Insight into the Redwood Fundamental Research Process
Fundamental research is the core of the Redwood investment process and all purchased securities are reviewed thoroughly and vetted by the investment team. Equally important, all owned positions are monitored for continued strong fundamentals and must remain attractively valued in order to be retained in client portfolios.
Apple (AAPL) represents a good example of the Redwood stock selection process. The stock has been held in the Large Core and Large Growth portfolios since Redwood’s inception and is currently the largest position in each strategy. The company ranks highly in the Redwood proprietary quantitative model and has consistently reported better earnings than Wall Street expectations. The company has improved its operating margins from 12% to 28% over the past five years and has accumulated more than $25 billion of cash on its balance sheet. A series of innovative and easy-to-use products like the iPod, iMac and iPhone drove 36% revenue and 60% EPS CAGR over the past five years. Despite the stock’s appreciation, earnings have outpaced the strength in its stock price. The P/E multiple on the stock declined from 30 five years ago to less than 15 today and trades at a discount to the S&P 500 P/E.
During 2010, AAPL introduced the iPad tablet to both great fanfare and skepticism. The Redwood portfolio team viewed the iPad as the critical variable for the company to maintain its ability to exceed investor expectations for revenue and earnings growth since the iPod had reached close to full penetration and growth was decelerating.
To evaluate the product, the Redwood portfolio conducted in-depth due diligence on the iPad. The process included a hands-on evaluation, analysis of the tablet market and an assessment of the economics of the product. After trying the product, reading reviews and talking with customers, the team concluded that the iPad was highly differentiated and likely to see broad adoption. While the notebook computer was superior to the iPad for content creation (spreadsheets, video editing, presentations), the iPad was a superior product to a notebook computer for content consumption (surfing the internet, playing games, reading books). Given the lower price point for iPads relative to notebooks, the Redwood team was convinced that the iPad could garner significant market share within mobile computing.
The investment team anticipated that the iPad’s creative design, slick operating system, and good value would be enhanced by the “App Store,” which offers thousands of free or inexpensive applications. With the App Store, the iPad’s functionality became more robust and the user experience became even more exciting and enjoyable. Moreover, the pricing of iPad applications (less than $2.99 for most) further reduced the total cost of ownership for an iPad relative to a notebook computer.
With 215 million notebooks sold in the world annually, the Redwood team projected that tablets could quickly garner at least 15% market share from notebooks or 32 million units per year. Initial Wall Street expectations for the tablet market were far less; fewer than 10 million units sold annually. AAPL sold 7.5 million units in just the first six months of sales. Redwood’s analysis of the iPad’s economic contribution proved to be more accurate as evidenced by two quarters of earnings reports that meaningfully exceeded analyst estimates.
The longer term opportunity for AAPL will be determined by the direction of the tablet market. Will the tablet (iPad) market more closely resemble the MP3 (iPod) or Smartphone (iPhone) markets? In technology markets, a company with a dominant market share can control 70% - 120% of the profits of the market as other industry participants lose money. Examples include Google in Internet Search, Microsoft in Operating System, and Intel in Microprocessors. AAPL completely dominated the MP3 market by redefining the player and combining it with iTunes for music and videos. The company likely generated more than 100% of industry profits. In the Smartphone market, AAPL has executed on its strategy extremely well and garnered 15% market share. But with other strong players (Samsung, LG, Motorola, Nokia, RIMM) and operating systems (Android, Blackberry, Windows), AAPL does not have outsized profitability.
Redwood believes the tablet market is more likely to resemble the MP3 market than the Smartphone market because AAPL has a first-to-market advantage, superior product design, better price/performance than competitors and an integrated App Store. Initial sales of other tablets such as the Motorola Xoom and Samsung Galaxy have been disappointing.