As of the Jan. 10 close, shares of Apple (AAPL) were down roughly 33% from their October 2018 highs.
This is a painful development for one of the world’s best investors, Warren Buffett, who has seen nearly $20 billion dollars evaporate from his Apple position. (Buffett’s Berkshire Hathaway had 252 million AAPL shares, and possibly more, as of its last quarterly filing.)
If Buffett were a TradeStops user, our Stock State Indicator (SSI) would have told him to sell roughly 20% higher, when AAPL hit its red zone risk point almost two months ago (as you can see in the chart below).
But before we get into a discussion of why Apple’s best days may be over, it is important to focus on the real lesson here.
It’s hard to predict the future — and some would say impossible. But with the right approach to investing, you don’t have to. Instead you can focus your capital on the industries, sectors, and names where the trends and SSI status are positive, as Apple’s was for years.
Our studies of publicly available track records show that even the best investors in the world, in most cases, are better off approaching markets this way. So why not investors like you and me? The good news is that, even if Apple’s best days are behind it, there will be powerful trends in plenty of other stocks in the months and years ahead.
So, what happened to the mighty Apple?
On Aug. 2, 2018, Apple hit a milestone no company had ever reached. It exceeded a market cap of $1 trillion. This was a long way from 1997, when Apple was almost broke and the exiled founder Steve Jobs was called back in to save the company from oblivion.
Things looked so bad in the late 1990s, Dell Computer founder Michael Dell suggested Apple should voluntarily shut down and return the capital to shareholders. Twenty-one years later, Apple had proven itself the most valuable company in the world — and the first to be worth $1 trillion — as a result of the iPhone, the most beloved consumer product in the history of technology.
It is hard to overstate the sheer triumph of the iPhone. Not only was the iPhone the most successful consumer technology product the world had ever seen, its launch seeded the global smartphone market — the most lucrative software platform the world had ever seen.
The smartphone industry enabled social media, the “app economy,” the “gig economy,” an explosion of mapping and messaging applications, a relentless series of upgrade cycles in batteries, chips and components, and much more.
For Apple moving forward, this is part of the problem. The whole smartphone industry has matured, which means Apple’s once-in-history feat can never be repeated.
To understand why the iPhone was such a wildly profitable product, consider Apple’s ability to sell a mass market item, at a luxury goods price point, with a user replacement cycle of once every two years.
No other consumer product has ever matched this. Nobody sells at mass market volume with a luxury goods price (like selling a Honda but charging for a Mercedes). And nobody sells high-end technology with such rapid turnover. Only Apple pulled it off brilliantly.
The reason this was possible was the nature of the smartphone market. Under normal circumstances, a technology product that has to be replaced every two years would be considered low quality, or possibly even junk.
But Apple’s products were excellent quality from the start — and the two-year replacement rate came about because smartphone technology developed so quickly. Every 24 months, a new set of features or capabilities came out that were so compelling, consumers felt they had no choice but to upgrade.
That two-year replacement cycle made Apple into a profit juggernaut, with fat profit margins that refreshed themselves every 24 months.
But now Apple’s biggest competitor is Apple itself, because the replacement rate has slowed dramatically. Consumer research shows the iPhone replacement cycle was still at two years as recently as 2015. Since then, it has stretched out to three years, and could stretch out further still.
If iPhone users buy a new phone every three years instead of two, then all other things being equal, Apple loses 33% of its revenues. If the replacement cycle stretches out to four years, 50% of prior revenues are gone.
There are a billion-plus users who already have iPhones in 2019. Their habit of staying with their phones longer will be a huge challenge for Apple.
To be sure, there are other benefits to Apple’s installed base of iPhone users, which powers the Apple ecosystem. But the vast majority of revenue Apple makes is still tied to iPhone sales (about two-thirds). All its other lines of business are practically rounding errors in comparison.
We know how it looks when a global technology matures, because the personal computer business hit its high-water mark in 2011. We are all familiar with the lengthened “useful life” of PCs today. It’s no longer surprising to expect a laptop to function, without upgrades, for four or five years if not even longer. Smartphones are headed in the same direction.
At the same time, lower-cost competitors are catching up. Apple is only the No. 3 smartphone brand by volume, behind Samsung and Huawei. They and others are willing to accept much lower profit margins, and their feature sets are increasingly “good enough” and, in some areas, superior to Apple’s.
This came after the shares had already entered a downtrend, as indicated by our red zone SSI trigger back in November. Apple’s CEO, Tim Cook, blamed China’s economy and rising trade war tensions. As he said in his Jan. 2 letter to investors:
While we anticipated some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China. In fact, most of our revenue shortfall to our guidance, and over 100 percent of our year-over-year worldwide revenue decline, occurred in Greater China across iPhone, Mac and iPad.
China’s economy began to slow in the second half of 2018. The government-reported GDP growth during the September quarter was the second lowest in the last 25 years. We believe the economic environment in China has been further impacted by rising trade tensions with the United States.
It’s true that China’s economy is in trouble, and that multiple companies, not just Apple, have been negatively impacted. But that is only part of the trouble. The smartphone industry is slowing down globally, with declining sales in multiple countries.
At the same time, Apple has lost its competitive product edge in China. Huawei and Samsung have caught up in the features race, and newly cost-conscious consumers in China appreciate that rival phones from Huawei, Xiaomi, and others are often 50% cheaper than Apple’s. (A boycott of Apple products due to trade war fallout is also a factor).
In a mature smartphone market, everyone will have to accept lower profit margins, less ability to stand out, and less profit to go around as replacement cycles lengthen.
So, what can Apple do to reclaim its former glory? Almost nothing. This is less a criticism of Apple or its management than a recognition of Apple’s genius in riding the smartphone boom to unimaginably dominant heights.
For Apple to find another product as brilliant as the iPhone, in the hundreds-of-billions-of-dollars revenue scale to which it is now accustomed, it would have to tackle a market that is massive in size. There are only two big enough to fit the bill: Healthcare and electric cars.
But to dominate either of these would require bold and risky moves, and the kind of aggressive capital spending that would nauseate Warren Buffett. (Not to mention the global auto market is already hypercompetitive.)
We can’t help but look to the simple lessons here. Ever since Steve Jobs’ return, and Tim Cook retaking the reins as his successor, Apple has been an amazing investment. But great investments do not stay great permanently.
For example, General Electric (GE) was one of the most brilliant investments of the 1990s. You could have bought GE not much above $2 per share in 1990, purchasing large quantities as a conservative investment, and seen a more than fourteen-fold return over a decade, plus dividends. But then, in 2000, came the peak, and GE has been a painful roller coaster ever since.
With Apple, we can celebrate the achievements of one of the great entrepreneurs of all time (Steve Jobs), and one of the great investments of all time, yet recognize when it is time to move on.
Richard Smith, Ph.D.
CEO and Founder of TradeSmith