aspect of yesterday’s trading may be the signal that corporate magnates in China are starting to feel a lot better about themselves and their businesses. The safer way to go is probably to look for sold-off US firms that have a lot of Chinese exposure.
the ETF phenomenon
To my mind, the ETF phenomenon is not just a story about price advantage. I think the popularity of ETFs is an indicator of a fundamental sea change in sentiment on the part of individual investors. For me,ETFs mark the end of the almost twenty-year love affair of individuals with actively managed mutual funds–and maybe with mutual funds, period–that began after the stock market crash in 1987.
Just as individuals shifted from relying on retail brokers to puting their faith in mutual fund portfolio managers after Black Monday, the trigger for the change in direction has been the Great Recession. Its cause is the continuing failure of even the most highly publicized active managers to beat their benchmark indices-or, even if they did, to preserve during the downturn of 2007-2009 what their clients thought of as enough of their wealth.
The new trend is for individuals to take responsibility for themselves and to allocate their portfolios by sector through narrowly focused passive vehicles, that is, ETFs.
price war? yes and no
Exchange traded funds, which now control over $1trillion in assets in the US, appear to be entering a new phase of competition, one marked by sharp reductions in their management fees. The media are calling this a “price war.”
It’s not a price war in the most dramatic sense–where firms with excess production capacity slash selling prices in a desperate bid to keep their heads above water, or to generate cash flow needed to repay debt. But it still is one, in the sense of a widespread fall in fee levels.
What do the fee reductions mean?
a maturing industry
1. At one time, ETFs were competing for investor dollars primarily against their cousins, index mutual funds.
During this period, simply having an expense ratio lower that that of an index fund was all an ETF needed to succeed. Today, despite the fact that their per share expenses are already far below those of index funds, ETF companies are beginning to slash their fees further.
(An aside: to some extent, the ETF fee advantage is offset by the commission charges that ETF transactions bring with them. More important, buyers pay more than net asset value at the time of purchase, sellers collect a bit less. There isn’t enough data available for third parties to determine what this bid-asked spread typically amounts to. Comparisons of ETFs vs. index funds usually deal with this issue by ignoring it, making ETFs look somewhat more attractive on a cost basis that then actually are.)
That’s because competition between ETFs and index funds is over. Index funds have been defeated. The new contest for customers is between one ETF and another.
closing the door to newcomers
2. Investment products like mutual funds and ETFs have substantial up-front fixed costs, mostly computers and professionals to manage the money and safeguard it. So they initially run at a loss. Once a fund gets to the point where fees cover these costs, however, new assets bring almost pure profit. Margins expand fast.
At some point high margins become a negative, not a positive. They act as a lure for new competition. And they allow new entrants to become profitable quickly.
Therefore, lowering fees has a second purpose. It lengthens, possibly by an enormous amount, the time a potential new entrant must operate at a loss–and increases proportionally the amount of assets he must gather in order to reach profitability. Naturally, this decreases the attractiveness of the industry to newcomers. So, as counter-intuitive as it may seem, the fee reductions also serve to preserve the long-term profit profile of at least today’s very largest players. It makes no economic sense for anyone else to enter the fray.
It’s interesting to note that of the three largest sellers of ETFs in the US, BlackRock, Vanguard and State Street, only Vanguard has a significant actively managed mutual fund complex. All the other last-generation investment companies have had their heads in the sand. Internal forces of the status quo have preferred to let assets leave rather than create an ETF divisions that might be headed by a political rival.