Hailed by The New York Times as a "guru to Wall Street's gurus," value investing expert Bruce Greenwald takes some time to offer his insight and advice to The Motley Fool. A professor at Columbia University's Graduate School of Business, Greenwald has also authored multiple books, including Value Investing: from Graham to Buffett and Beyond.
Apple and IBM were both enjoying record margins a year ago. Greenwald explains the difference between the two tech giants, then looks at Nestle and Coke and how they manage to remain recession-proof and inflation-proof.
Full transcript below
Bruce Greenwald: If you look at the comparison of Apple to IBM, they were both, a year ago, at historically high profit levels. Apple's profits, as a fraction of operating earnings, were 40%. It's a big, global goods market.
They spend only about 2% to maybe 2.5% of their income on R&D. Advertising is even less than that; it's only a billion dollars. There are not a lot of fixed costs, here. They're all variable costs, and what that means is people can come in at the margin, without being able to capture a huge part of this market, and undermine Apple.
If you look at the history of that market, first with Motorola and the Razr, and then with Nokia and their phones, there has never been a sustainably dominant competitor. If you look at the Razr at its peak, it's at a 15% margin.
When Apple is at 40%, that's an inflated margin that's clearly going away. What you've seen in the last two quarters is that that's come down to 28%. There's been a huge drop in those margins.
In contrast, if you look at IBM, IBM is also at historically high margins. If you look seven years ago, it's at 14% operating income to earnings. You look today, it's at 20.5%.
On the other hand, IBM dominates a lot of little vertical markets in a lot of localities because it's the support that they give, it's the selling expertise that they have, that enables them to be the company that they are. To compete with them on that level, you have to have that local presence, both in the specific product market, and in the geographic area.
If you look at IBM, they have suffered, too. Their sales are down a lot, but their margins have shown a lot more stability.
To the extent that the market is moving away from the Apple direction, away from manufacture -- because productivity in manufacturing is 5-7% a year, and demand growth is 3-4% a year, so just like agriculture that's going away -- into these very much more differentiated service markets, these much more fragmented service markets, it looks like the profits may be more sustainable than people are giving them credit for.
That means that things are probably not as crazy overvalued as some people think, especially if you concentrate on locally dominant service franchises.
Matt Koppenheffer: You may have some of these examples like Apple, where the margins are at risk, but then a lot more examples that are balancing that out.
Greenwald: Right, that are not that expensive. A classic company of that is Nestle has come down because they've started to do stupid things that they're historically prone to do in capital allocation, which means they make their money in the markets they dominate.
I could give you an example of a similar company. Coca-Cola, historically, has made more than 110% of its operating profits in the 8-10 biggest markets in which it operates, which means it loses money in the markets where it's not dense and doesn't have scale and distribution.
Same thing is true of Nestle. Where they try and go all over the world, and they have sub-scale distribution networks, they lose money -- and they've just started doing that again.
Where they were sensible and they consolidate and license their products in the markets where they don't have dominant scale and distribution, and concentrate on markets where they do have dominant scale and distribution -- like pet food in the United States -- they do very well.
But they're trading at a 3.3-3.4% dividend. Their growth, because they are in high growth areas -- if you read their financials, it looks like the growth is slower because historically, it's been in Swiss francs, and the Swiss franc has been appreciated -- strongly relative to the currencies in which they sell, but their growth is probably, especially in earnings because they have operating leverage, maybe 6%, which is a little above the 4.5% nominal world GDP growth, or even 4% nominal world GDP growth.
You had a 6% earnings growth, a 3.3% dividend, and probably some buy-backs on top of it because they really don't need all that much capital, so you're looking at a 10% return on a stock. That is extraordinarily safe.
You look at what happened to them after 2003, where their input prices went through the roof, and there was no general inflation, and their margins go up steadily. You look at them in the crisis ,and they're barely affected by it in 08-09.
It's sort of recession proof and inflation proof, and it's a 10% return. Maybe as low as 8, but in a world -- even where 30-year Treasuries, which have all the inflation risk, are 3% -- that is not an expensive stock, and there a fair number of opportunities.
Not as many, obviously, as there were 18 months ago.
Koppenheffer: When the market goes up as much as it has, you naturally have that.
Greenwald: Right. Right, you're naturally not happy.