Instead of further examining where Apple’s current (and future) products fit in on the “innovation scale,” in Part II I want to talk about Apple as an investment, and where its products fit in in terms of investment value.

Apple has been a fantastic investment over the past decade. In fact, since April 2003 when they launched the iTunes store (and iPod sales took off), a dollar invested in Apple would be worth over $40 today – an annualized return of almost 70%. That’s a return that would make most venture capitalists blush. Not bad for a company founded 27 years prior.

One more statistic: even if Apple stock had gone nowhere from its IPO in 1980 up to 2003, its annual return over the three decades since going public would be 13%, which still beats the S&P 500 by over 3%. In other words, almost all of Apple’s current value (~$230 billion) was created over the last seven years.

Where did that value come from? For the seven years ending 2009, sales grew from $5.7bb to $42.9bb. Over 70% of that growth came from new products: the iPod, the iPhone, media sales, and other related peripherals. On a net profit basis, even more than 70% of Apple’s growth came from new products (segment margins aren’t disclosed, but overall margins have hugely increased and most of that likely came from new products). Aside from the storied brand name, Apple is basically a startup that was funded with the cash and income from their struggling Macintosh business.

Apple and the Red Queen Run the Hedonic Treadmill

“…it takes all the running you can do, to keep in the same place.” – The Red Queen, Lewis Carroll’s “Through the Looking-Glass”

So, clearly, the law of large numbers comes into effect when looking at Apple’s future growth prospects. To double revenues, Apple would have to sell an extra $43 billion a year in products – that’s over 68 million iPhones or 32 million Macs every year.

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Insight: When looking at a company, what type of building is it?

Large companies (with competitive advantages) can be pyramids or skyscrapers. Both are large and have commanding presences. Both have high returns.

Pyramids are strong — you can’t knock them over. Skyscrapers are tall and strong, but they can be knocked over much easier. For a pyramid to be destroyed, it must start at the top, and slowly erode over time. After a while, only the foundation will be left. With a skyscraper, the foundation can be destroyed first, and the rest of the company will go with it.

Wal-Mart is a pyramid. Google is a skyscraper (for now — it seems that Larry & Sergey are in the process of building the foundation up). Berkshire Hathaway is a pyramid. Newspapers were pyramids — however, over the last two decades, they have been slowly chipped away starting from the top. Now, the foundation is about all that’s left.

Skyscrapers can be turned into pyramids over time.  But that requires great management and somewhat favorable circumstances. The time it took to build a company doesn’t necessarily tell you what type of building it is.

You can combine this analogy with Buffett’s moat analogy. Moats are barriers to entry — the wider the moat, the harder it is for competitors and disruptive technology to affect the company. But if the moat can be crossed, you’d much rather have a pyramid than a skyscraper.

Related:

The presentation above compliments my previous post on the systemic causes of the financial crisis. Some of the illustrations didn’t translate well on SlideShare, so to download the original in PDF format click here (6.4MB).

(The following is an excerpt from the most recent letter to the partners of Braewick Holdings LP. I’ll be posting a presentation that goes along with this commentary shortly.)

There have been many explanations thrown around of how we got ourselves into this mess. However, I have a slightly different take on what really caused the problem—and what hasn’t been fixed yet.

The public always enjoys finding someone to burn at the stake. Who is to blame for the current mess? Many culprits have been named: greedy executives, The Fed, short sellers, Democrats, Republicans, CDO’s, CDS’s, real estate speculators, and so on. However, the real issues are more systemic. Derivatives and bad mortgages may be where the problem started, but in and of themselves, did not cause this mess.

In my view, there were three problems that led to the collapse of financial markets: misaligned incentives, poor risk management, and needless complexity. All three problems are not specific to the current crisis, but are widespread and must be addressed to avoid future dilemmas.

If You Give A Mouse a Cookie…

He’s going to want some milk. And if you give a Wall Street executive a $30 million bonus, he’s going to want a bigger one (and he’ll use the same methods to get it—after all, it worked the first time, didn’t it?).

Misaligned incentives were pervasive. And because incentives drive behavior, things are eventually not going to turn out as desired.

This occurred on almost every level. Executives were being rewarded for taking risks with only short-term payoffs. Mortgage originators made money based on the volume of mortgages given, not on their quality. Rating agencies getting paid by the companies they have to subjectively rate (causing a huge conflict of interest). Home buyers were incentivized to buy a house they couldn’t afford with low down payments, teaser rates, no-documentation Adjustable Rate Mortgages, and 0% interest.

Many of the asset managers (including banks, hedge funds, and insurance companies) were given incentives to take huge risks with the firm’s capital only because they produced outsized short-term gains. They were given very large bonuses or a cut of the profits with no downside risk (other than a pink slip and severance payment). There was no link between immediate actions and their future consequences.

Business managers and decision makers need to constantly look at how their incentives are structured. People will naturally do things in their own self-interest, and managers need to react accordingly. Some incentives aren’t so obvious—giving a trader a cut of the profits may not sound bad at all. But even if it’s not their intent, people usually end up gaming the incentive in their favor. If traders aren’t punished for taking long-term risks in pursuit of profit, then guess what—that’s what they’ll do.

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Studying Students’ Reaction to Chance

An interesting article on a contest held at University of Virginia’s Darden School of Business. The contest split 269 students into two groups:

1. The first chooses one of two unmarked briefcases. One has a check for $18,750, and the other has nothing. Before opening the case, they are offered a chance to receive a fixed amount of cash in its place. It’s their choice.

2. The second group is given the cash upfront, and then offered the chance to buy one of the briefcases. For the student mentioned in the article, he was given $3,000. He could have walked away with the $3k, or bought the right to choose one of the cases.

The research showed that “buyers” (the second group) were more likely to keep the cash. Of course that isn’t rational, because the expected value of the case selection is $9,375 (a 50% chance of getting the $18,750 check).

The students admitted the decision is easier on paper, and more difficult when you have a handful of cash.

Overall, I’m glad Darden is doing research like this and teaching the students about decision making in the face of uncertainty. More schools should be doing the same.