Back in April of 2010, popular MMO blogger John Chow and myself got into a debate over where you should trade Apple (NYSE: AAPL) on the markets. This was the Monday following the initial release of the infamous Apple iPad, which reportedly sold a few hundred thousand units. I bet that the direction of Apple would actually be LOWER on Monday, despite a great headline number — John disagreed, citing a good response to the new product launch. The result? Apple traded higher on Monday, April 5th by 1.07%.

Why John Chow was the winner

As soon as the day closed, John and I got to talking:

Now, while the stock of Apple was up on the day, my verdict was that I was in fact the winner because they underperformed the market. Perhaps John and I come from two different schools of thought, but I really don’t care how awesome my stocks are doing if they are underperforming the market. On the day, Apple underperformed the technology benchmark slightly… so I took this as to say if there was zero news, Apple would have been up more. Why do I put more weight on relative performance versus nominal performance? Any investor can just dump their money in a large index fund and do fine… there is no point in owning Apple and trying to pick stocks if you are underperforming the broader basket of stocks.

Regardless, I read what I said… and because I didn’t mention relative performance I am writing this review as payment for a lost bet. As it happens, John was absolutely correct about Apple’s stock! Looking over the past few months, Apple has actually outperformed the S&P 500 Index by roughly 15% and has been one of the best performing companies in the markets. Was this due to strong iPad sales? That is too much for me to extrapolate — but the news now is that Apple valued higher than Microsoft!

Is Apple Overvalued Here? Was John Chow Just “Lucky?”

It remains my contention that John was the fortunate benefactor of random upward momentum in Apple’s stock. The reason that he expected the stock to trade up was that the iPad sold a lot of units. Despite how many units they sold (which was actually in-line with expectations), it is important to look at how the stock market actually works. Naturally, everyone and their grandmother knows that Apple is “sexy” and that people like their products. The problem here is that investors aren’t dumb — positive sentiment is already factored in.

Apple is a great growth company, but I absolutely hate putting cash to work in stocks that are positively viewed by the market. Why? Think about upside and downside. Assuming that market movements are relatively unpredictable, which I think most of us would agree to, stocks that are “good” will not move up on positive news (they are already assumed to be good) but will get slaughtered on bad news (nobody expects a company like Apple to issue a product recall). On the other hand, stocks that are frowned upon now will do awesome on any piece of good news, while bad news is largely ignored because the company is already seen as being of lower quality so they won’t do too bad.

Looking at the performance of Apple, it is common for stocks to trade up on the expectation and sell on the news — in fact, so popular it is an axiom. This is why Apple always gets killed the day after they release good earnings: they might have been good but everyone saw it coming. The market sees forward 6 months, so trying to profit off of news like the iPad is insane difficult. Did John Chow get lucky? I don’t think so — he knows a lot more about the tech space than me and probably has additional insight into Apple’s products. However, I would think that over the short term my track record would be better. John won this round.

A Smarter Investment Strategy That Makes Sense:
At the very least, I think that it is psychotic that Apple is valued higher than Microsoft… and would embark on a long-term “short Apple, long Microsoft” strategy for investing. This will capture any outperformance of Microsoft in a market-neutral way. My prediction is that growth in Apple will inevitably slow down, no matter how good you think they are. People are currently willing to pay more than 22 times the amount of Apple’s current earnings to own shares (what we call a “P/E ratio”), whereas Microsoft is getting less than 14 times. However, Microsoft generates cash like nobody’s business ($21B last year), and Apple isn’t even close to that good ($12B last year). Stock value is all about cash flow that the business is experiencing. Despite the fact that Apple might gain more cash flow per year over time, they would have to surpass Microsoft’s $21B number in around 6-7 years in order to end up more profitable into perpetuity. To this, I say “fat chance.” In fact, if both companies held their current cash generation rates, Microsoft is worth twice as much as Apple.

My Gift to John Chow

For John’s birthday, and for winning our little bet, I compiled a completely customized portfolio strategy report for him and sent him it in the mail, along with a copy of one of the best investing books out there — “One Up On Wall Street” by Peter Lynch, one of the greatest investors in history. I put some effort into developing this report, and it recommended a portfolio allocation to John based on two things: 1) his personal investment profile (as a technology lover); 2) the market conditions. I recommended weighting his stock portfolio in a certain manner that I feel will outperform the markets, and recommended stocks that I felt are underpriced and worth investing in. I don’t want to reveal the actual report, which was around 5 pages and professionally printed, but here is a screenshot:

The Proof Is In The Pudding

I issue an unofficial email newsletter to friends and family that want stock picks and pans when I see the opportunity. I run what I call “Jim’s Value-Growth Portfolio” privately through ThinkOrSwim.com (my broker). My portfolio to date is actually up a considerable amount — despite the fact that the market is down. I do not short stocks in it, so anyone can get invested and feel comfortable.

The last date I updated my performance was May 2th: My portfolio is up 9.31% and the S&P500 is down 2.64%, an outperformance of about 12%. Here is a chart of my investments versus the market:

To me, it’s all about timing the market and investing in the right industries when it is most prudent — this is why John Chow’s strategy of investing in companies that have a new product that he thinks is cool, is basically heresy to me. And hey, when John wrote “ Oh crap! That was wild market ride! I hoped you picked up some nice stock bargains! I did!” on May 6th, I recommended staying on the sidelines and the broad market is down over 6% since then.

Bottom Line: John Chow won this round of stock picking in the tech space, but I’d still give myself the edge on the broad market. At any rate, I figured this would be a chance to get a few good jabs in on the man. Congratulations John, you’ve proven your mettle in IT stocks.

-Jimvesting Dot Com