How to Buy an Individual Stock (If You Must)

Good fortune has struck the Accountant household again. Cash has piled up while the retirement accounts are maxed out. Significant funds were added to the non-qualified index funds and there is still cash waiting for investment.

I’m generally uncomfortable with too much uninvested cash. Never one to time the market (not that I haven’t tried, but my results were as expected) I like to get my army, called capital, into battle as quickly as possible.

In the last few weeks I added selectively to my portfolio, even adding a new name to the mix. Since I preach index fund investing so heavily it requires some explaining why I did what I did.

First let me introduce you to my new soldiers. I added to the ranks of Altria (MO) and Philip Morris International (PM). The name of the new platoon — wait for it — is Apple. Yeah, I know. Back in September I warned of the risks of owning index funds and individual stocks. My argument was simple. Buying certain big name stocks (companies actually; remember you are buying a fractional share of ownership in an ongoing enterprise) can overweight your portfolio. Since Apple comprises a whopping 3%+ of the S&P 500 weighting, buying more Apple stock on the side starts to make the ship feel a bit top-heavy.

Sometimes it’s best if you do as I say and not as I do. I have the luxury of a larger net worth so I can have a larger mad money account to play with. The only thing is these new purchases are in what I call a serious money account. The purchases are planned as very long-term holdings.

I have some explaining to do, kind readers. I’ll outline why I like Apple enough to buy even after a massive run-up this year and a market looking frothy. My reasoning for adding to my large amount of MO and PM follows the Apple discussion with my thoughts on two stocks I own but have concerns with: Netflix and Tesla.

The Case for Apple

Some people recommend diversification as a way to mitigate risk. I recommend diversification (index funds) because most people don’t know how to value a potential investment or don’t have time to do the evaluation.

My investing history has included a small number of companies with most of my money in mutual funds (index funds the last decade or so). Instead of diversifying to mitigate risk I research to mitigate risk. As long as I’m going to research I may as well do an in-depth analysis. If I do a good job and the investment is solid with an adequate margin of safety it makes sense to buy a lot of that investment.

Apple is a company I’ve watched for a long time. I made excuses as to why I shouldn’t buy it, but the story is too compelling to pass anymore.

Apple is a massive company. Normally companies so dominant tend to stagnate as competitors eventually pass them buy. The biggest market capitalization stock changes each decade. Today’s big names eventually wither and die. Anyone remember Eastman Kodak or Xerox? They’re both still around and publically traded. They were also darlings of another age. In 1973-4 they were part of the Nifty Fifty. Time has not been kind.

So why Apple? It’s a huge company; the biggest on the planet by many measures.  Only a few enterprises have ever been bigger when adjusting for inflation. The Dutch East India Company was worth north of $7 trillion in today’s dollars so Apple has a ways to go to reach the milestone. The real reasons to consider Apple are margin of safety (they have a lot of cash), growing profits and a cult-like following.

A cult following is not a reason to own a company, but if the fundamentals are there with an adequate margin of safety a cult following becomes icing on the cake. As long as the veneer shines you can enjoy profits.

The main reason I bough Apple is the margin of safety. Take a glance at the chart of Apple’s cash position. The cash position is over $250 billion. After total debt is subtracted you still have over $150 billion as of September 30, 2017. This, by the way is the wrong way to look at Apple’s cash situation. When other liquid and short-term assets are included, Apple could retire 100% of its debt.

Therefore, a better way to view Apple’s cash position is to subtract the short-term investments to cover long-term debt and other liabilities. Inventory and receivables are enough to retire all liabilities, including long-term debt.

This leaves us with long-term investments and cash in the checkbook, revealing the true cash holdings of Apple: $201.3 billion. That is a massive pile of money!

The next step in valuing Apple is to check the price of the stock (what I can buy it for) against reported earnings per share of $9.21, the so-called P/E ratio. Apple’s P/E ratio as I write is 18.58. This means if earnings remained unchanged it would take a bit longer than 18 ½ years for Apple to earn enough profit to buy 100% of its outstanding stock as long as the stock price didn’t change.

An 18 P/E ratio for such a dominant and growing company is rather reasonable. Apple spends a pile of money buying back its own stock and in dividends to shareholders. But the pile keeps growing. These are good times in the world of Apple.

The dividend yield is 1.47%. This is slightly lower than the S&P 500 as a whole where the dividend yield is currently 1.86%. The earnings yield is 5.4% as I write. This means if Apple distributed all its profits as a dividend the yield to shareholders at the current stock price would be 5.4%. Also a good indicator.

So far we have an interesting scenario, but not enough to buy the stock! Before I open my checkbook I want a margin of safety. And that is where the cash hoard comes in.

The market cap of Apple is $878.5 billion with 5.1 billion outstanding shares.

The $201.3 billion in cash represents $39.47 of cash per share! At today’s closing price on November 16, 2017 of $171.10, cash represents 23% of the stock price!

Look at it another way. Suppose you buy a wallet or purse for $171.10 and when you get home you find $39.47 tucked inside the wallet. If the original price was good, it just got better!

Two hundred billion is a lot of safety margin and makes an Apple investment worth considering. However, I’m digging deeper. If 23% of the stock price represents cash in the bank, then the P/E ratio is less than indicated. If the cash portion of the stock price is removed from the listed price (remember you buy the stock and find a bonus $39.47 per share in cash) the stock price is really $39.47 lower. (If you think Apple is worth $171.10 per share as an ongoing enterprise and get $39.47 in cash along with the stock purchase, you really only paid $131.63 per share for Apple the company.)

