We like to test market chatter with indicators. Talk really is cheap, but investors tend to be a bit more judicious with real investment dollars. The Fund King methodology is all about measuring what investors are actually buying and selling and comparing that with what people are saying.

As you can tell from the title, we are going to use Apple’s common equity as an indicator to test a market rumor for four reasons:

  1. AAPL is well known.
  2. It accounts for about 20% of the QQQQ.
  3. It is one of the top holding of Hedge Funds.
  4. Lackluster performance has kicked off rumors of big redemptions in the hedge fund space.

How does a hedge fund work?

The first thing to understand is how most hedge funds work. Almost all hedge funds are structured as partnerships. The fund manager is the General Partner (runs the partnership and gets the management and performance fees) and the investors are Limited Partners. Agreements vary from shop to shop but most only allow for redemptions twice to four times a year. To redeem your interest, you need to give advanced notice (say, 45 days).

The structure allows hedge fund operators to invest in more illiquid instruments and strategies because, unlike a mutual fund or an ETF, the chance having no cash to meet a sudden redemption is minimized. Investors are very wealthy individuals or increasingly institutions so the annual, semi-annual or quarterly cycles are seen as a small price to pay for access to “smart money.”

What does this have to do with AAPL?

If you are thinking in terms of iPad sales this holiday season, not that much, directly. But, one of the ways we like to use the Fund King Method is to verify or debunk what we are hearing in the marketplace. While we may hear rumors that hedge funds have in general not lived up to expectations this year and may be facing big redemptions, it is hard to collect solid evidence of either postulation in time to position one’s portfolio. The reason we do not have hard evidence is not due to some sort of conspiracy. Hedge funds are private companies and they have a right to keep their positions and trading intentions to themselves. The information will eventually be disclosed but, by then it will have little commercial value.

When hedge funds receive notice (30-45 days) of redemptions, they are compelled to sell assets to meet those redemptions (which are met primarily in US dollars). Since hedge funds often invest in illiquid assets (private equity deals, complex swap arrangements, custom built derivatives, funny stocks in foreign markets and so on…), they tend to sell down the most liquid assets first.

This could be part of the reason we are seeing money coming out of the “riskier” assets and “popular” trades around the world, and a subsequent rebound of the US dollar…or maybe not. What we need is a clearer indication of what is going on. That’s where a big, favorite holding like AAPL comes in.

Is AAPL a perfect indicator?

Unfortunately, there is no such thing. AAPL has had a tremendous run in terms of both its products and its stock price…so some year-end profit taking is probably inevitable (just in case the Bush tax cuts don’t get renewed). But, since we should see a fair number of iPads under the tree this year, a big drop might be a confirmation that the hedge fund redemption story has temporarily swamped AAPL’s fundamentals.

How can we play?

Since most of the money being redeemed will be repositioned with other firms, the net effect over a three month view will be negligible. However, we may see some downside in risky assets (and upside in safer assets) in December with a reversal in January (perhaps a pronounced “January Effect” coming up). Expect a lot of “disinformation” which may take the form of this attempt to tout a growth stock with deep value methodology, but do not let the buzz distract you from the price action. If hedge funds are under pressure and need to sell down a big stock like Apple, you do not want to stand in the way of that or other top performing, liquid assets. But, also, you do not want to be overly gun shy when these assets are being offered at a post-holiday discount in the early days of January. Keep your eye on Apple…the stock price may be telling you some valuable information about the short term state of the markets. And you may even get a chance to pick some up at a good price.

P.S. Don’t settle for a lump of coal in your stocking

When I was researching AAPL and hedge fund holdings, I came across this post from MarketFolly.com. I had to read it several times because I could not believe that someone of David Einhorn’s stature and reputation could make such a dopey statement about Apple (AAPL). If you watch the whole interview, he comes across as sensible but the Apple section is still a shocker.

Of his AAPL position Einhorn says, “Looking at Apple today, the stock is about $310, or $320 a share. There’s about $45 a share in cash. So you’re paying about $265 for the business. I think they’re going to earn well over $20 a share in the next year, so you’re looking at a PE net of the cash in the low teens, which is below a market multiple.”

Source: MarketFolly.com

If he thinks AAPL can earn $20 a share and presumably more in years to come, then 15-16x earnings is probably not an outlandish price to pay. If you agree with his thinking, fine.

But, he chose to engage in a bit of deep value flim-flammery by deducting the cash from the stock for the purpose of comparing it to the market and trying to dress up the stock as “cheap” relative to a market full of corporations that are also sitting on huge piles of cash (over US$1 trillion by some reports).

This method of analysis is common in deep value situations. Someone might come across a company trading at $60 with $45 of cash on the books and conclude that one is getting a good value because you are only really paying $15 for the business. But, the P/E always includes the cash portion of the balance sheet because the cash is part of the earnings potential of the company (for better or worse).

Applying this sort of deep value thinking to a growth stock trading at nearly 4x book would get you “dope-slapped” before you could finish the sentence as a first year analyst. Why? Because that $45 represents half the balance sheet and is actually a drag on earnings (and bad for shareholders) rather than a positive. Slicing it away to pretty up a P/E ratio in the current low interest rate environment is a shocking attempt to “apply lipstick to the pig”. For someone who has made his reputation by showing which emperors were parading around without clothes, the irony is rich.

AAPL may be the greatest stock in the world but not because you can trim $45 from the $310 “P” to get a somewhat lower P/E ratio.

Disclosure: neither long nor short AAPL…just watching.


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