Riding the bouncing Apple

(Note, this article was originally written with Apple at $95. Within 24 hours it had dropped 5%)

After my cautions last week on Apple stock having a high price I sold some covered calls on my position. That caution seems well placed today. The company reported a blowout quarter but tempered expectations for the future and the stock fell.

During the final three months of 2006, Apple said it earned $1 billion, or $1.14 per share, compared to $565 million, or 65 cents a share, in the year-ago period.

Revenue for the quarter hit a record, reaching $7.1 billion, up 24 percent from $5.7 billion the previous year.

Analysts, on average, were expecting earnings of 78 cents per share on sales of $6.42 billion, according to a Thomson Financial survey. That means Apple beat earnings targets by 46%. Much more importantly they reported profit margins of 14% versus 10.6% predicted (why, oh why doesn’t the financial press report these numbers).

The reasons for all those earnings were roughly in line with what was predicted here during initial stock coverage. In particular this was part of the original analysis: “Because Macs are still only 3% of the computer market, so if they grow to just 4% of the market it means growing 45% of Apple’s sales by 30% -- or an overall 13.5% sales growth right there.” Guess what? The IDC market research firm reported Wednesday that Apple's share of the PC market in the U.S. had grown to 4.7 percent in the quarter, up from 3.6 percent a year ago.

Despite all this I am calling the next six months for apple as “choppy and bouncy.”

Why? Well, for starters Apple forecast fiscal second-quarter revenue of $4.8 billion to $4.9 billion and earnings per share of 54 cents to 56 cents. Analysts had projected revenues of $5.22 billion and earnings per share of 60 cents, according to Thomson Financial. Lowered earnings will damp the stock upside in the immediate future.

In the intermediate term I think Apple TV has great promise and the iPhone could be the next iPod, but both are farther from profits than the market is pricing in right now (see here for a primer on net present value). The iPhone won’t even launch for 6 months and there are a number of issues that may prompt many people to wait until the second version comes out (example: many road warriors want a cell phone that accepts a spare battery).

All the good news is priced in. Potential bad news could come from the iPhone rollout (delays?) or the SEC investigation into Steve Jobs’ role in stock backdating, for example. Apple is one of the most volatile stocks around, so expect an appropriate ride.

That’s why I think Apple stock will be a rollercoaster for a while. If you bought when I called it near $50 you can sell and watch or ride the coaster, or try to make some money selling covered calls like I am. I’m not too worried about having the stock called away because I believe there will be buying opportunities as we move forward.

Invest Well,

FW

The Finance Wonk Reading List

This is a list of some financial books I've benefited from and think are worth reading. I will try to give a useful description of what makes each one useful and how it reads. I've put in links to buy the books and yes, full disclosure, I do get a credit from Amazon if you purchase through the links. If you aren't comfortable with that go ahead and search the book yourself from the Amazon home page. Please send me feedback, comments, and other book ideas - email link.

A Random Walk Down Wall Street:

The investing classic for people who treasure an ability to see clearly. Burton Malkiel did an amazing job years ago of putting together a firmly argued criticism of conventional thinking and the mutual fund industry and uses a wide variety of well documented sources to demonstrate the usefulness of index funds. He teaches the reader about the impact of randomness on the market and some of the studies that have established certain elements of the "conventional wisdom" to be wrong. This book is clearly and enjoyably written and highly educational. It has been updated over the years and if you haven't read it in a decade or so (as I hadn't recently) it's worth reviewing one of the newer editions. If you think this is an effusive review you're right. I am generally pretty harsh on investing books but if you're only going to read one book on investing this should be that book.

One Up on Wall Street:

This is a book by Peter Lynch, the legendary manager of the Fidelity Magellan fund, the best performing mutual fund from 1977 to 1990. If you read "A Random Walk Down Wall Street" (above) it will occur to you that someone has to have the best performing mutual fund, so this doesn't necessarily prove anything about his prowess (although I'm not saying he isn't good). One thing that is sure is that Peter Lynch used his star investor status to write a lot of books. All of them are squarely aimed at the do-it-yourself investor and are written in an easy to read flowing style that will help anyone finish the book. This is one of the core books and if you read this one you've pretty much read them all. This book does contain a number of useful educational sections although it is very general in nature. A good book for light reading and a good starter book if you aren't sure about investing for yourself yet. Give this book as a gift to that aunt who wants to start taking care of her own money and you can't go wrong. If she likes it and asks smart questions, go with "Random Walk" above and bring her here to join the discussions!

Valuation:

An excellent guidebook on ways of arriving at a valuation for a company. This book is a much easier read than some financial books but still has some good math. It makes ample use of big block diagrams and simple cartoons to explain concepts. Addresses the point of view of the investor and the point of view of a corporate acquirer. I actually laughed at the section on how companies value other companies for mergers and acquisitions: they have a spiral showing the process that frequently leads to mergers that reduce value, this graphic should be posted in every boardroom in America!

The Conservative Investor's Guide to Trading Options:

I bet many people think that title is an oxymoron. While options can be used in risky ways (and are primarily known for that) there are actually a number of strategies where the downside is fixed and knowable. I regularly engage in many of these practices myself and can attest to their effectiveness. It's fun (at least for those with the financial wonkyness gene) to locate a place in the market where people are being silly and make a few grand with a safe option strategy. This book is very nice because it doesn't just have theory but also gets into considerations of trading commissions and the specifics of how to place your orders such that you don't get stuck with half a position, your online broker will know what a "net purchase" is, even if it isn't an option on the web page.

Principles of Financial Engineering:
This is a rather dense and mathematical book, probably more of a reference book than a page-turner. Working through the first chapter (which doesn't have much math) with a pencil and some scratch paper is a very useful experience. Most home readers will not have much use for the sections on forward contracts and swap engineering or the repo market, but the chapters on options and engineering positions with options are very useful to even the most experienced option trader. If you're going to trade options in any sort of rigorous way you should have this book on hand. If you want to learn about the delta hedging I've mentioned before, this is the book.

When Genius Failed:

Not exactly an investing book, this nonfiction dramatic retelling is an inside look at one of the first "star" hedge funds and how it imploded. It's the story of Long Term Capital Management, which was founded in 1993 with a legendary bond trader and two Nobel Prize winners as core partners. It's a story of how over-reliance on a mathematical model led to spectacular returns and then an implosion so big the US Treasury got involved due to concerns the hedge fund would melt down the world markets. The author gets extra marks from me for digging into a description of what the trading strategy was and including several full page data plots. Fun reading for an airplane, no scratch paper needed.

Against the Gods:

The rather odd title on this book is a reference to the belief in ancient times that trying to control ones fate was an act "against the gods". This book is similar in philosophy to the top book here "A Random Walk Down Wall Street" but this book starts with a broad historical review of the way that people once believed that fickle gods ruled success in every endeavor and from there builds through the history of statistics and the birth of the idea of risk management. By the midpoint of the book the discussion is focused on University Economists and the birth of the portfolio management concept. By the end of the book the discussion has reached the cutting edge of non-rational behavioral theory and various advanced approaches to market analysis. This book is not for everyone and doesn't quite live up to its audacious title, but it is certainly interesting and will be valued by those who don't mind a dense read. I disagree with some of the finer points the book mentions, but most of them seem to be minor points the author isn't delving into very deeply anyway.