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3 Strong Trends, 1 Money-Making Trade

"Get out! The stock market is overvalued." That's the message from many stock market strategists.

I can't blame them, either. The data is certainly on their side. The Shiller P/E ratio, which uses an average of inflation-adjusted earnings over the past 10 years, is 23.5. That's nearly 50% above its historical average and quite lofty considering all the uncertainty that still surrounds the global economy today.

So maybe they're right. Does that mean we should we stay away from investing in the market? Perhaps. But we don't need to invest in the entire market. We invest in opportunities within the market.

Don't sit on the sidelines

Sitting on the sidelines, just because a market P/E ratio looks too high, sounds like a great way to miss an opportunity. That's why I devised this technique to navigate through potentially volatile markets:

  1. Find the best investments in the strongest macro trends
  2. Trade if trading is the right thing to do
  3. Only bet with the odds on your side

Even if the stock market is flying high and could hit some turbulence soon, there are always good ideas out there. We just have to find them. In fact, I sent you this research report because I've found one. So let's get to it.

1 + 1 + 1 = 4?

Great things can happen when trends combine together. Charlie Munger, Warren Buffett's right-hand man, calls them lollapalooza effects – where the sum of the parts is greater than the whole. Munger convinced Buffett to invest in lollapalooza effects, helping turn both men into billionaires.

We may not turn into billionaires overnight, but I think we can make lots of money following these 3 trends as they come together over the 5-10 years:

  1. Our connected world becomes more connected
  2. Mobile computing devices gain more and more acceptance around the globe
  3. High-end consumers continue to drive consumption recovery

Must... have... internet!

In college, I didn't even know how to connect the 2400 baud modem in my dorm phone to my computer. Today, I feel lost if I temporarily lose connectivity on the metro to and from work. But it gives us a sense of how big the smartphone market could become, as cell phone users around the world upgrade their devices to stay connected. We crave information and have to have it now – right at our fingertips.

In 2010, Gartner Research found that Blackberry maker Research in Motion (Nasdaq: RIMM) sold over 47 million mobile devices. That's not quite as impressive as the 461 million devices Nokia (NYSE: NOK) sold. But it gives us a sense of how big the smartphone market could be because over the years, as cell phone users around the world upgrade their devices to stay connected. And that doesn't even account for the tablet craze that is just beginning or that next great device that hasn't been invented yet.

Well done, big spenders

Right now, do you know who is buying those smartphones and tablet computers? A look at the retail sales data and some logic will answer the question.

Retail Sales: Total

Retail sales have stormed back above their pre-recession high. But the recovery couldn't have been on the backs of average consumers. Retail analyst Howard Davidowitz aptly pointed out they remain in "pretty terrible shape," with high unemployment and huge debt burdens. Declining same-stores sales at Wal-Mart (NYSE: WMT), supporting the average consumer, and growing comparables at Costco (Nasdaq: COST), catering to the high-end crowd, offer further proof that the average consumer is not leading the recovery. Retail sales are up because above-average consumers have the means to spend and now feel more confident to do so.

As promised, I've identified 3 strong trends for you:

  1. Increasing internet connectivity
  2. Growing smartphone and mobile device adoption
  3. High-end consumers leading the spending surge.

What company stands to benefit the most from these 3 converging trends? Apple (Nasdaq: AAPL) sits right in that sweet spot. Here's why.

Changing my iTunes

I give my daughter credit for opening my eyes. Of all the music players she could have wanted a year ago, she had to have an iTouch. She gave me some song-and-dance about how cool it was and all the apps (software applications) that were available. All I heard was the sound of dollars flying out of my checking account. She usually doesn't ask for much. So for her birthday, I surprised her with a trip to Best Buy to buy one.

She started 8th grade last fall. My wife and I decided to buy her her own computer. Being a cheapskate and a Windows guy, you can imagine my reaction when she asked for a Mac Book Pro. She told me about all the Peter Lynch-style research she had done, which consisted of naming friends with Macs. Another trip to Best Buy and another Apple product began soaking up bits and electrons from my wireless router and electrical outlets.

Mi Casa Es Su Casa?

After I helped my daughter navigate her laptop and played countless hours of Angry Birds, it dawned on me: With very little effort, I was now an Apple addict. I prayed that my Blackberry would survive long enough for Verizon to announce it was officially carrying the iPhone on its network.

It did, and I love my iPhone4.

Come to think of it, my wife's and daughter's phones will need to be replaced soon. It's very possible – dare I say probable – that I could purchase 2 more iPhones in 2011, along with an iPad2 for my metro ride to work and a 27-inch iMac for the home office.

