A Blog by Jonathan Low

 

Apr 24, 2012

When Too Big Is Too Bad: Is It Time to Harvest Apple Stock?

Oh, no. Not another one of THOSE articles.

You know, the 'whither Apple; is it overpriced, underpriced, about to explode, about to collapse' tilt-a-whirl to which customers, investors, suppliers and soothsayers have been subjected for, well, just about forever.

No, the latest issue may not be apparent to those beyond a small-ish circle of market watchers. The concern is that Apple now comprises over 4% of the S&P equity index. That does not seem like a large number by itself, but in the universe of stock market averages it is enough to literally move the entire market. On some days little ol' Apple can affect the direction of the broadest market indices.

How totally cool. And how utterly scary. Not because there is anything wrong with Apple: it's price-earnings ratio is reasonable, products are iconic, growth prospects believable. But because any company's stock performance, having achieved that degree of size and influence, tends not to be sustainable, those concerns now affect Apple.

The challenges are that 'concentration risk,' or the ownership of the stock in too few hands, makes it susceptible to uncertain swings. And markets abhor uncertainty. The other issue is that historically, growing to this size tends to be an effective long term sell signal. Other tech behemoths who have hit Apple's place in the stratosphere: Microsoft and Cisco...

So, cheer them on. Buy their stuff. Exult in the triumph of the digital David over the gimmicky Goliaths. But remember that for many others, investing is a rational business not an emotional entertainment. JL

Ben Levisohn and Joe Light report in the Wall Street Journal:
How do you like them apples? Investors got a scare on Monday when Apple, among the best-performing stocks of 2012, tumbled 4.2%, capping a five-day stretch during which it lost 8.8%. The stock continued its slide later in the week, finishing Friday down 10% from its all-time high.

You didn't have to own a single share to feel the pain. That is because Apple, the largest public company in the U.S., now makes up more than 4% of the Standard & Poor's 500-stock index and almost 18% of the Nasdaq-100. On some trading days, Apple alone can determine whether broad stock indexes are up or down. On Monday, for instance, the Nasdaq fell 1.1%, while the Dow Jones Industrial Average, which doesn't include Apple, rose 0.6%. On Friday, Apple fell 2.5%, sending the Nasdaq down 0.4% even as the Dow rose 0.5%.
Making matters trickier, a broad swath of mutual funds have been piling into Apple shares of late—even funds dedicated to such specialties as small-company and emerging-market stocks. The result can be what experts call "concentration risk," or too big a position in a single stock.

The good news is that there are ways to reduce this risk. By sticking to broader market indexes, choosing alternatives to traditional market-capitalization-weighted mutual funds and investing in other companies that benefit from Apple's growth, you can cut back on Apple and still prosper if the stock continues to rise.

"Apple's had an amazing run," says Barry Knapp, chief equity strategist at Barclays Capital in New York. But "once a stock gets to this level of contribution, you have to think about its effect on markets."

Pricey? Cheap? Who Cares?
It isn't clear whether Apple, at $573 per share, is over- or underpriced. Depending on the valuation measure used, different investors can come to different conclusions.

Some companies that previously reigned as the largest in the S&P 500 got there because of irrational exuberance. Cisco Systems, CSCO -1.16%for example, saw its price/earnings ratio, a measure of valuation, swell to well over 100 at the stock's peak in 2000—versus the S&P 500's average P/E of about 25 at the time.

Apple is another story. Since it rolled out the iPhone in 2007, its P/E has shrunk, notes Horace Dediu, a former telecom analyst at Nokia NOK -1.37%and founder of Asymco, a data-analysis firm in Helsinki. In 2007, Apple's P/E based on the next 12 months of earnings was about 30; now it is about 12.8, compared with the S&P 500's average of 12.5.

During that same period, Apple's stock price has soared sevenfold—but its profits have increased by 1,200%.

One reason why Apple's P/E is so reasonable, experts say, is that the technology sector is especially fickle, and investors are unsure of future profits. "This is a technology company in a world where technology changes quickly," says John Goltermann, a portfolio manager at Obermeyer Asset Management in Aspen, Colo. "Now, it's the incumbent, but that's not necessarily going to be the case forever."

Purely from a portfolio-management standpoint, however, whether or not Apple is overvalued is largely irrelevant. What matters is how much the company dominates your overall holdings.

Yet many investors aren't heeding that advice. Financial planner Bruce Primeau of Summit Wealth Advocates in Prior Lake, Minn., says he just brought on a client who has almost 20% of his portfolio in Apple stock, which the client plans to manage by himself, outside of Mr. Primeau's purview. Mr. Primeau says he is trying to convince the client to diversify out of the holding, but has had little success so far.

"I can run retirement projections until the cows come home" on the rest of the portfolio, he says. "But no matter what I do, Apple is going to have the most significant impact."

Outsize Influence
History hasn't been kind to companies that dominate the S&P 500 to the extent that Apple now does. Since 1990, four other companies have comprised 4% or more of the index, according to the Leuthold Group: Microsoft MSFT -0.93%in January 1999, General Electric GE -1.50%in December 1999, Cisco in March 2000 and Exxon Mobil XOM +0.46%in April 2008. None of them stayed at that level for more than one year. Apple crossed that threshold in February and remains there now.

"It's always been a good long-term sell signal," says Doug Ramsey, chief investment officer at Leuthold Weeden Capital Management. "Companies haven't been able to sustain that position for long."