This drives the P/E ratio lower by 23% to 14.29. Now the P/E is below the market average for a company with tremendous market power, growing earnings, a dominant market position and a cult following. With the safety of margin firmly in place I am ready to buy. So I did.

Of course my valuation research went much deeper than what I outlined here. To keep this post sane I abridged the content.

The Case for Altria and Philip Morris International

Tobacco seems a bad investment idea as more people quit smoking each year. However, investors forget the real fact the percentage of people who smoke is declining, but the increasing population keeps sales declines more muted.

MO and PM are dominant in their markets. PM was spun off from MO many years ago. MO has the U.S cigarette market and PM has the non U.S. markets.

I will skip the heavy analysis of these two companies. It takes a lot to get me to buy a new investment, but I’ll add to existing stock holdings when opportunity is ripe and as long as the story still resonates.

The margin of safety is smaller for MO and PM than Apple. However, virtually every company has a smaller margin of safety compared to Apple!

Let me sum up my reasoning for owning these two companies in the words of Warren Buffett. Buffett once said about MO, the product costs a penny to make and is addicting, what’s not to like? I think the reason Buffett doesn’t own MO is because he wants to protect his reputation. Your favorite accountant has no reputation to protect so I loaded the boat with MO and later PM.

Tobacco use as a percentage of the population has been declining since around 1964! MO and PM know how to navigate in this environment and have done so successfully for 50 years. Profits keep growing and the board of directors keeps paying out the majority of profits in dividends. Life is good for the owners of these two companies; not so much for the users of their products.

My buying trigger for adding to my large pile of MO and PM is the dividend yield on periodic market scares about the world ending for tobacco companies. When the dividend yield is over 4% I review the company prospects. If nothing has changes I add more shares. (In reality all I’m doing is reinvesting a portion of the accumulated dividends.)

There is also another interesting development at MO and PM. PM developed a smokeless tobacco product called iQOS. PM developed the product and recently licensed it to MO for sale in the U.S. Demand has been so high there are shortages of the product. And the profits are a lot higher than traditional cigarettes!

Revenues and profits look ready to accelerate over the next years and decade. Decades of stock accumulation in these two companies has been good for my wealth. And when their stocks go on sale I have a tendency to buy more.

The Problems with Netflix

As a disclaimer, I own Netflix and have made a lot of money on the stock. However, I am uncomfortable with my position.

I love the company and their product. Who doesn’t like commercial-free programming?

Netflix has a leadership position in their space, but lacks a margin of safety. When I bought Netflix years ago it was under the assumption they would turn a profit on their business model. I am beginning to doubt that is possible. And don’t believe their reported earning!

This year Netflix added a large number of new subscribers as in past years. However, their increased spending on new programming will increase so much as to consume the entire revenue from over a half million new subscribers! Yikes!

The increasing programming costs never seem to end and competition keeps popping up. Disney is pulling their titles from Netflix in 2019 to start their own streaming service at a “significantly lower price” than Netflix.

The worst problem for me is their accounting! Netflix amortizes their content programming costs over four years. This is insane! This one simple accounting gimmick allows Netflix to report a profit while cash-flow negative. Like I said, insane!

Here is how egregious their accounting method is. Take House of Cards as an example. They amortize the production costs from the first season over four years. Does this make sense? Not a chance! Most of the value from Season One of House of Cards ends shortly after the season went live. Considering the problems surrounding the main actor, Kevin Spacey, the value of those titles is impaired even further and faster.

A damning statistic reveals amortization of content expense is increasing faster than revenues. Past sins are catching up and it’s only going to get worse.

I’m not selling yet, but Netflix is on the watch list. I watch Netflix close for signs subscriber growth is slowing. If they can’t reach a cash flow positive situation before subscriber growth slows Netflix is in big trouble.

The Story of Tesla

Tesla is different from Netflix. Netflix is a one-horse show while Tesla makes cars, batteries, solar panels and solar storage. The finances for Tesla are stretched, as with Netflix, but with many more options for success.

I own Tesla and if the wheels don’t fall off — pun intended — the company will be wildly profitable. There are a lot of ifs right now. The Model 3 has production issues and the main man, Elon Musk, spreads himself thin at times running so many disparate companies.

I consider Tesla a mad money holding right now. Tesla is burning through cash and looks to do so for several more years. Musk doesn’t have much in the way of accounting gimmicks I disagree with, but he does use plenty of financing gimmicks to fund the company’s burn rate.

My Tesla investment is small. If the stock came down in price $100 or more I might add to my position. Might.

A lot of issues need resolution before I jump into Tesla deeper. Tesla is one of those companies which will either crash and burn leaving investors licking their wounds or they’ll end up bigger than Amazon. Musk is the right man with the right dream coupled with the right work ethic to get the job done.

Tesla is not for the faint of heart or to be purchased with the rent money. Just warning you.

One More Thing

Most people buy stock by placing a purchase order. So do I, most of the time.

However, there is a trick you can use to buy listed stock at a price less than the price quoted. But that is a story for our next post.

I had to do something to get you to come back. Besides, I talked enough for one post.