The Trend Is Strong with This One

Looking back, it's easy to see how this happened. Apple's stylish products helped my daughter, and many other customers, navigate our digital world easily and effectively. And the revolution is growing.

I don't like to extrapolate my experience to the masses, but I will. Take a good look at the chart below.

Apple product unit sales by year

What do you see? I see more Apple products in more homes – and I see that trend growing. I also see customers willing to pay the price to be a part of the Apple crowd. Higher volumes with higher average prices are a winning combination – and one that's not likely to subside in the near term as iPad adoption explodes, iPhone sales increase, and Macs continue to take market share. The trend is strong at Apple.

Or Is It?

Consumer confidence can be very fickle. Should the global economic recovery sputter or stock markets reverse course, consumers could tuck their tails between their legs and run the other way.

And that's just one of the risks associated with Apple. As Google (Nasdaq: GOOG) Android-based phones and Nokia smartphones get cheaper and build out-of-this-world apps for customers, customers could look at Apple's higher prices and pass, thereby reducing Apple's profitability.

But it is interesting to note that Apple is reportedly developing a lower priced iPhone to fend off the challenges from Android and Nokia. Let the smartphone war begin!

And let's not gloss over the importance of Steve Job driving product development at Apple. Apple's innovative spirit will suffer a setback if he's not able to return to the company in some capacity.

Risks Worth Taking

Yes, those risks are real – even a little scary considering the stock's meltdown in 2008-2009. But based on the numbers that I am about to show you, those are risks worth taking. If strong volume and pricing trends continue, free cash flow will grow, and Apple shares could trade for as much as $550 a piece. However, if investors find half a worm in their Apple, shares could only be worth $275.

My valuation range may be wide, but we don't need a precise value to make money. What we need is to know how attractive Apple shares are based on their risk and reward. An investing plan can help make our buy and selling decisions. Here's how.

Using different valuation scenarios, I estimated a range of company values for Apple. From that range, we can compare the potential upside (reward) and the potential downside (risk). As long as we're getting more reward for the risk we're taking, we should invest in shares.

Before putting our capital at risk, we should demand at least 2 times as much reward as risk. And at that level, we should only invest a small amount of capital – like 1-2% of a portfolio. But as the price falls and the reward-to-risk ratio rises, we should practice what Warren Buffett preaches by "investing heavily in (my) best ideas."

Using a valuation range of $275 - $550 per share, let's see what Apple's investment plan below tells us to do today.

Company Current Price Reward/Risk Stock Price Action Reward Risk
Apple Inc. (NYSE: AAPL) $344.25 Sell Price $550.00 Sell All 0.0% -50.0%
1/2 $458.33 Sell Some 20.0% -40.0%
1/1 $412.50 Hold/Consider Sale 33.3% -33.3%
2/1 $366.67 Hold/Start to Buy 50.0% -25.0%
3/1 $343.75 Buy Average Position 60.0% -20.0%
Downside Risk $257.00 Overweight 100.0% 0.0%

Source: Author's calculations

Apple's been trading around $345 per share, recently – that's nicely below the $367 price tag that gives twice as much upside as downside. So the investment plan is screaming: "Buy shares today! And buy more on the dips, Fool!" So here's the plan.

  1. Using my $50,000 of capital, I bought 2 shares of Apple around $347, which is a 1.4% allocation
  2. I will buy 2 more shares if the price drops below $344, bringing the position to about 3%
  3. I will up my allocation to 10% if the price drops below $275

As I said in an earlier article, I believe markets are going to be very volatile over the next decade, especially as investor sentiment moves between greed and fear. There's greed in the air today. That means we need to be more willing to trade in the near term – buying dips and locking gains as necessary – even if the long-term trend is strong. Fortunately, my investment plan gives us clear buying and selling points to make money with Apple.

The Foolish Bottom Line

Cautious optimism is my mantra right now. With equity prices flying higher, the opportunities are fewer and farther between – but they are there. You just have to know where to look. Investors willing to go against the cautious grain and invest in Apple should taste the sweet fruit of success as it navigates those 3 strong trends.

David Meier is an Associate Advisor for Million Dollar Portfolio. He owns 2 shares of Apple. He does not own any of the other stocks mentioned. Costco and Wal-Mart are Motley Fool Inside Value selections. Google is a Motley Fool Rule Breakers recommendation. Apple and Costco are Motley Fool Stock Advisor recommendations. Wal-Mart Stores is a Motley Fool Global Gains selection. The Fool has written puts on Apple. Motley Fool Options has recommended a diagonal call position on Wal-Mart Stores and a bull call spread on Apple. The Fool owns shares of Apple, Google, Costco Wholesale, and Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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