Tag Archives: investor behaviour

Apple below $100

In a market like this one, it’s impossible to tell what is going to happen next. The smell of fear has been in the air with greed cowered by uncertainty. Greed may push back soon with earnings, and particularly guidance, dictating the short term path whilst oil and China, amongst other macro factors, will continue to dominate the overall direction.

Overall I remain cautious on equities with a downward bias. I am sticking to my conviction stocks whilst keeping cash on the sidelines until I find a blatant bargain or two. Notwithstanding that stance, it’s always good to look at your positions and see if some risk management re-weighting is called for. And that’s the reason for a quick look over Apple before its earnings next Tuesday.

Apple is in a hapless position currently and likely has to blow away the December quarter estimates (on the number of iPhones sold, the average price, and the gross margin received) PLUS give a strong March quarter guidance to move up in a meaningful way. Given that a repeat of the outstanding results of last December’s quarter (see post here) compared to current expectations is improbable, I would suggest Apple could trade around or below $100 for a while yet. Analysts, whilst screaming about its valuation, have become increasing negative on the December quarter and guidance for their Q2 quarter. Apple may struggle to come in much above the top end of its guidance of 77.5 million iPhones (it has come in above guidance for 5 consecutive quarters albeit at a steadily reducing level above the top estimate).

The geographic split of revenue, as per the graph below, will also be closely watched to see if China’s economy is impacting Asian growth.

click to enlargeAAPL Revenue by region Q42015

Despite its best efforts, Apple remains primarily a phone company with last year’s iPhone revenues making up two-thirds of the total, as per the graph below (with my estimates for Q1).

click to enlargeAAPL Revenue by product Q42015

I played with some estimates to stress the view on an AAPL valuation below $100. Taking a jaundice view of adjusting average analyst non-GAAP estimates for 2016 and 2017 plus some pessimistic estimates of my own on 2016 and 2017 (with iPhone slowing to sales of 220 million and 200 million compared to around 230 million for 2015), I estimated the forward PEs, excluding net cash (currently around $150 billion), as per the graph below (based upon diluted GAAP EPS, not the adjusted EPS analysts love) using tonight’s close of $96.30. The multiples are quarterly point estimates using the share price one month after the quarter’s end.

click to enlargeAAPL Forward 12 Month PE Ratios Q4 2015

The graph above clearly shows the swings in sentiment on Apple over recent years as the market grapples with the future demand for the iPhone after each upgrade cycle. Tuesday will indicate whether the current concerns about iPhone sales and margins peaking are justified. Other concerns, such as a possible $8 billion tax bill from the EU, pale in comparison to those iPhone concerns. Notwithstanding these real concerns, forward multiples of below 8 look too low to me given Apple’s operating record (unless you buy into the Apple could be the next Nokia thesis which I don’t).

By way of a comparison, my estimate for a similar graph for Google is below (again using diluted GAAP EPS). Google will be another stock where earnings for Q4 will be very interesting as they split out their figures in line with the new Alphabet structure and (maybe) demonstrate again their new emphasis on cost control. Expectations look high based upon its current valuation.

click to enlargeGoogle Forward 12 Month PE Ratios Q4 2015

The comparison does reflect positively on Apple’s current valuation multiple and I’m happy to hold the AAPL position I have. A key outcome from the AAPL earnings call will be if Cook can provide sufficient catalysts for Apple’s value to trade significantly above $100.

As always, time will tell.


Follow-0n Evening 26th after earnings: Over the next few days and weeks, I’m sure the chatter about Apple and the iPhone will likely get over-bearing. The delicately posed share price of $99.99 before earnings will come under pressure. Q1 revenues were at the lower range of expectations and Q2 guidance at $50-$53 billion is weaker than expected. China revenues showed slowing growth. On the positive side, the average revenue per iPhone in Q1 was higher than expected and operating margins were strong. I revised down my estimates for AAPL’s 2016 and 2017 diluted EPS (to $9.15 and $8.60) and iPhone sales to 210 million and 190 million. The revised revenue splits and forward PE multiples (at share price of $99.99) are shown below. Thesis, as per post above, on AAPL’s valuation remains basically unchanged although the share price see some selling pressure in the short term.

click to enlargeAAPL Revenue by region Q12016

click to enlargeAAPL Revenue by product Q12016

click to enlargeAAPL Forward 12 Month PE Ratios Q1 2016.png

Time for a gamble?

