Bullish Cross

On October 1, 2011, we published a 12,000-word (24 Single-Spaced MS-Word pages) article entitled The Apple Game-Plan for October which basically laid out what we expected to see out of Apple and how to position before and after the iPhone 4S event. If you go back and look at that October game-plan, you will see that everything played out precisely as planned. We got everything we wanted and Apple traded exactly as we expected it to.

We have high expectations that this Apple Game-Plan for December & January will provide a lot of guidance and a good plan for the next few months. The point of this article is to offer up a general thesis for how to position in the various Bullish Cross portfolios and to provide information that we think is important for determining the short and intermediate-term direction of the stock going forward.

The research we’ve conducted for this report has produced some extraordinary information regarding how Apple tends to perform and trade during different time-periods in the quarter. You’re going to be pretty surprised what the analysis indicates regarding Apple’s performance for December and January.
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Thursday, November 17, 2011 — After Apple fully recovered from the depths of the financial crisis to make fresh all-time highs in early 2010, the stock began its very long period of P/E compression. All maturing growth stocks undergo the painful process of P/E compression. In some cases, this process will happen way before the company actually begins to slow down from a growth perspective.

In some rare tragic cases, some growth companies will go through a period of premature P/E compression as a result of Wall Street failing to adequately understand the company or the market in which the company operates. Unfortunately, Apple does fall within this subset of tragic cases.

Even thought the company recorded accelerated revenue growth in 2010 and much of 2011 as well as very explosive earnings growth, Wall Street has felt the company’s growth topped out sometime in 2007. Since 2007, Apple has struggled to maintain a P/E or PEG ratio that is anywhere close to commensurate with its growth rate or reasonable forward expectations.

Year after year Apple has reported an earnings and revenue that is on average about 50-70% above Wall Street initial expectations heading into the year. And every year, Apple trades at a depressed valuation. For example, heading into fiscal 2011, Wall Street analysts were expecting Apple to report $17.34 in earnings per share on $75 billion in revenue on the year. Apple reported $27.68 in earnings per share on $108.25 billion in revenue. That represents a 59.64% earnings beat and a 44.33% revenue beat on Wall Street’s earnings expectations heading into the year. This was Wall Street’s expectation on the first day of fiscal 2011. This after Apple reported an 80% earnings beat on Wall Street’s earnings expectations for 2010.
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Tuesday, November 15, 2011 — In Chapter 5, we detailed the inherent limitations of financial analysts and how those limitations impact the accuracy level by those analysts in forecasting Apple’s P/E ratio. We also detailed the principle of using “Reasonable Conservatism” to model, forecast and invest based on determining where Apple’s floor might be. Instead of investing on high Apple can go at the most aggressive end of the spectrum, investors should formulate their investment strategies based on their well-reasoned determination of where the floor happens to be with Apple.

In this chapter, we get into the actual elements that go into the forecasting models that try and predict Apple’s future P/E ratio. FIrst, let me say that this is an extraordinarily complex and often-time, a subjective science. While earnings is very data oriented, forecasting Apple’ P/E ratio requires a lot of very subjective conclusions. People can disagree on the scope as well as the degree of impact that these different elements have on Apple’s overall P/E ratio. Yet, experience goes a very long way in being able to accurately assess each of these elements appropriately.

Many of you won’t agree with me on the conclusions I draw and that’s totally fine. I’m extremely confident both in my abilities, and on my handle of the material. This all will come down entirely to your depth of experience with the equity markets. This is why extraordinary financial analysts tend to fail when it comes to forecasting P/E ratios. They simple cannot wrap their mind around or simply do not have the requisite experience to properly assess the subjective market analysis component of the equation — which is probably the most important in this case. Let’s begin. In no particular order, these are the elements that impact and determine Apple’s trailing P/E ratio and which should be thought about when forecasting future trailing P/E ratios:
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Thursday, November 10, 2011 — As we explained in Chapter 2, anyone who can forecast Apple’s future earnings and future trailing P/E ratio can forecast Apple’s stock price. In fact, Apple’s stock price is nothing more than multiplying Apple’s trailing 12-months (TTIM) of earnings per share (EPS) by its price-to-earnings ratio (P/E Ratio). If you know both variables, then you know Apple’s stock price. For example, if Apple trades at a 12.5 P/E ratio in October 2012 and the stock reports $44.00 in earnings per share on a trailing 12-month basis, then it necessarily follows that Apple trades at $550 a share. That is a mathematical fact.

More on the Limitations of Financial Analysts
While most analysts do spend a tremendous amount of time forecasting Apple’s earnings, you’ll notice that not a lot of analysts give a basis or a well reasoned argument for why they believe the stock will trade at the multiple they assume in their analysis. I find this to be rather shocking as getting Apple’s P/E ratio right is far more important than getting the earnings number right. A forecast that misses Apple’s fiscal year EPS by $1-$2 has far less of an impact than a forecast that under or over-estimating Apple’s P/E ratio by a factor of 1 or 2.

Here’s why. Suppose Analyst A holds a 1-year price target of $572 a share based on his forecast that Apple will trade at a 13 P/E ratio on $44.00 in earnings. The analyst believes that Apple will trade precisely at $572.00 the day after it reports its fiscal Q4 2012 earnings. Now suppose that Analyst A missed on his earnings expectations by $2.00 but got the trailing P/E ratio number right on the dot. If this were the case, the stock would trade at $546.00 a share or just $26.00 or 4.55% under his price target. That’s no big deal at all. He pretty much nailed it.

Now suppose Analyst B perfectly forecasts Apple’s EPS number of $42.00 a share but completely over-estimates what type of a P/E ratio Apple would trade at. For example, suppose instead of believing that Apple’s P/E ratio would contract, that he believed in the notion that Apple would see P/E expansion. Instead of forecasting a 13 P/E ratio, Analyst B believes that Apple will trade at a 15 P/E ratio and thus holds a price target of $630.00 a share. Notice that $42.00 x 15 = $630 while $44 x 13 = $572.00.

By over-estimating the P/E ratio by a factor of 2, Analyst B completely missed his price target. Even though Analyst A missed on earnings, he got the price-target almost exactly right. And that’s because he was able to understand what the market would be willing to give Apple in terms of a valuation in 2012.
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