Even lesser levels of dominance can be unsustainable, notes Feifei Li, head of research at Research Affiliates. According to the firm, between 1952 and 2010, companies that led their sector in market capitalization have underperformed their sector by 3.2% per year for the next decade. Since the middle of 2007, meanwhile, 26 of the 100 largest companies in the S&P 500 have dropped out of the top 100, according to Leuthold Group data.

The reason they slide? Big companies tend to be less flexible, are easily distracted into markets outside their specialty and face higher government scrutiny, according to Research Affiliates' Ms. Li. To wit: The U.S. Justice Department last week sued Apple and book publishers for allegedly colluding to raise prices. Apple declined to comment.

Despite the risks, some fund managers have been ramping up their allocations to Apple dramatically in the past few years, as Apple's stock has soared.

"Whenever a name becomes dominant, it can distort the decision making of the manager and the people investing in their portfolios," says Tom Brakke, president of investment researcher tjb research. "But as long as it's going up, people tend not to notice."

The $108 million Matthew 25 fund, for example, has 17.6% of its portfolio in Apple, the largest holding among all large-cap stock funds, according to investment-research firm Morningstar. That is up from 10.7% in March 2009. The DWS Large Cap Focus Growth fund has a 14.6% stake in the company, up from 3.6% three years ago. And Fidelity Contrafund, a core holding in many 401(k)s, as of the end of February had nearly 10% in the company, more than three times its position at the end of March 2009.

Mark Mulholland, the portfolio manager of the Matthew 25 fund, says having a 17% stake in a single company isn't abnormal for the fund, which owns 19 stocks. Because Apple has been so strong it would be "more risky not to have a heavy position," he says.

A Fidelity spokeswoman said the Apple holding has benefited Contrafund shareholders and is a result of the manager's "rigorous investment process." A DWS spokeswoman says the managers of DWS Large Cap Focus Growth, a portfolio of 35 stocks, look for companies that have attractive valuations, will benefit from strong secular growth stories and have products that are gaining market share.

What to Do
The first step in reducing a position is to take a full inventory. Search your fund companies' websites for your funds' holdings, which should be reported at least quarterly. The "Portfolio" section of Morningstar.com also has an "Instant X-Ray" tool, which shows you how much of your mutual funds and exchange-traded funds are in specific stocks.

Examine everything. Apple has been showing up in unusual places, including small- and midcap, foreign, emerging-market and European stock funds, among others.

A caveat: Reducing exposure to Apple means investors could miss out on future gains. Nevertheless, given the stock's rapid climb, many experts recommend an overall exposure of 3% to 5%.

To get there, investors likely will have to look beyond the S&P 500 index of large-cap stocks—the go-to index for many investors. But those investors should think beyond large caps anyway, experts say, and hold sizable chunks of smaller stocks as well, both in the U.S. and beyond.

People who invest primarily in index funds can reduce their exposure simply by broadening the indexes they use. While the PowerShares QQQ QQQ -0.92%ETF, the most popular index fund that tracks the Nasdaq-100, has a nearly 18% stake in Apple, that drops to about 4.5% for the SPDR S&P 500 SPY -0.85%. The iShares Russell 1000 IWB -0.82%ETF, which follows the largest 1,000 companies in the U.S., has a 4% weighting, while the Vanguard Total Stock Market VTI -0.86%ETF, which tracks the MSCI U.S. Broad Market Index of nearly all U.S. stocks, has a 3.6% stake.

Indexes that are weighted by factors other than market capitalization can reduce the impact of Apple even more, says Cokie Berenyi, a financial planner at Alphavest in Charleston, S.C. She recommends keeping money in ETFs that weight stocks equally, rather than by market capitalization, to avoid overconcentration.

The Guggenheim S&P 500 Equal Weight RSP -1.06%ETF, for example, has only about a 0.2% allocation to Apple—and the rest of the stocks in the index. This year, the ETF has returned about 11%, roughly the same as the market-cap-weighted SPDR S&P 500 ETF.

Equal-weighted ETFs have their drawbacks. For one, they skew an S&P 500 fund more toward midcap stocks because they take an equal allocation in every stock in the index. That will cause the ETF to lag behind if large stocks take off. With a 0.4% expense ratio, the Guggenheim ETF is also pricier than typical market-cap-weighted ETFs. But those factors are more than offset by eliminating the risks of concentrating in one stock, Ms. Berenyi says.

A few actively managed mutual funds have been among the top performers, despite relatively small positions in Apple. As of April 18, the Dynamic U.S. Growth fund and the Weitz Research fund ranked among the top 10% of large-cap growth funds during the past 12 months despite owning no Apple shares in their most recently announced portfolios, says Morningstar. The Thornburg Core Growth fund also ranked in top 10% of its peers, according to Morningstar, despite having only a 3.1% stake in the company. The funds have expense ratios of 0.95%, 0.9% and 1.45%, respectively.

For holders of individual stocks, the best approach is to identify other companies that will benefit from the forces that are driving Apple's stock higher, says Amy Lubas, a strategist at Ned Davis Research, including the mobile Internet, cloud computing and the continued digitization of media.

That means looking at Apple's suppliers, such as chip-makers Qualcomm QCOM -1.11%and Skyworks Solutions, SWKS -4.39%and companies set to benefit from the continued growth in the mobile Internet, such as data-storage provider EMC EMC -0.86%.

"You might not want too much Apple, but fighting those trends would be foolish," Ms. Lubas says. "They're all intertwined."

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