Looking at the Magnificent 7

The "Magnificent 7" companies have replaced the "FAANG" stocks, which means that Netflix has been dropped from the growthy-tech investor zeitgeist and Microsoft, Nvidia, and Tesla have been added. The combined market capitalization of the Mag 7 is $14 trillion, which is equal to one-third of the total market capitalization of the S&P 500 companies ($43 trillion). 

That is a very high level of concentration in the top index picks, which means that the returns for the float adjusted, market capitalization weighted index that most index investors buy (SPY) will likely be meaningfully different than the returns on the equally weighted index (e.g. RSP). (The equal weight RSP is trading for 19x earnings versus 21.5x for the SPY.)

Since we are generalists at CBS, it is "our business to know" what is going on with everything, even the frothy Magnificent 7. I thought that we should take a look at the cash generation power of these businesses. What do you get for $14 trillion? How are the free cash flow conversion margins - are these actually good businesses - and what is the valuation (FCF/EV)?

Before I did that, I wrote down my subjective view of business quality or moat for each, on a one to five scale. I am a customer of five of the seven (i.e. all of them except Nvidia and Tesla). How hard would it be for me to fire them? How hard do I think it would be for a team of well-funded 10x engineers to disrupt them? 

Based on that framework, I think that Tesla is 1/5; clearly the worst. (It now has the smallest market capitalization by a significant margin, while it was once larger than Facebook.) I think that Apple is clearly the best, 5/5. I gave Nvidia 4/5 although I am not very familiar with the company or its products. I think that Microsoft, Amazon, and Google are 3s and Facebook is a 2. (Without Instagram, Facebook would be a 1.)

How did my subjective view line up with the numbers? Surprisingly well. Click the table below to enlarge:

Some observations that stand out:

Microsoft blew an entire quarter's revenue, $65 billion, on the acquisition of Activision. But even adding that back, Apple generated almost as much free cash flow ($34.5 billion) as the other six companies combined ($46 billion).

Apple has the second highest free cash flow margin (29% of revenue) of the Mag 7. Nvidia's was 46%, a tobacco-like margin. We know that Amazon is a low margin retail business, Tesla is a joke of course, but Microsoft and Google have very lackluster free cash flow conversion.

Google's stock based compensation (SBC) in the most recent quarter was equal to 30% of cash from operations, and capital expenditures were equal to 58% of cash from operations. (Or 6% of revenue and 9% of revenue, respectively, if you want to look at it that way.)

Apple spent only 8% of cash from operations on SBC in the most recent quarter (3% of revenue), and only 6% of CFO on capital expenditure (2% of revenue), leaving much more free cash flow.

We know that Google is an inferior business to Apple because Google pays a gigantic tithe to Apple. But notice that Apple's most recent quarter cash flow was running at a 5% yield on the enterprise value. That is much more attractive than the other companies in the Mag 7 (which otherwise seem quite expensive).

Apple seems to have the best combination of moat and valuation. If you had to own one of the Mag 7, Apple would be our choice, hands-down, based on business quality and valuation. (Maybe you do have to own one. How far from the S&P 500 index and its performance are you allowed to stray?)

Berkshire has $156 billion of Apple stock, just over a quarter of its own market capitalization. We do not like Buffett's energy pick, but we do like his tech pick.

2016 Begins with Ultra Distressed Energy Companies on the Brink

Judging by the bond prices, many of these are likely to file in 2016:

• ZINC, the July 2017 3.8% note trading at 20 cents; ytm 155%
• GDP, the 8.875% notes traded at 8; current yield >100%.
• EXXI, the 3% notes traded at 6; current yield 50% and ytm 145%
• TC, the 7.375% notes traded at ytm of 134%
• SD, the 8.75% notes traded at 12; ytm >100%
• PVA, the 7.25% notes traded at 13; ytm>100%
• BTU, the 6% notes traded at 18.2; ytm 88%
• CLF, the 5.95% notes traded at 28; ytm 88%
• LINE, the 8.625% notes traded at 16; ytm 78%
• XCO, the 7.5% notes traded at 27; ytm 72%
• SSE, the 6.5% notes traded at 16; ytm 54%

Energy and resources. These companies have a combined market cap of $1.67 billion. In all likelihood based on the bond prices, that is illusory. Maybe in 2016 lots of illusory wealth will be revealed as worthless.

What if FB ad revenue that is funded by VC equity contracts, and the multiple contracts, and much of that $300 billion market cap is revealed as illusory? What if the Amazon flywheel runs in the opposite direction (both AWS, as an expression of the VC bubble, and the traditional business, as an expression of consumer spending), and some of that $317 billion market cap is revealed as illusory?

What if the replacement cycle on Apple devices lengthens, or consumers get tired of paying 100% markups for memory, and some of that $587 billion market cap is revealed as illusory wealth?

Well, then, we'd have a bear market.

