Ever since legendary business magnate Carl Icahn sold his Apple shares earlier this year, many investors lost faith in the company’s future and withheld from taking a position in the tech giant. But history shows that following the herd mentality, even if propagated by someone as prophetic as Icahn, isn’t always the best idea.
Michael Lee of Hypotenuse Capital Management exemplifies this way of thinking. Lee recently took a long position in Apple despite the negative attitudes toward the company’s stock, arguing that Apple’s unparalleled management and product quality are being ignored by the market.
SumZero: What about Apple initially caught your eye as a value investor?
Michael Lee, Hypotenuse Capital Management, LLC: Buying stocks just because they are statistically cheap is superficial and what really got me to commit capital was the quality of Apple’s business and executive leadership. We’re all familiar with Warren Buffet’s quote: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” I believe Apple investors are getting the opportunity to buy a wonderful business at a wonderful price.
SumZero: What is the market missing?
Michael Lee, Hypotenuse Capital Management, LLC: I think that investors occasionally lose sight of how good some businesses are, and consequently sell them off to irrationally high cash flow yields. There have been a number of high-quality large-cap technology businesses that have traded to low multiples of free cash flow over the past ten years or so. Each of those occasions proved to be great buying opportunities - Microsoft, EBay, Intel, Cisco, EMC and Oracle are just a few examples that come to mind. The key is to figure out whether or not the business model is enduring and sustainable over a long horizon.
Imagine a fictional company that has developed several revolutionary products that transformed the way people live. Customers line up around the block to buy these products and some people, in a few extreme cases, will sell a kidney to get one. These customers use the products for hours and hours every single day. The company is run by one of the most ethical and inspiring CEOs in the world who leads some of the most brilliant, hard-working, and motivated employees on the planet. Obviously, the company I am describing is Apple and yet the stock and options are priced in such a way that the market is basically telling us that it thinks Apple will be out of business in six or seven years. This seems excessively pessimistic.
SumZero: What key metrics should investors be paying attention to as your thesis matures? Which metrics (e.g. MacBook sales growth), if any, are inaccurate or insignificant indicators of Apple’s future health?
Michael Lee, Hypotenuse Capital Management, LLC: I am certain that iPhone unit sales will fluctuate wildly over the quarters and years to come, but all I really care about is whether or not existing Apple customers are switching to Android or some other alternative in significant numbers. As long as users and developers are delighted with the product, the rest of the numbers will take care of themselves. This is one of the reasons I admire Tim Cook: he focuses the company on putting out great products that its customers will love and consistently states his willingness to ignore stats like market share.
SumZero: What are the biggest risks associated with the trade in your view?
Michael Lee, Hypotenuse Capital Management, LLC: I think what everyone fears with a handset company is that someone or thing will completely alter the paradigm in such a way that the iPhone goes the way of Palm, Nokia, Motorola and Blackberry, i.e., into extinction. The iPhone will be ten years old next June. As the platform ages, there continues to be a delicate balance between offering innovative and useful features without making the products overly complex or cumbersome. If employees lose their motivation and/or focus and the iOS ecosystem devolves into a hopelessly buggy experience that turns off users, then it will be time to worry about the future of Apple.
SumZero: Part of the long thesis is in Apple’s impressive balance sheet. Does Apple manage its immense cash pile intelligently?
Michael Lee, Hypotenuse Capital Management, LLC: I would say they manage it sensibly but not optimally. The best possible scenario for investors is to have a management team that knows how to redeploy its capital and earn exceptional rates of return, either through building businesses organically or investing externally like Buffett has done with Berkshire Hathaway. Clearly Apple hasn’t found enough good ways to invest all the capital internally or you wouldn't even ask this question. It is theoretically possible that Tim Cook and the board could hire someone like Ted Weschler or Todd Combs to allocate capital externally on the company’s behalf, but I suspect that most of Apple’s shareholders wouldn’t be so happy about such a move. Hence, I think the fact that Apple has returned so much cash to shareholders through dividends and buybacks is a perfectly sensible next best strategy even though it is not the optimal one.
SumZero: Apple investors have done incredibly well over the past decades due to the company’s explosive innovation and growth. Can a company of Apple’s size continue to grow and innovate?
Michael Lee, Hypotenuse Capital Management, LLC: The global annual smartphone market is about 1.4 billion devices and Apple has less than 20% share of the market. Given that the world population is about 7 billion, there are plenty of reasons to believe that Apple can continue to grow organically in the handset market alone. Getting into a discussion on future innovation is inherently speculative so my instinct is to be very cautious with my comments here. With this said, we are still in the early innings of seeing what can be done with “wearables” like Apple Watch, products for the home like Apple TV, and other potential “Internet of Things” products. The automobile market is clearly something that will get a lot of attention in the coming decade. There are plenty of big visible opportunity sets out there for Apple to pursue; to think that Apple would miss out on any or all of them entirely seems unlikely.
SumZero: Members of the tech community claim that with ever-increasing competition, smartphones are headed towards commoditization and will eventually see a significant decline in profitability. Do you agree with this? If so, what does this mean for Apple’s business model?
