By Dr. David Edward Marcinko MBA CMP©


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I am not a neurologist, psychologist, or psychiatrist. But, it is well known that emotional and behavioral change involves the human nervous system. And, there are two parts of the nervous system that are especially significant for holistic financial advisor; the first is the limbic system and the second is the autonomic nervous system. 

According to Dr. C. George Boerre of Shippensburg University of Pennsylvania, this is known as the emotional nervous system.

1. The Limbic System

The limbic system is a set of structures that lies on both sides of the thalamus, just under the cerebrum.  It includes the hypothalamus, the hippocampus, the amygdala, and nearby areas.  It is primarily responsible for emotions, memories and recollection. 


The small hypothalamus is located just below the thalamus on both sides of the third ventricle (areas within the cerebrum filled with cerebrospinal fluid that connect to spinal fluid). It sits inside both tracts of the optic nerve, and just above the pituitary gland.

The hypothalamus is mainly concerned with homeostasis or the process of returning to some “set point.”  It works like a thermostat:  When the room gets too cold, the thermostat conveys that information to the furnace and turns it on.  As the room warms up and the temperature rises, it sends turns off the furnace.  The hypothalamus is responsible for regulating hunger, thirst, response to pain, levels of pleasure, sexual satisfaction, anger and aggressive behavior, and more.  It also regulates the functioning of the autonomic nervous system, which means it regulates functions like pulse, blood pressure, breathing, and arousal in response to emotional circumstances. In a recent discovery, the protein leptin is released by fat cells with over-eating.  The hypothalamus senses leptin levels in the bloodstream and responds by decreasing appetite.  So, it seems that some people might have a gene mutation which produces leptin, and can’t tell the hypothalamus that it is satiated.   The hypothalamus sends instructions to the rest of the body in two ways.  The first is to the autonomic nervous system.  This allows the hypothalamus to have ultimate control of things like blood pressure, heart rate, breathing, digestion, sweating, and all the sympathetic and parasympathetic functions.

The second way the hypothalamus controls things is via the pituitary gland.  It is neurally and chemically connected to the pituitary, which in turn pumps hormones called releasing factors into the bloodstream.  The pituitary is the so-called “master gland” as these hormones are vitally important in regulating growth and metabolism.


The hippocampus consists of two “horns” that curve back from the amygdala.  It is important in converting things “in your mind” at the moment (short-term memory) into things that are remembered for the long run (long-term memory).  If the hippocampus is damaged, a patient cannot build new memories and lives in a strange world where everything they experience just fades away; even while older memories from the time before the damage are untouched!  Most patients who suffer from this kind of brain damage are eventually institutionalized.


The amygdalas are two almond-shaped masses of neurons on either side of the thalamus at the lower end of the hippocampus.  When it is stimulated electrically, animals respond with aggression.  And, if the amygdala is removed, animals get very tame and no longer respond to anger that would have caused rage before.  The animals also become indifferent to stimuli that would have otherwise have caused fear and sexual responses.

Related Anatomic Areas

Besides the hypothalamus, hippocampus, and amygdala, there are other areas in the structures near to the limbic system that are intimately connected to it:

  • The cingulate gyrus is the part of the cerebrum that lies closest to the limbic system, just above the corpus collosum.  It provides a pathway from the thalamus to the hippocampus, is responsible for focusing attention on emotionally significant events, and for associating memories to smells and to pain.
  • The ventral tegmental area of the brain stem (just below the thalamus) consists of dopamine pathways responsible for pleasure.  People with damage here tend to have difficulty getting pleasure in life, and often turn to alcohol, drugs, sweets, and gambling.
  • The basal ganglia (including the caudate nucleus, the putamen, the globus pallidus, and the substantia nigra) lie over to the sides of the limbic system, and are connected with the cortex above them.  They are responsible for repetitive behaviors, reward experiences, and focusing attention. 
  • The prefrontal cortex, which is the part of the frontal lobe which lies in front of the motor area, is also closely linked to the limbic system.  Besides apparently being involved in thinking about the future, making plans, and taking action, it also appears to be involved in the same dopamine pathways as the ventral tegmental area, and plays a part in pleasure and addiction.

2. The Autonomic Nervous System

The second part of the nervous system to have a particularly powerful part to play in our emotional life is the autonomic nervous system. 