Longer Bill Burr On Steve Jobs

"Bill Burr Doesn't Believe The Steve Jobs Hype - CONAN on TBS"

In re: GT Advanced Technologies, Inc., et al.; RESPONSE OF DOW JONES & COMPANY, INC. TO RELIEF SOUGHT BY DEBTORS IN THEIR EMERGENCY MOTION FOR ENTRY OF ORDER, PURSUANT TO BANKRUPTCY CODE SECTION 107(B) AND BANKRUPTCY RULE 9018, AUTHORIZING FILING UNDER SEAL $GTAT

From the motion:

"Dow Jones & Company, Inc. (“Dow Jones”), publisher of The Wall Street Journal, Dow Jones Newswires, and a variety of other news and information publications, respectfully submits this response to the Debtors’ request (DN 92) to file an unredacted version of the Supplemental First Day Declaration of Daniel W. Squiller (the “Supplemental Declaration”) under seal, or in the alternative, to file the full document in the public docket. [...]

During an adjournment in the initial hearings on October 9, the courtroom was cleared to address this motion. Only the United States Trustee and counsel for Apple and the Debtors were permitted to participate. On information and belief, this closed hearing continued for at least twenty-five minutes. [...]

More than the Supplemental Declaration is at stake. Dow Jones is concerned that information submitted as the cases progress that touches in any way on Apple, or falls within the expansive terms of the confidentiality agreement (DN 92-3), will be subject to seal, redaction, or other restrictive terms. [...]"

Arguments:

• The Supplemental Declaration Does not Qualify for the Limited Exceptions to the Right of Public Access Described in 11 U.S.C. §107(b).
• Preventing Public Access to the Supplemental Declaration Would Also Run Afoul of Critical Constitutional Principles.
• In the Alternative to Full Disclosure of the Supplemental Declaration, the “Least Restrictive” Means of Balancing the Public’s Right of Access with the Limitations Described in Section 107(b)(1) is to Closely Redact the Document – Not to Seal it Entirely.
• The Court Should Also Release Any Transcripts and Recordings Made of the Closed Hearing Held on October 9, 2014.

Steve Jobs: The Lost Interview

Worth watching. 4/5.

Making Industrial Sapphire

See the Mohs scale of mineral hardness. Sapphire is corundum, number nine on the scale.

Bearish Apple

Looks like $700 in September was the peak. The new CEO is too dumb to understand a simple balance sheet arbitrage.

Hardware

1: "[A] 7-inch tablet, Wi-Fi only with all the attributes of a good tablet. Capacitive touchscreen. Snappy processor. Front facing camera. 4GB of internal memory and an expandable memory slot. I later found out that these devices are now all over the supply chain in Shenzhen. At volume, say 20,000 units, you can get them for $35 apiece. [...] Once my heart started beating again, the first thing I thought was, 'I thought the screen alone would cost more than $45.' My next thought was, 'This is really bad news for anyone who makes computing hardware.'"

2: "The Fire is more like an accelerator — it’s a vehicle for turning active Amazon.com customers into even more active Amazon.com customers. Apple’s goal is to sell as many iPads as it can. Amazon’s goal is to sell as many Kindle Fires as it can to a specific audience: active Amazon.com customers. And for that specific audience, it’s a very appealing proposition. The Fire makes it even easier to do things you’re already doing — reading Kindle e-books, watching movies and TV shows through your Prime membership."

$AAPL

Good commentary [pdf]:

"When we look at our cash flow models, assuming Apple can maintain its current operating margins (a heroic assumption in the face of increased competition in the tablet market), to justify the current stock price, it appears to us that Apple will have to sell about $2.6 trillion worth of total products and services over the next ten years. Last year’s revenues (for the fiscal year ending 9/24/11) totaled $108 billion. [...] Since not all 310 million people in America use Apple, those who
do need to spend a lot more and the vast majority of those sales will need to be on devices because iTunes sales do not bring much profitability."

Hussman on Growth

At the end of this week's Hussman essay is the best thing I have ever read on growth.

Consider a very large, untapped market for some product. We can model the growth process in terms of how quickly that product is adopted by new users, whether there are any "network" effects where new buyers are attracted to the product because other people already use it, how frequently existing users replace their products, whether late-adopters come in more slowly than early-adopters because of budget constraints, how quickly the untapped market grows, and a variety of other factors.

Whether you do this sort of modeling with a spreadsheet or with differential equations, you'll get essentially the same results. Specifically, growth rates are always a declining function of market penetration. Most strikingly, the growth rates begin to come down hard even at the point that a company hits 20-30% market penetration. Network effects accelerate the early growth, but also cause growth to hit the wall more abruptly. Replacement helps to accelerate the early growth rates too, but ultimately has much more effect on the sustainable level of sales than it has on long-term growth. In fact, if the replacement rate (the percentage of existing users that replace their product each year) is less than the adoption rate (the percentage of untapped prospects that are converted to new users), it's very hard to keep the growth rate of sales from falling below the rate of economic growth.

