"To love is to suffer. To avoid suffering one must not love. But then one suffers from not loving. Therefore, to love is to suffer; not to love is to suffer; to suffer is to suffer. To be happy is to love. To be happy, then, is to suffer, but suffering makes one unhappy. Therefore, to be happy one must love or love to suffer or suffer from too much happiness."
--Woody Allen, "Love and Death" (1975)
The purpose of this morning's opening missive is to provide an anatomy of a poor investment short in Apple (AAPL) over the last 12 months, and to demonstrate how I attempt to minimize losses during periods when a stock goes against me.
Much like a baseball hitter, an investor fails to get a hit much of the time.
In baseball, a .330 hitter, one who gets a hit in every three at bats, is considered an All-Star player.
It's more complicated as a trader or investor. But, from experience, being right a bit over half the time and employing thoughtful risk management tools can produce All-Star results.
Last year on September 8, you wrote:
Now for purposes of clarification, I plan going forward to offer my 12-month risk/reward quotient in my write-ups of individual companies. Here's my 12-month calculus for Apple, which was trading at around $106 a share at last check:
- Upside: $115 (+8%)
- Downside: $90 (-15%)
Since that time, Apple has increased $68 or about 7.5 times the amount you thought possible. Granted, it is slightly more than a year.
You are just small short now in Apple.
I don't care that you are long or short. But I do think it's important to provide some guidance as to why you're only small short given your prior comments. Last year, I mentioned that your ranges were absurdly small, both to the up- and downside. Had this been a down year and you disliked Apple, it could have gone down more than your prediction. But as we've seen, it has gone up far more than you thought possible.
For the homegamers, it would be helpful if rather than just providing a variant view, you provided key links in your articles that are shaping your investment and trading decisions. For example, if Apple keeps rallying, at what point will you cover again? And if it falls, when will it have fallen enough?
Kevin then added a second comment:
Thanks, Doug. I think readers would benefit when you bridge the "before" and "after." This is not a "gotcha." And again, I don't really care whether you are long or short. I am more interested in the thought and investment/trading processes.
As a reader, I want to know what moves your needle as you consider increasing or decreasing your position. That is, I want to know the good, bad, and the ugly.
When I see "variant views" with a stream of negativity toward any stock, I lose interest. I lose interest because the author is just looking for confirming articles leading to confirmation bias. I am more interested in what is shaping your thinking either positive or negative.
I gave a quick and hurried response to Kevin in my Diary late that day that I wanted to expand upon my answer this morning.
First is the admission to Kevin and everyone else that I have been wrong on Apple.
With regard to Kevin's last observation -- that I tend to link confirming articles leading to confirmation bias -- when I read thoughtful articles supporting my position, I pass them on in the belief (as articulated by Warren Buffett) that there is no such thing as reading too much. As to articles that are in opposition to my position, my view is that there is so much (and often one-sided) bullish Wall Street commentary that it is not necessary for me to provide delivery!
As to Kevin's second-to-last observation - what moves my needle -- that answer is the fundamentals relative to price action (more on that below).
As to Kevin's isolation of the Sept. 8, 2016, to November 2017 time frame's miss in Apple's share price range (absurdly too small was his term) relative to my expectations, this is correct, but I believe we really should think about the entire five-year period I have been short in varying sizes in Apple. The fact is that from September 2012 to September 2016 Apple's shares made little progress and displayed low volatility. It was only in 2017 that the pattern of much greater price change/volatility changed.
It also should be importantly observed that during the last 12 months the general market advanced much greater than I had assumed in my baseline calculation, upon which my Apple upside target/potential was calculated.
I would note that, to me, the subject of my analysis, Apple, is at times less important than the context in which I navigate through an unprofitable investment position. So, I will spend less time going into the analytical weeds of my Apple short and more time in explaining how I manage positions.
There are no easy answers to Kevin's questions. To be frank, each situation is different. Companies are diverse and the events that contribute to disappointment or success in analysis also are likely to be different. As well and as mentioned, stocks move within the context of and relative to the market. Get the market wrong, as I did, and I likely will get Apple wrong!
Strategies Employed to Mitigate Losses
Apple has been a short of mine, on and off and in various sizes, for about five years.
I still believe in the Apple short, but it is clear that my earnings and sales expectations for 2018-19 were too low as I have understated the consumers' response to the iPhone iterations post the iPhone 6), I have overstated the company's vulnerability to price competition, I have misinterpreted the strength of Apple's service business and I have underestimated the valuation expansion in the shares that we have seen this year.