While waiting for earnings season to show how firms are forecasting the impact of macro trends, it’s a good time to look over some investing ideas for the future. Having a few names selected that can be picked up in market weakness is always a good way of building quality positions. It also helps in viewing current positions to see if they stack up to alternatives.

Regular readers will know that I think the insurance sector is best left alone given pricing and competitive pressures. Despite the odd look from afar, I have never been able to get comfortable with hot sectors such as the Chinese internet firms (as per this July post). The hype around new technologies such as 3D printing has taken a battering with firms like 3D Systems and Stratasys bursting the bubble. A previous post in 2014 highlighted that a focussed play on 3D printing such as Sirona Dental makes better sense to me. The Biotech sector is not one I am generally comfortable in as it seems to me to be akin to leveraged one way bets (loss making firms with massive potential trading a large multiples of revenue). Firms such as GW Pharma which are looking at commercializing cannabinoid medicines for multiple sclerosis, cancer and epilepsy have had the shine taken off their gigantic runs in the recent volatility. My views on Trinity Biotech (which is not really a biotech firm) were expressed in a recent post in May and haven’t really changed despite a subsequent 25% drop. I need to see more results from TRIB to get comfortable that the core business justifies the current valuation with the upside being in the FDA approval of the Troponin point-of-care cardiac tests. Other ideas such as online education firm Houghton Mifflin Harcourt (in this post) have failed to sparkle.

click to enlargeInvesting Ideas October 2015

This leads me to the online gambling sector that I have posted on many times (here and here for example) and specifically to the Paddy Power/Betfair merge. My interest in this sector has not been one from an investment point of view (despite highlighting that PP and Betfair would make a good combination in May!) but I can’t get the recent performance of these two firms out of my head. The graph below shows the profit before tax margins of each (with my estimate for 2015).

click to enlargePaddy Power Betfair Historical PBT Margins

One of the things that stand out is how Betfair’s margin has improved, despite the recent headwinds such as the UK point of consumption (POC) tax. Indeed the market view that Betfair CEO Breon Corcoran is the new messiah can best be illustrated in the graph below on the firm’s performance since he took charge (revenue in sterling). It shows solid revenue growth (particularly from sustainable markets) and the incredible recent growth in EBITDA margin despite the drag of 9% of EBITDA margin from the POC tax.

click to enlargeBetfair Revenue Split & EBITDA Margin to July 2015

At the most recent results, Corcoran did highlight some headwinds that would bring the margins down (e.g. phasing of marketing spend and increased product investment) but emphasised the “high level of operational gearing” in the business and the “top-line momentum”. The merger of these two high class firms under a proven management team does make one giddy with the possibilities. The brokers Davy have a price target of €129 on the Paddy Power shares (currently trading just below €100). More information should emerge as documents for the shareholder votes are published (closing date expected in Q1 2016). An investor presentation does offer some insight (for example, as per the graphic below).

click to enlargeOnline Gambling Sector

I have calculated some initial estimates of what the combined entity will look like. Using an assumed constant sterling to euro FX rate of 1.30 and trying to adjust for Betfair’s funny reporting calendar, I estimate calendar year revenue growth 2016 to 2015 at 17% assuming a sterling reporting currency, as per the split below.

click to enlargePaddy Power Betfair pro-forma revenue split

I also calculated a profit before tax margin for the combined entity of 18% which increases to 21% post cost savings. Given approx 91 million shares in the new entity, my estimated operating EPS for 2016 is therefore approx £3.85 or approx €5.00 which gives a 20 multiple to operating earnings at the Paddy Power share price around €100 today.

So is buying into the merger of two quality firms with top management in a sector that is undergoing rapid change at a multiple of 20 sensible in today’s market? That depends whether you think it’s time for a gamble or whether patience will provide a more opportune time.

One must look at one’s own behaviour….

That markets often behave irrationally, particularly over the short to medium term, is generally widely accepted today. Many examples can be cited to show that human behaviour does not restrict itself to the neo-classical view of rational player’s expected utility maximisation. The subject of the behavioural impact of humans in economics and finance is a vast and developing one which has and is the subject of many academic papers.

