Carl Icahn Thinks Apple Should Buy Some Stock
Here is Carl Icahn's very interesting letter to Apple! It is very interesting! No, come on, it's silly. Carl Icahn has long had an idea for Apple. The idea is that Apple should buy back a ton of stock. This idea is not original to him. Lots of people have thought this. Most of them are Apple shareholders. The idea is, if you own some stuff, and someone else buys a lot of that stuff, then the price of that stuff goes up, and you are now richer. 1 Apple shareholders, like most people, want to be richer. There's nothing wrong with that. In fact, Apple agrees, and is buying back a ton of stock. Icahn just wants it to buy more, quicker.
But here is the structure of Icahn's argument:
- Apple is doing great stuff and making lots of money.
- That means its stock price should go up.
- No one has noticed this but me.
- Now I'm telling you.
- So you can buy the stock before everyone notices and it goes up.
This argument is in some strict sense self-defeating. If Apple is undervalued because no one has noticed how good it is, and Icahn points out how good it is in a public letter, then people will know how good it is, and they will buy up Apple stock until it is appropriately valued. Certainly the market will move faster than Apple will; the market doesn't have to hold board meetings and consult its lawyers. So by the time Apple acts on this anomaly, it will have disappeared. 2
But of course it's not an anomaly. It's just a disagreement over valuation. Some people in the market ascribe less value to some of Apple's business than Icahn does, based on the same public information. To the extent the market reads his letter, is persuaded and bids up the stock, then Apple's opportunity will disappear by lunchtime today. To the extent that the market reads his letter, is unpersuaded and doesn't bid up the stock -- and it was up less than 1 percent as of 10 a.m. -- Apple will have to ask itself: Do we agree with Icahn or the market?
The answer could be Icahn, based on his deep research and insight into Apple's business. Why not? But of course it is not obvious that Icahn has any better information than the market. I mean, this is something that Icahn is telling Apple about Apple:
While Apple has not announced plans for a TV set and may never do so, we believe we have good enough reason to expect the introduction of an UltraHD TV set in FY 2016.
Icahn is not even telling Apple to introduce a TV set here! He doesn't care if they introduce a TV set. 3 He's saying that Apple's stock is undervalued because the market underestimates the chances that Apple will announce plans for a TV set, build one and then sell 37 million sets by the end of 2017. Perhaps he's right. You know who would know? Apple. You or I might buy Apple stock because Carl Icahn thinks it will introduce a TV set, but it would be a lunatic move for Apple to do that. Apple has better information on this point.
The letter describes Apple's business and competitive environment in strange detail, and then concludes with this beautiful mad passage:
Our valuation analysis tells us that Apple should trade at $203 per share today, and we believe the disconnect between that price and today’s price reflects an undervaluation anomaly that will soon disappear. Mutual funds today face fierce competition with index funds that simply match the S&P500 index (in which Apple has a weight of 3.4%). Surprisingly, many mutual funds are underweight Apple, meaning that Apple represents less than 3.4% of their overall portfolio. This also means they are more likely to underperform the index if Apple outperforms, which is obviously an eventuality that should concern them. With more and more funds flowing from mutual funds to index funds (because mutual funds have consistently failed to outperform) the last thing they will want to see is their underperformance exacerbated by remaining underweight Apple as it continues to outperform. As the strength of the earnings growth we forecast materializes, and these funds scramble to correct this mistake, only to find themselves competing in the market to do so, a de facto short squeeze may occur, and we can only hope that the company has repurchased all the shares it can before that happens.
I think this means:
- Some people don't own Apple stock.
- If Apple stock goes up, they will be sad, because they'll wish they'd owned a stock that went up.
- Then they will buy Apple stock, and it will go up.
This is a "de facto short squeeze," which is a lovely phrase that appears to mean "stock goes up because people want to buy it." But, look, yes, if you are underweight a stock that outperforms, you will underperform; if you are overweight a stock that outperforms, you will outperform; if you are underweight a stock that underperforms, you will outperform; and if you are overweight a stock that underperforms, you will underperform; I think those are all the permutations. 4 Mutual funds are not unaware of this. But Icahn's delightful model is that they will be driven to buy the stock after it goes up, because they will regret having missed out on its rise. That theory is silly -- the right time to buy a stock is before it goes up, not after 5 -- but also probably true. Capitalism is great.
Of course Icahn is kidding. He doesn't really think that there's an anomaly that's about to disappear, or that Apple needs to act fast to take advantage of its benighted shareholders. He thinks the following three things:
- It would be nice if Apple bought more stock, and public letters about undervaluation are a time-honored way to put pressure on companies to buy more stock.
- It would be nice if Apple's stock price went up, with or without a buyback, and a public letter describing undervaluation and urging buybacks is a good way to talk his book to the rest of the market.
- Mucking around with Apple in public is lots of fun.
Don't underestimate the last one! My assumption is always that Icahn's activism is driven more by sheer joy than by financial analysis. To be fair, there's plenty of financial analysis in this letter. (There's a whole spreadsheet at the back!) But the motivation of this letter is not the financial analysis, it's the joy.
Which of course makes it a joy to read. But there are some downsides to this approach. In particular, the reputation of hedge-fund activists as short-term-oriented financial engineers with no interest in or understanding of companies' businesses is not exactly improved by long meandering letters that lead to the inevitable conclusion of "buy back more stock!" Icahn is surely right that Apple's board and management agree that the stock is undervalued. All boards and managements always think that. But whereas Apple's board and management has many angles to attack that problem -- building new products, improving its business, improving its communication with the market or, sure, buybacks -- Icahn leans heavily on the one. A company whose only response to undervaluation was always stock buybacks would probably not deserve much of a valuation.
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There is a secondary and more interesting idea, too, which is that corporate managers tend toward empire-building and misallocation of capital, and that their best use of excess cash is often to return it to shareholders, certainly more often than the managers think it is. I generally think this is correct! I mostly like buybacks, and as a casual observer I am inclined to think that Apple has more cash than it needs and can afford to give lots of money back to its shareholders for them to allocate to other, riskier, higher-growth ventures. But all of this seems strictly unnecessary to Icahn's argument; just "someone buying stuff I have makes the price of that stuff go up" is entirely sufficient.
To put it another way: If Icahn actually believed his letter, he would send it to Apple privately. The fact that he's releasing it publicly means he doesn't.
"While we think adding a TV set to the Apple ecosystem would be meaningful from a financial perspective, we understand that you may choose not to do so, as you have wisely stated that 'the toughest choices for Apple are what not to work on.'"
I mean, there are nine, if you include market weight and market perform, but you don't want to read that list and I don't want to write it.
As Icahn is arguing to Apple. Actually I may be misreading this passage about the mutual funds. I don't really know what it means. Probably nothing? Just, like, an opportunity to mention index funds?
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