And I remain of the view that Apple's replacement cycle will lengthen in the fullness of time, which will bring with it product pricing pressure, some sales and profits disappointments and a weakening share price. However, 2016 will not mark a peak in earnings, which was my previous thesis.
Here are some of the techniques and basic tenets I use to navigate in both losing and winning investments and, as Kevin asks, that shape my moves:
* Weighting and averaging into positions: A market dominated by machines, algorithms and strategies that worship at the altar of price momentum provides opportunities because it produces exaggerated price moves. This creates more uncertainty of entry points, which are less predictable and less precise (at least for me!). To accommodate this market backdrop, I start small in size and gradually build up the positions.
* Weightings are not fixed: Individual stock weightings should be subject to your risk profile/appetite, your conviction level and, in my case, if the stock is performing according to my expectations. In 2017, when Apple was going against me, most of the time I kept my Apple position quite small.
* As reward/risk is asymmetric, my weightings are different in longs versus shorts: One can lose an infinite amount if a short goes against you, but you only can make 100% on a short if the company goes bankrupt. My short size positions are rarely above 2%, while long positions can be more than twice that figure. Small in size is under 1%, where I resided for most of 2017 in my Apple short.
* Employ strict risk control techniques: I take a lot of small losses. It's easy to say stop losses and let your profits run, but it is a lot harder to execute. When wrong, stay small in size. I trade actively, sometimes daily, but nearly always weekly in those core positions. (Producing total transparency of trades would be just too damn confusing for subscribers, so I identify when there is a change, like from medium to small and vice versa.)
* I try to be opportunistic: Even a trending stock provides numerous contra-trend trading opportunities. I am almost always trading around a core position -- selling rips, buying dips -- even in the broader market's one-way action of the last few years. That is a means of mitigating losses when wrong.
* Make an assessment of why the stock is moving with you or against you: If there is no change in the fundamentals and the stock is moving against me, I typically add. But if there is a change in the fundamentals and the stock is moving against me, the best course is to eliminate the position and/or keep it small as I did this year.
* I tend to act swiftly prior to breakouts and breakdowns: I don't typically wait for the technical break in the line -- I am anticipatory!
The Genesis of My Apple Short and How I Maneuvered Around It
Over five years ago, on Sept. 24, 2012, I outlined in "The Bear Case for Apple" a summary of my 10 concerns at that time:
- Quality vs. price: Apple is now selling less or equal for more money.The company used to sell a better product for more money, which is a great strategy. Its products were simply market-defining, and competitors were not close. Recently, however, things have changed, and competitors have caught up. Now Apple is selling an equal to worse product than the competition for more money (both phones and tablets). That strategy cannot work forever. This is the biggest issue.
- Delivering a more complicated product: Products are also getting more complex and Microsoft-like.Apple's challenge is to deliver ever more complicated products (with a lot of new components) in sufficient quantities. See most recent Foxconn issue. Previously, we would never have seen such a story because there were never issues and nobody would dare voice them, especially not an avowed Apple zealot like the author of this interesting article.
- The Oracle of Cupertino: Steve Jobs is no longer around to convince consumers that his products are magical.There is no longer a single visionary voice, especially with the vision of Steve Jobs. There are stories floating around about internal disagreements and power struggles given the unique void created by the loss of a single dominant figure in an unusual corporate structure that he controlled.
- Increasing product homogeneity: Apple no longer has a huge ecosystem advantage.Most if not all the apps that consumers care about are available on Android and Microsoft (MSFT), which can also run Office apps such as Excel that Apple doesn't. The first-mover advantage might be lessened or lost if Apple continues to try to do everything on a proprietary basis -- for instance, maps (and who wants a smartphone with bad maps?).
- Economic headwinds: Some of the markets served by Apple are saturated, and in a worldwide economy facing strong headwinds, consumers may balk at a product that can be purchased at much lower prices from competitors.Until last quarter, Apple never missed consensus expectations during a product transition. There is more to last quarter's miss than transition.
- Poor economic proposition for Apple's partners: Apple's carrier partners do not like the economics they give to Apple.Apple's partners have shown that they can and will shift to the good alternatives that consumers seem to like (e.g., Samsung Galaxy).
- Roadblocks to new initiatives: Potential business partners in general do not like or trust Apple relative to other initiatives.The music industry and AT&T have not had great experiences with Apple, and the company might find it hard to sign deals for new initiatives.
- Product cannibalization: The iPad mini may cannibalize the higher-margin iPad -- or just be a neutral at best.
