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The worm in Apple

At least once a semester, a few of my Texas Lutheran students have wanted to evaluate Apple for inclusion in their investment portfolio. With our internship, students must follow Warren Buffett-inspired principles such as is the investment understandable and predictable. If a business is not understandable and predictable, it is incredibly hard to value and most likely does not have a sustained competitive advantage.

Adhering to this philosophy has been rather difficult at times. My students will make arguments as to how "cool" Apple products are or that their latest iteration of the "iPhone or tablet will revolutionize the way we do things."

Given the string of successes Apple has had, it was hard to argue. However, in March 2012, we penned a letter to our private clients discussing our concerns about Apple's sustainability as a business model, but it kept trudging forward.

In August 2012, we wrote an article in this column outlining our concerns. Apple continued to push forward, making our view point look silly and ill-informed.

So why did we avoid an investment in Apple?

To make a point with my students, I cut out 10 years worth of financial data on Apple. There was no "cool factor" - just raw data to analyze. My students quickly honed in on the fact that as recently as 2005, Apple was losing money. So much for long-term consistency and predictability.

Then, we discussed the fact that Apple's visionary leader, Steve Jobs, was responsible for developing the products now on the market. They recognized that Jobs had died.

Next, we reviewed a string of key personnel departures. First there were some sacrificial lambs that were fired when things did not go right. And then, there was the exodus of key talent looking for greener pastures.

One tech-savvy student chimed in that Apple was introducing newer generations of products that did not have that many new features but had significantly higher prices than competing products. In an environment where money is tight, consumers are far less willing to upgrade just for a few new features, especially when it comes at a high price. Furthermore, the students deduced that if they switched from one Apple product to another, it would simply be a move from one profitable product to another. In the process, existing lines were cannibalized.

Finally, we scoured the inventory of several online retailers and saw numerous competitors to Apple's products being sold for much less - and just six months after Apple introduced them. This is not the definition of a sustained competitive advantage.

After walking through this process, my students took a step back and passed on Apple.

Apple then hit a price of $705 a share in September, making it the most valuable company ever. However, since then, the reality of Apple's issues have come to the forefront and its stock price has fallen by 38 percent, chopping a massive $250 billion from its value.

What can be learned from this?

First, "cool" does not equal profitability, consistency or sustainability. Five years of profits does not mean a company is predictable. It simply means they hit a hot streak. Be careful of shooting stars as they tend to flame out.

The worm in Apple represents the same threat to all businesses. Absent a "protective moat," competitors will steal market share, introduce substitute products and drive lower profit margins. Therein lies the trick - finding the businesses with broad and lasting protective moats such that they do not have to reinvent themselves every few years.

Intelligent investing involves easy concepts. They are just hard to implement and stick to. As such, discipline and logic are absolute requirements for managing a successful portfolio. Although it is hard to go against conventional wisdom, truly contrarian thought can provide much better investment returns and reduce risk.

Finally, there are no extra points given for an increased level of difficulty, so keep it as simple as possible.

Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.

By Dave Sather, Originally published Tuesday, January 29, 2013, Victoria Advocate