One of the great things about Karl Smith is that he usually responds to critical comments thoughtfully and collegially. His response to my post on Apple is no exception. Let me take his responses one at a time.
Smith begins his response by writing that:
So, I am not actually making any statement about whether Apple’s stock price is “too high” or “too low.”
Smith wrote in his original post that:
On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.
Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.
He wasn’t saying that there is a risk that Apple will never pay out enough cash to shareholders to justify the price of the stock, but that there is “approximately zero probability” of this happening. If a share of Apple stock has the same value as a pile of ashes, then it is not only worth less $375, it’s worth less than $1. That sure sounded to me like he was arguing that Apple’s stock price of $375 is “too high.”
Smith goes on to respond to my observation, based on my experience, that it can be very beneficial to shareholders for a company to hold cash on its balance sheet so that it can act decisively when opportunities arise, by writing that:
In Jim’s scenario he has a lot of cash on his balance sheet and that allows him to make strategic purchases. But, by construction you know who doesn’t have that cash – Jim’s shareholders.
If Jim had paid out the cash to his shareholders then they would have it. And, if Jim could convince them that he really did have all of these great opportunities they could give it back to him. The fact that no one wants to give Jim cash should be taken as evidence that giving Jim cash is not a good idea.
On a blackboard, maybe. If we lived in a world where it was free, instantaneous and riskless to go through the fundraising process, I guess this might work. Actually raising cash from investors can take anywhere from days to months, and you can lose the chance to buy the asset, or lose the chance to get the best price; it is often expensive, especially in the time and attention of senior managers; and, it often results in information about the potential investment or acquisition leaking out to the market while you are raising the money, which can materially increase whatever you have to pay for the asset, and maybe cause you to lose the deal entirely.
In response to my point that maybe Apple is keeping cash on its balance sheet in part to work a tax angle, Smith writes that:
Yeah, this is just akin to saying that I am reading their signals wrong which of course could be true.
This is a very different statement than “a share of Apple stock is worth the same as a pile of ashes.” If Smith is saying that his actual argument is that it is possible that Apple is just never going to deliver cash to shareholders, because of a principal-agent problem or some other issue, then I have misunderstood what he wrote, and we are in agreement. My argument is that Smith has not come close to making the case for what a rational expectation for future cash dividends to shareholders from Apple ought to be.
In response to my point that maybe Apple is using the cash in part to deter potential competitors, Smith writes that:
Again, its clear why this is good for Apple. Its not immediately clear why its good for a diversified shareholder who also own stocks in the companies that Apple is deterring.
Except that an Apple shareholder might not have the opportunity to invest in such a competitor because it is private, or because it is a division of another company that requires making a compound bet on that division plus the rest of the company, or because the investor has finite time and attention to devote to her portfolio, or for any other of a large number of reasons. I don’t think it’s especially bizarre that a shareholder of company X tends to be made better off when company X succeeds versus competition.
Smith concludes with this:
Key in my claims is that under none of these hypotheses is it in the interest of the Management to take these actions. Whether its in the interest of shareholders to take some action different than what they are taking I am not taking a stand on.
What is true – and a puzzle – is that under some variants of my claims it would be in the interest of private equity to take over the firm. The private equity problem is difficult as well though. Because, its clear how given these principle-agent problems one can create discounted present value using private equity.
Its not perfectly clear how one extracts that value.
Smith has argued that a given shareholder will get more free cash flow by paying $380 for a bunch of ashes in a trash can than by paying $382 for a share of Apple stock. The important exception is that she can get cash in pocket by selling this share to some other buyer of the stock. Smith is arguing that any investor who counts on that is counting on a greater fool buying it, because Smith can see what they cannot, which is that Apple will not ever pay dividends. (Once again, if he is really saying that it’s possible they won’t pay dividends, then we have no disagreement.) But exactly this judgment is the contested issue. This is what markets price.
Here’s the most obvious way that you extract the value if you are convinced that a stock’s market price overestimates its true value: you short it. If Smith doesn’t believe that the market will, in any feasible investment horizon, figure out that he’s right and begin to heavily discount Apple’s stock price, then you have just defined an asset that will, with respect to this issue at least, retain its value – otherwise known as “a good investment.”
(Cross-posted to The Corner)