When considering aspects such as competitive strength, fundamental quality, and valuation, Apple (AAPL 0.38%) stock looks like a nice fit for Warren Buffett's portfolio. However, Apple isn't a Warren Buffett stock, and the Oracle of Omaha has publicly stated that he won't invest in the company. Why is it that Buffett won't take a bite of Apple?
The case for Apple as a Warren Buffett stock
Warren Buffett is all about competitive strengths, and brands can be one of the most powerful sources of competitive advantage. Apple is the most valuable brand in the world, according to both Interbrand and the Forbes brand ranking. This competitive differentiation is allowing the company to truly crush the competition when it comes to sales and profit.
The business is doing great from a financial point of view. Sales grew 30% during the last quarter, and Apple produced nearly $30.5 billion in free cash flow over the period. Apple holds nearly $178 billion in cash and investments on its balance sheet, so its financial strength is unquestionable.
Source: Apple.
All this comes for a very reasonable price: Apple trades at a P/E ratio of 16.7, a discount versus the average valuation for companies in the S&P index, in the neighborhood of 19.5. Valuation is certainly no reason to stay away from Apple stock. If anything, the price tag looks quite attractive.
Warren Buffett has traditionally avoided tech companies, but he did make a big investment in IBM (IBM 1.56%) in 2011. While IBM stock has delivered uninspiring returns since then, Buffett hasn't lost his faith in Big Blue. Far from it: He even bought more IBM stock in the fourth quarter of 2014.
What does IBM have that Apple doesn't that lured Buffett to invest in one but not the other?
Warren Buffett on Apple and Google
In May 2012, Buffett was asked about his opinion on Apple and Google, and whether he would buy either of these two companies. Buffett said he believes that both Apple and Google offer substantial upside potential in the long term but that he wouldn't invest in them. In his own words: "I would not be at all surprised to see them be worth a lot more money 10 years from now, but I would not buy either one of them. ... [I] wouldn't short them, either."
Source: The Motley Fool.
Buffett was quite clear that he feels more confident when it comes to a company like IBM than when trying to evaluate Apple or Google: "The chances of being way wrong in IBM are probably less, at least for us, than the chances of being way wrong in Google or Apple. ... I just don't know how to value them."
Change and innovation as a double-edged sword
It's important to note that Buffett isn't saying IBM will necessarily do better than Apple over the coming years, only that he feels more confident in his ability to analyze the business and its long-term prospects.
Considering IBM's trajectory over the decades, its deep relationships with corporate customers, and its diversified global presence in different business areas, the company stands out as a particularly solid investment in the tech industry. In a sense, IBM is a services company as much as a tech business.
When it comes to Apple, things are very different. Its competitive advantages and financial strength are unquestionable, but the company needs to permanently innovate to sustain growth.
Buffett doesn't like change. In his 1987 letter to shareholders, he wrote, "Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or 10 years ago."
The iPhone didn't exist until 2007, yet the product generates more than 50% of Apple's revenue. In fact, when excluding the iPhone from Apple's performance in the last quarter, sales would have declined year over year.
Apple was a very different company 10 years ago, and chances are it will go through many big changes in the coming 10 years. Innovation can create extraordinary opportunities for growth and profitability, but it can also be a major source of risk. That's the kind of risk that Warren Buffett doesn't like taking.
