There are a few companies that have been successful in building cult-like loyalty among both consumers AND investors. But none have been able to do it as well as the Apple Inc. (AAPL) empire created by Steve Jobs.
Apple has done a tremendous job of creating products that meet the every-day needs of consumers around the world. Heck, it’s been said that Apple actually created some digital needs – just so it could fulfil those needs with a new version of its products. While I still do the majority of my work on a PC (most trading and charting platforms run better on Windows), I’m a huge fan of my iPhone and iPad – and can’t imagine changing my research and communication processes to run without Apple products.
But as we head into the end of the year, the Mercenary Trader book is short Apple – and we have already locked in a profitable trade. Furthermore, we’re holding our position with a relatively loose risk point – giving the stock plenty of room for volatility as it continues to trade lower.
Over just the last three years, AAPL has increased by well over 400% as the company has manufactured blockbuster hit after blockbuster hit. Nearly every new product launch has been met with overwhelming demand, and has met and exceeded user expectations on a regular basis.
But with the company that Steve Jobs poured his heart and soul into – now passed down to a new generation of executives, one has to wonder whether it is really possible for the company to continue to meet and exceed expectations… Not only for consumers, but also for investors.
The Valuation Case
Any time an analyst or a trader brings up the prospect of shorting AAPL, the first and primary argument against this move is based on the valuation of the stock. This is an important issue that certainly needs to be taken into consideration.
Apple’s fiscal year end is September 30th, and for the past year the company booked earnings of $27.68 per share. Thankfully, Apple’s books are relatively clean, so this earnings number is a high quality figure for determining the company’s valuation.
In fiscal 2012, analysts expect earnings to grow by 25% – to $34.56 per share, and then by 12% to $38.59 in 2013. I’m not sure how anyone can determine a high-conviction EPS number for two years out in this consumer-driven business but we’ll roll with that for now…
Based on these numbers, AAPL is currently trading at 10.5 times next year’s expectations – not exactly a frothy valuation for a leader in the consumer technology sector.
But let’s think about what it takes for AAPL to maintain its current earnings level – not to mention growing EPS over the next several years. Apple has made itself successful by churning out blockbuster products that are a step (or two) ahead of the competition and are innovative to the point where they are a “must have” for a large portion of the global consumer demographic.
Apple thrives on new products and without successful product launches, it will not even be able to maintain current revenue and earnings levels. The amount of recurring revenue pales in comparison to the new product revenue the company relies upon.
With Jobs no longer at the helm, shareholders face a significant risk that new products will NOT be accepted in the same cult fashion – leading to lower earnings levels – which means that the 10.5 PE may not be as low as it appears on the surface.
Considering the size of the company (AAPL has a market cap near $340 billion and annual revenue near $110 billion), it will become more difficult to scale meaningful growth over the long-term – and without this growth, investors cannot justify a premium earnings multiple.
The bottom line: Apple’s above-average growth days are in the rear-view mirror and investors are coming to terms with the fact that this is a high-quality, mature company.
From a chart perspective, Apple gave its first warning sign in mid-October when the stock briefly gapped up to a new closing high – and then three days later gapped sharply lower leaving an “island top”
Of course, there’s nothing magical about this chart formation. The key is to determine what is happening behind the scenes…
For a cult-stock like AAPL, the bullish gap to new highs was a strong bullish indicator. Considering the challenging market environment, this show of strength undoubtedly caused both retail and institutional investors to commit more capital to this high relative-strength opportunity.
Three days later when the stock gapped sharply lower, those new buyers were trapped in a losing trade. As global uncertainty increased, confidence levels dropped. The Mercenary Live Feed took a short position on 10/25 at $401.28 as the stock began to follow through on this bearish pattern.
Fast forward to late November, and the stock is facing another key technical challenge. Apple is pressed right up against the 200 day exponential moving average (EMA) which provided support during the last challenging period (late June).
The last time Apple reached this important line, investors stepped up to support the stock and AAPL charged to a new high. But that was about the time that the iPhone 4S was announced, and also matched a period where the broad stock market found support and entered a wide trading range.
Today, the company is without its dynamic leader, but is reportedly about to reveal a new television product. The broad market is entering another freefall environment. And uncertainty levels are high.
If AAPL finds support at this juncture, some of our open profits will be at risk. On November 21, we took half of our profits off the table at $370.23 and we have moved our risk point to breakeven for the second half.
But if AAPL does NOT find support at this level, it could be a major shock to the Apple faithful – and lead to panicked selling from investors with less confidence.
It’s All About Reward vs Risk
When working through bullish or bearish trading scenarios, it is important to remember that we are always working with imperfect information. It’s impossible to know for sure whether the iTV will turn out to be a blockbuster hit or not. It’s even more difficult to accurately predict how investors will react to the next product, earnings announcement, or economic report.
As nimble traders we subscribe to Peter Brandt’s concept of having strong opinions, weakly held. This means that we are willing to develop an opinion of how a stock might trade, we’re willing to risk capital on this assessment, but we are always willing to re-evaluate that scenario based on new information coming to market.
In the case of AAPL, the path of least resistance still appears to be lower, and we have been able to lock in profits and cut back our initial risk to zero. If the 200 EMA does not hold, the next major support level is the May low near $310. This represents more than $50 in additional profit – and may also give us a chance to pyramid our exposure along the way.
The action in the overall market is currently punishing speculative bulls and rewarding traders who anticipated a “flight to quality.” With no end in sight to the debt situation in Europe, and plenty of economic uncertainty in the US, the path for AAPL should continue to point to lower prices.
Read more posts on Mercenary Trader »
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.