Michael Lee, Hypotenuse Capital Management, LLC: I think this is probably the number one reason why most investors pass on Apple. While this hypothesis is certainly rational, I think the analysis falls a bit short. People tend to believe that Apple competes in the same market as all of the Android manufacturers, as if all the participants in the market are playing on the same terms. Actually, they don’t play on the same terms at all. Most of the Android ecosystem only designs the hardware, while they are reliant on Google to provide the actual operating system software and carriers for distribution and customer service. In contrast, Apple provides almost the entire end-to-end experience from hardware, software, services, retailing, and support.
On the front end, having hardware and software design integrated under one roof is a big advantage to Apple in terms of providing a superior user experience. This is not to say that Samsung and Google aren’t capable of collaborating to put out a great product. They can, but it is a much more cumbersome and complex inter-company process than what Apple faces internally. When Google puts out an update for Android, the software has to go through a second round of qualification and customization for each manufacturer and model. It isn’t uncommon for there to be a delay of three to six months until it is actually available for any given customer’s handset.
From an independent developer's perspective, the Android ecosystem is just a mess - there is a massive problem of having to optimize for dozens if not hundreds of different handset models and many versions of the operating system. This lack of uniformity, in addition to the fact that iPhone users tend to be more affluent and spend more money on apps and in-app purchases means that developers always develop the best apps for iOS first. It will take a pretty radical change in the handset marketplace for this dynamic to shift drastically.
SumZero: So what about the back end?
Michael Lee, Hypotenuse Capital Management, LLC: On the back end, having a retail distribution presence is also a big plus for Apple. In addition to having the ability to control sales and marketing to the consumer through the retail experience, Apple also has the ability to provide better customer service through its network of Genius Bars. When your Samsung Galaxy breaks down, it’s not obvious where you should take it, but if your iPhone breaks down, you can get it replaced the same day by an Apple employee at your local Genius Bar. This infrastructure sets Apple apart from the rest of the field.
The handset industry is actually made up of two almost completely different markets: Apple operates in its own orbit and has a near-monopoly on the high-end of the handset market while everyone else has to struggle tooth and nail for whatever market share they can scrounge up in the Android universe. To think that Apple will simply get cut down to a hardware manufacturer’s operating margins is a stretch because Apple isn’t just a hardware company.
For this reason, in comparing Apple’s margins against a manufacturer like HTC or Samsung, Apple’s profitability will always look absurd. But if you benchmark Apple’s margins against Microsoft or Google, they don’t look nearly as crazy. The hardware components may commoditize, but the end-to-end experience has not - and may never.
SumZero: Apple’s relationship with China has been strained recently, especially since Beijing maintains a hostile attitude towards phones that protect user privacy. Do you think that Apple’s use of its encryption code as a selling point will harm sales in its second-biggest market? How will this affect your position?
Michael Lee, Hypotenuse Capital Management, LLC: If the Chinese government intervened significantly against Apple it would be a huge negative for earnings and terrible for shareholders. It would also be terrible for tens of millions of Apple customers, hundreds of thousands if not millions of Foxconn and other supply chain employees in China, not to mention China’s trade relations with the rest of the world. For the time being I expect Apple and China to continue to live with one another.
SumZero: What are Apple’s biggest problems right now?
Michael Lee, Hypotenuse Capital Management, LLC: My greatest fear is that management and employees will eventually become complacent and lose their focus on developing the exceptional products that their users love. If Apple keeps designing and building exceptional, useful, and convenient products for their customers, the company will be immensely successful. Management needs to continue to keep all of its constituents motivated, happy, and invested to get there. This includes customers, suppliers, developers, governments, and employees. If they succeed at this I am quite certain the shareholders will be happy too.
SumZero: Other than the iPhone, which of Apple’s products or services, if any, will play a key role in the company’s performance these next few years?
Michael Lee, Hypotenuse Capital Management, LLC: Services revenue from iTunes, App Store, AppleCare, iCloud, etc. now represent about $24 billion in run-rate annual revenue, growing at about a 20% annual rate. To put that in perspective, Microsoft and Google have total revenue of $87 billion and $78 billion, respectively. Apple has built a large-scale, high margin recurring revenue business that I think investors will learn to appreciate more as that earnings stream continues to grow. In addition, the implication of the growth of the services is that consumers have been spending more and more money on their app, music, and video collections. As this sizable investment from consumers grows, I would argue that the cost of switching away for Apple customers becomes more and more difficult to fathom.
Beyond services, it will be fascinating to see where the company can take Apple Watch, Apple TV and whatever is in the works for the automobile market in the years to come.
SumZero: Apple’s major tech rivals (Google, Amazon, Microsoft) have been developing their own AI systems. How critical is Siri’s ability to compete with rival A.I. (e.g. Amazon’s Echo) to the company’s long-term success?
Michael Lee, Hypotenuse Capital Management, LLC: One of the reasons why Apple has always been so successful in its endeavors is that it has always been about making its customers’ lives more convenient and meaningful. Siri has been a wonderful development that has made interacting with Apple devices easier and faster. Opening up Siri to the developer community so it can be integrated with third party applications will make Apple devices even more convenient and useful. In the long run, if you believe that automated products like self-driving cars are really the future for our society, then whoever does machine learning best will likely be a very big winner - not just in handsets, but in large swaths of the GDP for decades to come.
