Thanks to his unbelievable track record of compounding capital over many decades as the CEO of Berkshire Hathaway, Warren Buffett is probably the most closely watched investor out there. Everyone can learn a thing or two following his advice and actions.
One of Buffett's best bets has been to buy shares in Apple (AAPL 1.88%), the dominant consumer-electronics enterprise. Berkshire first purchased the stock in the first quarter of 2016, and since the start of that year, Apple has soared 862% (as of Dec. 17), meaningfully outperforming the S&P 500.
As of this writing, 25% of Berkshire's massive $299 billion portfolio is in Apple, making it its top holding, even after the Oracle of Omaha trimmed the position over the past year. Continue reading to learn what first caught Buffett's attention and if the stock is a smart buy right now.
Nearly a decade ago, just before Buffett and Berkshire first bought a stake in Apple, it was obvious that Apple possessed one of the world's most powerful brands. The company's successful history of developing and bringing to market extremely popular and in-demand hardware devices allowed it to resonate strongly with consumers. That positioning has helped the company flex its pricing power.
Besides Apple's brand, Buffett likely understood that the company had tremendous customer loyalty. Credit partly goes to the brand's image.
However, Apple's ecosystem, which mixes its hardware offerings with a suite of internally developed software and services to provide a superior user experience, essentially locks consumers in, discouraging them to change to competitors' offerings. Buffett even suggested that if you offered someone $10,000 on the condition that they could never use an iPhone again, the deal would be declined -- probably without hesitation. This points to Apple's customer loyalty.
Buffett appreciates businesses that are in sound financial shape, and perhaps no company is as financially fit as Apple. It generates incredible amounts of operating income and free cash flow quarter in and quarter out, allowing management to repurchase shares and pay dividends. As of Sept. 28, Apple had a net cash position of $50 billion, a financial cushion that lets investors sleep well at night.
During the first three months of 2016, Apple shares traded at a price-to-earnings ratio (P/E) of 10.6. With the benefit of hindsight, that valuation made the investment opportunity seem like a no-brainer. No wonder Buffett made the decision to buy Apple stock then.
After such a fantastic run in the past several years, Apple shares trade in record territory. The stock isn't cheap, compared to its past, selling at a P/E multiple of 41.7 right now. That represents a sizable 86% premium to its trailing-10-year average valuation, which makes the stock definitely expensive.
Paying this high of a P/E ratio isn't ideal, in my opinion. It indicates heightened expectations, enthusiasm, and optimism surrounding Apple, which leaves zero margin of safety for prospective investors.
Making matters worse is Apple's growth outlook. According to Wall Street consensus analyst estimates, the company's earnings per share are set to rise at a compound annual rate of 11.6% over the next three years. That forecast doesn't justify paying the high valuation.
Berkshire locked in some profits in 2024 before a potential hike in the capital gains tax rate. In addition to that, I'm guessing that valuation is the key reason Buffett and his team have trimmed the Apple position.
Investors who want to follow in Buffett's footsteps now and take a bite out of Apple stock should think twice. It's best to monitor the business and practice patience. Only consider buying when the P/E ratio gets closer to 25.