Author: Rocco Huang
Covestor model: Tortoise and the Hare
Disclosure: Long AAPL, AZO
On why he stopped going to a certain St. Louis restaurant, baseball fame Yogi Berra used to say: “Nobody goes there anymore. It’s too crowded.”
A similar paradoxical contradiction aptly describes Apple’s current situation: “Nobody buys Apple anymore. It’s too crowded.”
If you tell someone that your best stock idea is Apple, you will likely be met with sympathy. Very likely, he will think that you are either a naive amateur falling for Wall Street analysts’ over-optimistic bullish calls, or an Apple fanboy mistaking a great product for a great investment.
You can’t blame him. Buying AAPL seems to be the most generic idea on the Street, and you must be a real idiot if that’s the best idea you can come up with, he likely thinks. He’ll ask you in Socratic irony, hoping to teach you something: “How can a stock be so favored and remain undervalued at the same time? How can a restaurant be crowded and remain under-appreciated at the same time?”
Retail investors have been told by many popular books that the undervalued stocks are more likely to be found in the small-cap space that institutional investors neglect, and that a large-cap stock can’t be mispriced for long, with so many institutional investors scrutinizing the space so closely.
Let me explain to you why large-cap stocks can remain mispriced longer than smaller-cap stocks. The short answer: Institutional investors have to act by the rules of institutional investing, but you don’t.
Let’s think from the perspective of a typical long-only mutual fund manager, as the appreciation of mega-cap stocks like AAPL has to be supported by a broad base of institutional money.
This manager’s benchmark is the S&P 500. Typically, his investment mandate spells out how much “active weight” he can have. In asset management jargon, “active weight” describes the deviation of a stock’s weight in a portfolio from its weight in a benchmark index (such as the S&P 500). If an manager’s mandate says that he is not allowed to deviate by more than 2 percentage points in any positions, and if AAPL has a 3.5% weight in the S&P 500, then this manager can invest no more than 5.5% in AAPL, no matter how bullish he is, and no less than 1.5%, no matter how bearish he is.
A median stock in the S&P 500 has a market cap of $11 billion, accounting for less than 0.1% of the index. Let’s use auto parts retailer AutoZone Inc. (AZO) as a typical example. AZO’s market cap is less than 1/26 that of AAPL and accounts for only about 0.1% of the S&P 500. If this manager is convinced that AZO is undervalued, and accordingly allocates 1% of his portfolio to AZO, he is over-weighing AZO by 1,000% (10 times) compared to AZO’s share in the benchmark S&P 500 index. This overweighing, however, is well within the limit of his “active weight” restriction, since his active weight in AZO is only 0.9%.
With a sufficient number of like-minded value managers doing the same buying, AZO’s price can be driven up very soon, if it is indeed an undervalued stock to begin with.
Let’s now think about what would happen if this same manager is also convinced that AAPL is undervalued. Unfortunately, this time there is no way he can over-weight AAPL by 1,000%. To do that, he would have to allocate more than 35% of his portfolio to AAPL. I am pretty sure his risk control people would not allow this to happen, unless he is Warren Buffett.
Therefore, even if every manager on Wall Street believes that AAPL is undervalued, the stock can remain undervalued for an extended period of time.
Institutional investors have to follow the rules of institutional investing. Buffett, on the other hand, got to put more than 15% of Berkshire Hathaway’s equity portfolio in IBM. No other funds of similar size would do the same.
If this is what has been preventing AAPL from appreciating, I expect AAPL to find its intrinsic value only gradually and would not expect rapid price appreciation, because institutional investors can be expected to passively raise their stakes only after AAPL’s weight increases further in the S&P 500.
Fortunately, this is great for any retailer investors who are net savers. If one is expecting to add money to his equity portfolio in the future, then the longer AAPL remains undervalued, the merrier.
Let’s imagine that the $1 burger from your favorite restaurant is on sale for 50 cents because “nobody goes there anymore,” and you eat three today. The next day, when you show up before the counter again, I am pretty sure you will be more disappointed if the price has returned to $1 than if it remains depressed.
The expectation and goal should be the same when buying stocks as when buying your favorite burger.