SumZero: Can Apple become the first trillion-dollar company?
Michael Lee, Hypotenuse Capital Management, LLC: Tim Cook would tell you that this is an arbitrary outcome that is not particularly significant to the company. I don’t believe there are any insurmountable barriers to Apple achieving such a milestone.
SumZero: Where else do you see value in the market today?
Michael Lee, Hypotenuse Capital Management, LLC: With the market indices trading near record levels it has been difficult to find high conviction ideas but we have found a few places to commit capital.
The energy sector has obviously gotten a lot of attention over the last 18 months. Total Energy Services (TOT:CN) is a Canadian firm that I have written up previously on SumZero. Over the last two decades it has been a tremendously successful oilfield services company led by an exceptionally hard-working and effective capital allocator, Dan Halyk. It is our largest position and I am excited to see where Halyk will deploy capital in the quarters to come. If I could clone Halyk five or six times I’d divide up our capital equally between all of them and park it with them for the next thirty years.
There are some compelling opportunities to invest higher up in the capital structure in the publicly traded bond and preferred equity markets where restructurings and other catalysts should set the stage for outsized returns. We have sizeable positions in mining, industrials, and real estate related issuers.
Currently I am spending most of my time digging into small cap companies that have recently undergone governance or management changes. Due to their smaller size and new leadership, I believe there are some unique opportunities to capitalize on situations that many others will likely overlook.
SumZero: How has your approach evolved over the years?
Michael Lee, Hypotenuse Capital Management, LLC: Earlier in my career I focused more on the quantitative aspects of investing. I’ve always been pretty strong at math so it was easy for me to jump to the conclusion that I just had to find companies trading at low multiples or build a fancy excel model to be a good investor. On top of that, I was also pretty arrogant, and such hubris can lead to big mistakes. As the years have passed, I’ve tried to a) approach my analyses with more humility and b) look beyond the numbers and understand the qualitative aspects of what makes companies successful. These days I spend much more time trying to understand the biography, motivations, and moral character of a company’s leadership team than I do trying to model out future cash flows.
SumZero: Tell me about your investing background and investing mentors and heroes.
Michael Lee, Hypotenuse Capital Management, LLC: I was very lucky to spend a summer traveling in China with Patrick Byrne (chairman of overstock.com) when I was a first-year student in college. He bought me a copy of Roger Lowenstein’s biography on Warren Buffett. This was a life-changing moment for me and ultimately led me to pursue a career in investing. Beyond the numbers and statistics, I am absolutely amazed by the qualitative aspects of how Warren and Charlie conducted business over the past fifty years. Consider that Warren only takes a hundred thousand dollar salary and no bonus and place that in context with the fortunes he has helped build for his shareholders and employees over the decades. I believe this says something about Buffett’s character that is almost more remarkable than the IRR he has achieved.
There is a long list of finance and investing authors whose books and writings have been incredibly influential in my evolution. Highlights from this list are Guy Spier, Seth Klarman, Lawrence A. Cunningham, Torkell Eide, Patrick Hargreaves, Will Thorndike, Monish Pabrai, Ben Graham, Joel Greenblatt, Howard Marks, Roger Lowenstein and Michael Lewis. There have been a number of fellow managers who have challenged me to learn and grow in remarkable ways, including: Fang Li at Baleen Capital, David Li at Lizard Investors, Matthew Peterson of Peterson Capital, Alex Rubalcava of Stage Venture Partners, Scott Krisiloff & Jeremy Saltzberg at Avondale Asset Management, David Bryce at Pecan Street Capital, and Rob Longnecker at Jovetree Capital. Ben Claremon at Cove Street Capital requires special mention for regularly bringing many of these individuals on this list together at his outstanding 10-K club meetings in L.A.
Finally, I would be nowhere in this world but for my amazing wife, family, partners, and friends who make everything I do possible.
SumZero: What advice would you give to someone interested in pursuing investing?
Michael Lee, Hypotenuse Capital Management, LLC: First, as with learning any skill in life, it all starts with taking a detailed inventory of a) what you think you already know, b) what you want to know, and c) what it will take to figure out what you want to know. It is important to be humble in this process and be aware of the frontiers of your knowledge. From there nearly anything is possible if you are willing to invest the time and energy required to execute all the actions on list c). We live in an amazing era where anyone with a smartphone basically holds the entirety of the human race’s collective knowledge and experience in the palm of their hand. The only thing that really sets any given individual apart is their desire and willingness to sift through and put it all towards good use. Read. Don't give up; the most successful individuals I know are the ones who have learned to find opportunity in their failures. Take some time to think about what your purpose in life is; the wealthiest people I know are those who found a calling that was about more than just making money. Nurture relationships; seek out exceptional people whom you trust, love and admire and make the effort to connect regularly with them. Learn how to connect well with people. Show appreciation; a little bit of gratitude goes a long way. Lastly, nothing good has ever come of hubris.
Thank you for giving me the opportunity to speak with you!