- Growing size mandates delivery of more product blockbusters: An investor better believe in a huge new blockbuster product next year.TV is complex due to relationships with cable companies, set-top box manufacturers and channel guide programmers. Google may one up Apple in the space, as it owns Motorola's set-top box division and has Google Voice already. If it comes to integrating more complex solution for TVs with content, cable companies and other media partners have learned not to trust Apple given the poor outcomes other Apple partners have had (e.g., music industry, AT&T, etc.).
- Valuation: Apple's stock is cheap on a P/E basis but arguably very expensive on price/sales (4.4x) and total absolute market capitalization basis ($625 billion).
--Kass Diary, "The Bear Case For Apple"
My initial short in Apple on Sept. 24, 2012, was done at about $98 a share. The shares had risen by more than 80% in the prior 12 months before my short and had climbed from about $13 at the Generational Bottom for stocks in March 2009, for a gain of 600%.
Adjusted for splits, Apple closed at $174 on Monday, a gain of 77% from my initial short over five years ago.
Here is a five-year chart.
Let me briefly review that five-year period, mostly from memory.
To Kevin's question, from late 2012 to 2017 I invested and traded Apple on the short side, mostly profitably until this year. Indeed, as seen in the chart above and in the commentary below, the shares, though volatile, were roughly unchanged in a bull market for the broad indices from September 2012 to the end of 2016 despite an aggressive capital allocation strategy inspired by Carl Icahn and David Einhorn that led to a large buyback program.
In late 2012 and prior to the introduction of the iPhone 5, I produced the aforementioned "Bear Case for Apple" and I featured Apple in my 2013 Surprise List. In the following few months Apple's shares fell meaningfully -- from the $90s to below $56 in April 2013 -- in the face of fundamental disappointments as product sales missed and margins eroded. So far, so good -- I profited mightily with a reasonably good-size short and covered the short well.
At the core of my bearish view was a maturing smartphone cycle and Apple's vulnerability to average selling price erosion as competitors' price structures were appreciably less than that of Apple.
Later on, with the introduction of the iPhone 6 and its large screen I opined it likely would be the most important form-factor change in a decade and could lead to the last big replacement cycle for the company.
My recollection is that Apple's shares, after falling in late 2012 and early 2013, traded in a range of $55 to $80 until May 2014. The stock was remarkably stable -- not trading above $95 or so (back to September 2012 levels) until about August 2014. The shares then enjoyed a strong run into February 2015 to $130, staying at that level until July 2015 (I lost money on my core short during that time frame but, under the circumstances, I traded around the position just fine) . From there, after a couple of weak quarterly reports, Apple's shares slipped from the $130s to the low $90s in May 2016. At the time I had a reasonably good-size (fundamentally supported) position and profited. Apple's shares rallied and ended 2016 at about $115. As previously mentioned, in those four years they climbed not much higher than when I initially shorted the stock in September 2012 despite the aforementioned large stock buyback, market participants' large appetite for technology and an ebullient S&P 500 Index.
Things then changed rapidly in 2017.
At the beginning of this year Apple's shares broke out strongly following several slightly better-than-expected earnings reports and because of the strength of the U.S. stock market in general and technology in particular. Apple shares experienced something previously unexpected by me -- an expansion in valuation that has kept on going and going throughout all of 2017.
As chronicled in my Diary, I made some profitable and unprofitable (contra) short trades this year. I basically have maintained a small short core position in response to and respectful of the fundamentals and price action that has been, on a net basis, a losing position. To respond to another one of Kevin's questions, unlike in prior years where I conducted a steady narrative, I did not discuss Apple much this year in my Diary as it was clear that I was wrong and my quite small core short position reflected my lack of conviction based on the better operating results and the market's response to those numbers. I moved on to other shorts.
Under these circumstances I was not confident in changing my short size (see strategies above to mitigate risk).
With the benefit of hindsight -- investment wisdom is always 20/20 in the rearview mirror -- the proper investment posture over the last five years would have been, as suggested by Jim "El Capitan" Cramer, to buy all the dips since 2012. I did fine with my Apple short employing some of the strategies discussed in my opener today, but nowhere as well as if I had bought those many dips as Jimmy recommended in his columns and on "Mad Money."
I currently plan to maintain my Apple very small short, subject to the company's developing fundamental progress relative to consensus expectations and the share price response.
I continue to feel comfortable in my strategies discussed this morning, aimed at limiting risk and losses in my Apple short and in other shorts if they go unexpectedly and contrary to my expectations.
After all, to invest is to suffer.
(I hope you are getting this down!)
(This commentary originally appeared on Real Money Pro at 8:14 a.m. ET on Nov. 14. Click here to learn about this dynamic market information service for active traders.)