As a result of a recent side project, I have had cause to dig a little bit deeper into some of the principles behind behavioural economics and finance. In particular my attention has been caught by prospect theory, so named from the 1979 paper “Prospect theory decision making under risk” by Amos Tversky and Daniel Kahneman (who received a Nobel Prize in 2002 for his work on the subject), largely seen as the pioneers of behavioural economics and finance. In essence, prospect theory asserts that humans derive utility differently for losses and gains relative to a reference point.

My limited knowledge on the topic has been tweaked by a paper from Nicholas Barberis in 2012 entitled “Thirty Years of Prospect Theory in Economics: A Review and Assessment”. Although Barberis states that “while prospect theory contains many remarkable insights, it is not ready made for economic applications”, he highlights some recent research that may “eventually find a permanent and significant place in mainstream economic analysis.

Tversky and Kahneman updated the 1979 original prospect theory in 1992 to overcome initial limitations, so called cumulative prospect theory, based upon four elements:

1)    Reference Dependence – people derive utility from gains and losses relative to a reference point (rather than from absolute levels).

2)    Loss Aversion – people are much more sensitive to losses rather than gains of the same magnitude.

3)    Diminishing Sensitivity – people are risk averse in relation to gains (e.g. prefer certainty) but risk seeking in relation to losses.

4)    Probability Weighting – people weight probabilities not by objective probabilities but rather by decision weightings (e.g. objective weightings transformed by their risk appetite).

Graphically cumulative prospect theory is represented below.

click to enlargeProbability Weighting

Barberis highlights a number of sectors where prospect theory, as a model of decision making under risk, has applications. I will only comment on areas of interest to me, namely finance and insurance.

Probability weighting highlights that investors overweight the tail of distributions and numerous studies confirm that positively skewed stocks have lower average returns than would otherwise be suggested by expected utility investors. In other words, investors overestimate the probability of finding the next Google. This explains the lower average return of classes such as distressed stocks, OTC stocks, and out of the money options.

Loss aversion has also been used to explain the equity premium compared to bonds (i.e. returns have to be higher to compensate investors for volatility). Using an assumption called “narrow framing” investors evaluate separate risks according to their characteristics. This has also been used to explain why many people don’t invest in the stock market.

Prospect theory is also used to explain one long standing failure of investor behaviour, namely selling winners too early and holding on to losers too long. This is something that I have learned from experience to my determent and one piece of advice that many professional investors emphasis again and again. This characteristic was highlighted in research as far back as 1985 in a paper by Shefin and Statman. Further research to formalise this “disposition effect” is on-going and much debated. Other research focuses on the impact of “realisation” utility when it comes time to sell a stock (e.g. we derive more utility in selling a winner).

In the insurance area, prospect theory has been used to explain consumers purchasing behaviour. For example, if we overweight tail events then we likely
purchase too much insurance, at too low a deductible! Purchasing of a product such as an annuity is also impacted by our mentality of being risk adverse on gains/risk seeker on losses. The consumer is therefore more sensitive to a potential “loss” on an annuity by dying earlier than expected as opposed to a “gain” by living longer. One area that has proven difficult in using prospect theory is to understand what reference point people use in making decisions such as the purchase of an annuity.

There have been recent criticisms on the use of behaviour theories in finance and economics. Daniel Kahneman himself, whilst promoting the paperback launch of his 2011 bestselling book “Thinking, Fast and Slow” expressed his frustration at the blasé labelling of a divergence of social science as behavioural economics – “When it comes to policy making, applications of social or cognitive psychology are now routinely labeled behavioral economics”.

Another recent report entitled “How Behavioural Economics Trims Its Sails and Why” by Ryan Bubb and Richard Pildes claims that some policymakers naive embrace of the new field may actually be doing more harm than good. The report states that “fuller, simpler, and more effective disclosure, one of the main options in behavioural economic’s arsenal, is not a realistic way, in many contexts, to rectify adequately the problems in individual capacity to make accurate, informed judgments with the appropriate time horizons.” The report cites examples such as opt-out options in automatic enrolment of retirement savings and disclosure on teaser rates in credit products that claimed to offer reasoned choices to consumers but ultimately led to unintended economic impacts.

It is ironic (and probably inevitable) that some features designed to modify behaviour backfire given that, in the words of behavioural economist Dan Ariely, the premise of the theory is that “we are fallible, easily confused, not that smart, and often irrational.