Last week Felix wrote an interesting post on the valuation of high growth big cap tech, specifically Apple and Google. The debate in the comments was equally interesting. Felix thinks AAPL should not be worth more than GOOG, as recently become the case when the former’s market cap surpassed the latter’s. GOOG grows faster than AAPL, he points out, has higher margins, and is increasing market share in its core (web advertising) market while AAPL is losing share in its (iPod/iTunes); unlike AAPL, GOOG has a dominance in its fast-growing core market that amounts to a monopoly, option value from its many ventures, and finally no management succession risk. That should be worth a premium valuation.
All these points are either true or could be plausibly argued. So how can this be, given that the market prices in all knowable, digestable information (Felix is a great fan of indexation and presumably holds to a very dilute version of the efficient markets theory)? Why is a company with all these attributes trading at a discount to this relatively deficient one?
Baruch knows the answer. He gets paid to value high growth big cap tech. While he personally covers neither AAPL nor GOOG, in the vast expanse he calls his mind this does not disqualify him from opining about both companies firstly from the point of view of a Spinozist but secondly, from time to time, as a stock operator or “punter”. You will remember that from the first perspective, he likes neither of them very much. From the second perspective, Baruch has said he would actually be long AAPL here. In fact, the fund he works for is an owner in size. As for GOOG, it is a smaller position than the benchmark, an “underweight”, in the argot. Had he his druthers, moreover, Baruch would strongly consider a GOOG short.
There are two central concepts to tech investing — expectations, and the 2nd derivative of growth. Both of these concepts combine in interesting ways. Let’s deal with both, the role of expectations first.
Consensus expectations are important in any stockmarket sector. But the delta or surprise or the change in expectations after excellent quarters, for tech companies, tends to be higher than in other industries, and it is that change which really drives stock prices. Stock analysts tend to the conservative, especially in tech, given the volatility of earnings. There is rarely an incentive for them to stick their heads above the parapet. Indeed it is more often that analysts with buy ratings on a stock will have lower earnings numbers going into quarters than their peers, so they don’t inadvertently raise the average of published sell side expectations, “the consensus number” as calculated by Bloomberg or Reuters. It also allows them to write notes starting “XXXX comfortably beat our estimates, validating our positive view on the stock”, rather than “XXXX was in line, and you may well ask why I keep on supporting this piece of crap”.
The clever investor knows that tech is the definition of Talebian Extremistan, yet all the analysts live in Mediocristan, so buy side guys tend to have higher expectations than consensus when they own stocks, and lower expectations when they don’t or are short. This is why well-owned stocks, whose prices have risen into the earnings report, can fall even after the report has trounced consensus, and reviled, over-sold, shorted names who have missed consensus may even shoot up 5-10%. In either case, they under- or over-shot the “Whisper number”, the consensus of the powerful buy side names who may be long or short those stocks in size. Good luck finding out what the whisper is, as publishing it would immediately invalidate it. You’ve probably got to call a sell sider who talks to these bigger guys, and try and wheedle it out of her, and even then she may not know it.
Obviously the whisper influences stocks before they report, and explains much of the intra-quarter share price movement. That is a very likely reason for the disparity, Felix: underlying whisper numbers for GOOG are moving down, below the published growth rates and PEs and margins that you cite, and for AAPL they are moving up.
As for growth, we all know tech investors are fools for growth. Explosive growth beyond consensus rates shrinks PEs over time. You will find the pricey stock everyone laughed at you over saying “oh look at that idiot Baruch buying XXXX at 35x 09” will suddenly look a lot cheaper after everyone raises their eps 20% after a blowout quarter. Moreover, the growth will then expand your PE subsequently, as all the punters think, well they killed all the analysts last time, we know consensus tends to undershoot, mediocre beings that these analysts are, they’ll buy the crap out of it even more, your stock is at 40x a much higher consensus, and hey presto, you’re sitting on a 40% gain.
For assessing the ability of these stocks to meet and even blast through whisper numbers, nothing matters more than the second first derivative of growth, the rate of change of the growth rate. Distressingly, growth companies largely see declining growth rates, except at the very start of their product cycles (when they are largely still privately held), and it is this tendency that analysts tend to follow in their models. Accelerating growth rates upset this, however; the mean-reverting analysts get discombobulated and their estimates increasingly irrelevant.
Let’s put it all together. AAPL’s underlying growth rates are increasing with iPhone. And none of the analysts have 10m iPhones for Q3, but maybe a few buy side guys are thinking it may be possible. The published growth rates Felix has access to do not reflect this. GOOG’s growth rates are falling as their market share of total adspend grows, but the overall pie shrinks due to the non-recession we find ourselves in. The larger and more successful it is at growing in its market, the closer it gets to a crossover point at which penetration gains no longer offset the economic losses. We don’t know when that might happen, but it might be next quarter. Sure it’s a monopoly, sure it’s the fastest growing monopoly we know, with option value up the wazoo. But we simply know it too well. It no longer surprises us and may have downside risk.
AAPL’s average earnings surprise (the amount it beat consensus) in the last four quarters was +11% and every quarter was a beat. GOOG’s was +2% and missed twice. There are no statistics as to how they did against the whispers. Investors think consensus has a pretty good idea about GOOG’s quarterly prints, but know it’s probably wrong about AAPL’s. They may also suspect AAPL may be at the start of a mega product cycle with iPhone that could compensate for the decline of the iPod/iTunes franchise and accelerate the overall growth rate far beyond the static consensus. That’s real option value. And while it could change in a second, that’s why it’s worth more than GOOG right now.