[T]he key feature is that growth rates are a rapidly decreasing function of market penetration.

Apple is now valued at 4% of U.S. GDP, but then, Cisco and Microsoft were each valued at 6% of GDP at the 2000 bubble peak.

This really reveals the silicon valley VCs as a bunch of hacks and hucksters. Isn't it telling that they cash out when they IPO the companies? Is this a country of such rubes that they don't realize that companies without significant demands for capital are just listing on the public markets in order to hang paper on suckers?

Also, the short AAPL / long natural gas (aka the "Gundlach") is sounding more and more awesome. We are going to start tracking this trade on the blog. However, rather than spot natural gas or one of the awful natural gas ETFs, we will use CHK as our proxy because it's so undervalued.

"JEFF GUNDLACH: If I Were A Young Hedge Fund Manager, This Is The Insane Contrarian Trade I Would Make Right Now"

"If I were one of the nutty hedge fund guys, I would go short Apple, long natural gas, and leverage it 100x."

Steve Jobs Full Interview at 2010 D8 Conference w/ Mossberg

Steve Jobs on Action

Review of Steve Jobs Biography and the iPhone 4s

I just finished the Steve Jobs bio by Walter Isaacson. This has been reviewed to death already so I'll make just a few new observations.

First, Jobs was worth less than $10 billion (which is #39 in the U.S.) despite having created the most valuable company in the world by market cap, and also having cleared several billion in the sale of Pixar to Disney in 2006. Jobs was oddly unmotivated by money - perhaps because he became rich at such a young age. He could have been much richer, for example when Larry Ellison offered to back him in taking Apple private.

Something else odd about Jobs was that he lacked appreciation for science. This is obvious in his fad diets and reluctance to properly treat his illness, but also reflected in his form above function mentality. For example, he liked to design a case for a product before thinking about components that would go inside. The puzzle is how that could have resulted in phenomenal products like the iPhone.

But I can remember when the Macintosh and Apple software were really frustrating to use. Their office suite was a joke for years and the Mac OS X user interface is laughable. The Jobs fanaticism - leaving fans out of computers - resulted in his fair share of clunkers.

I wonder to what extent the recent string of successes resulted from the Jobs design genius finally being paired with competent "function" people, or technologies that allowed his ideas to be implemented in workable fashion? I give the book a 4/5.

The new iPhone 4s is fantastic. It is much much faster than a 3G thanks to the new dual-core processor and quadrupled RAM. The Siri voice recognition is surprisingly good although I don't find that feature especially useful in practice. The camera quality (and speed) is much better and the display is fantastic. This is a 5/5.

Steve Jobs Presents to the Cupertino City Council (6/7/11)

By the way, he mentions in the presentation that they tried to buy a group of apartment buildings when they were assembling the parcel for their new campus, but the buildings "weren't for sale".

When someone offers you a non-economic (i.e. irrational) premium for an asset that you own, you should always, always take it!

Stableboy on Schools of Thought in Technology Investing

I am concerned that the current stock prices of many consumer technology companies appear cheap on the basis of current earnings. The problem is that current earnings for a consumer tech company are much more misleading than the current earnings of a soft drink company. iPod destroyed Sony’s profitable Walkman division in two years. iPhone destroyed digital camera sales and dumb phone sales in two years as well. Now value investors are getting involved a lot in technology names and most will get their asses handed to them. The ironic thing is that most of them avoid owning Apple (and even worse, the contrarians will short it). So they will have losses on their longs and losses on their short.

I just shake my head at the idea of buying DELL, MSFT, GOOG. At this point, Google is making its products worse! They have achieved negative marginal returns from complexity!

Sculley on Jobs

The thing that separated Steve Jobs from other people like Bill Gates — Bill was brilliant too — but Bill was never interested in great taste. He was always interested in being able to dominate a market. He would put out whatever he had to put out there to own that space. Steve would never do that. Steve believed in perfection. Steve was willing to take extraordinary chances in trying new product areas but it was always from the vantage point of being a designer. So when I think about different kinds of CEOs — CEOs who are great leaders, CEOs who are great turnaround artists, great deal negotiators, great people motivators — but the great skill that Steve has is he’s a great designer. Everything at Apple can be best understood through the lens of designing.

Steve Jobs

Very sad to hear the news from Apple that Steve Jobs has died.

Prechter would point out that he leaves us with AAPL stock at an all time high, up over 10,000 percent since 1980, and now the second largest company by market capitalization in the world.

This makes Jobs likely to be remembered as the best CEO of all time, better than Buffett who missed his chance to quit at the top of his game.

Unlike most CEOs, Jobs was very thoughtful in public speaking. It's worth watching some of his best talks over again.

The Stanford commencement in 2005


The "Steve Jobs and Bill Gates Together" interviews at the All Things Digital conferences were also great.

Steve Jobs at WWDC in 1997