Missing the Obvious

December 9, 2012 (7:30 pm)

Since I’ve had some free time, I began looking at some interesting cases in Apple’s price action history that have been troubling me. It turns out that, after some digging, it’s actually quite simple. A recurring theme that it seems all Apple “watchers” (analysts, bloggers and investors, including myself) share is “missing the obvious”. These are seemingly simple concepts that were overlooked at one point or another, leading to important miscalculations.

The first of those cases took place on 4Q2011 earnings. Last October, Apple “missed” on earnings. The consensus estimate going into the report was 25% higher than Apple’s guidance for the quarter. The miss was essentially engineered by the analysts. Apple would have missed earnings estimates a majority of its earnings reports if consensus numbers were that high. This should have been a signal to investors that the bar was set too high. It only became obvious after the fact.

The next three “missing the obvious” instances became clear after putting together the P/E history chart above.

The first took place in early April 2012 when Apple rallied from $420 to $644 during a “parabolic” run. The shares hit a peak P/E multiple of 18.3x LTM EPS (its earnings over the past twelve month period). What became clear is that the 17+ P/E level is simply not sustainable for shares of Apple. It looks like anything above a 16.5x P/E is simply a “blow off top,” which is driven by irrational exuberance. Prices may continue to run above these levels, but only for a short time. It has proved to be a fantastic exit point historically. We know that the shares come back down to the 13.0x-14.0x level each quarter and should not fear that the stock will continue to run without us. At those levels, our main fear should be of a correction since almost all of the risk is to the downside. Based on this analysis, we clearly missed an obvious signal.

The second instance took place in September around the iPhone 5 launch. The shares steadily climbed from $570, after Apple missed earnings and sat at a 13.4x P/E level, to $705. At its peak, it rose above that crucial 16.5x P/E multiple. While we correctly took some profits here by selling 40% of our portfolio, we prematurely jumped back into the shares at $680 and again at $650. Looking at this now, I realize that we clearly missed an obvious signal of a continued correction. We took additional January positions at a 15.9x P/E ($680) and a 15.3x P/E ($650). Based on our P/E analysis, it’s clear that the shares will operate within a range each quarter, most likely from the 13.0x-14.0x level to the 15.5x-16.5x level. We should have been more concerned with downside risk at a 16.0x P/E than the risk of a continued rally.

The last instance took place in October 2011. The day before the earnings miss (the same report mentioned above), Apple’s share price hit an all-time high of $425. At the time, this represented 16.9x P/E. More importantly, it represented 15.4x the EPS reported the following day. Even at that lower P/E multiple, it was clear that the downside risk overwhelmed any potential upside. Even if the company had beat earnings, it would have rallied for a brief time before eventually coming back to test the 13.0x-14.0x P/E. We should have taken profits here the day before earnings.

The four cases we went through gave a clear signal for upcoming price action. Looking forward, we’ll keep these analyses at the forefront of our investment decisions and continue to develop strategies to avoid missing any of these “obvious” signs in the future.