The autonomic nervous system is composed of two parts, which function primarily in opposition to each other.  The first is the sympathetic nervous system, which starts in the spinal cord and travels to a variety of areas of the body.  Its function appears to be preparing the body for the kinds of vigorous activities associated with “fight or flight,” that is, with running from danger or with preparing for violence.  Activation of the sympathetic nervous system has the following effects:

  • dilates the pupils and opens the eyelids,
  • stimulates the sweat glands and dilates the blood vessels in large muscles,
  • constricts the blood vessels in the rest of the body,
  • increases the heart rate and opens up the bronchial tubes of the lungs, and
  • inhibits the secretions in the digestive system.

One of its most important effects is causing the adrenal glands (which sit on top of the kidneys) to release epinephrine (adrenalin) into the blood stream.  Epinephrine is a powerful hormone that causes various parts of the body to respond in much the same way as the sympathetic nervous system.  Being in the blood stream, it takes a bit longer to stop its effects, and may take some time to calm down again

The sympathetic nervous system also takes in information, mostly concerning pain from internal organs.  Because the nerves that carry information about organ pain often travel along the same paths that carry information about pain from more surface areas of the body, the information sometimes get confused.  This is called referred pain, and the best known example is the pain in the left shoulder and arm when having a heart attack.

The other part of the autonomic nervous system is called the parasympathetic nervoussystem.  It has its roots in the brainstem and in the spinal cord of the lower back.  Its function is to bring the body back from the emergency status that the sympathetic nervous system puts it into.

Some of the details of parasympathetic arousal include some of the following:.

  • pupil constriction and activation of the salivary glands,
  • stimulating the secretions of the stomach and activity of the intestines,
  • stimulating secretions in the lungs and constricting the bronchial tubes, and;
  • decreases heart rate.

The parasympathetic nervous system also has some sensory abilities:  It receives information about blood pressure, levels of carbon dioxide in the blood, etc.

There is actually another part of the autonomic nervous system that is not mentioned too often: the enteric nervous system.  It is a complex of nerves that regulate the activity of the stomach. 

For example, if you get sick to your stomach with a new financial advisory client – or feel nervous butterflies with your first patient encounter as a doctor- you can blame the enteric nervous system.

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On Psychology, Financial Planning and Investing Bias

Psychological Biases Affecting Financial Planning and Investing

Dr. Marcinko at Johns Hopkins University

By Dr. David Edward Marcinko MBA CMP®



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The following are some of the most common psychological biases.  Some are learned while others are genetically determined (and often socially reinforced).  While this essay focuses on the financial implications of these biases, they are prevalent in most areas in life.

[A] Incentives

It is broadly accepted that incenting someone to do something is effective, whether it be paying office staff a commissions to sell more healthcare products, or giving bonuses to office employees if they work efficiently to see more HMO patients.  What is not well understood is that the incentives cause a sub-conscious distortion of decision-making ability in the incented person.  This distortion causes the affected person – whether it is yourself or someone else – to truly believe in a certain decision, even if it is the wrong choice when viewed objectively.  Service professionals, including financial advisors and lawyers, are affected by this bias, and it causes them to honestly offer recommendations that may be inappropriate, and that they would recognize as being inappropriate if they did not have this bias.  The existence of this bias makes it important for each one of us to examine our incentive biases and take extra care when advising physician clients, or to make sure we are appropriately considering non-incented alternatives.

[B] Denial

Denial is a well known, but under-appreciated, psychological force.  Physicians, clients and professionals (like everyone else) are prone to the mistake of ignoring a painful reality, like putting off an unpleasant call (thus prolonging a problematic situation and potentially making it worse) or not opening account statements because of the desire not to see quantitative proof of losses.  Denial also manifests itself by causing human beings to ignore evidence that a mistake has been made.  If you think of yourself as a smart person (and what professional doesn’t?), then evidence pointing to the conclusion that a mistake has been made will call into question that belief, causing cognitive dissonance.  Our brains function to either avoid cognitive dissonance or to resolve it quickly, usually by discounting or rationalizing the disconfirming evidence. Not surprisingly, colleagues at Kansas State University and elsewhere, found that financial denial, including attempts to avoid thinking about or dealing with money, is associated with lower income, lower net worth, and higher levels of revolving credit.

[C] Consistency and Commitment Tendency

Human beings have evolved – probably both genetically and socially – to be consistent.  It is easier and safer to deal with others if they honor their commitments and if they behave in a consistent and predictable manner over time. This allows people to work together and build trust that is needed for repeat dealings and to accomplish complex tasks.  In the jungle, this trust was necessary to for humans to successfully work as a team to catch animals for dinner, or fight common threats.  In business and life it is preferable to work with others who exhibit these tendencies.  Unfortunately, the downside of these traits is that people make errors in judgment because of the strong desire not to change, or be different (“lemming effect” or “group-think”).  So the result is that most people will seek out data that supports a prior stated belief or decision and ignore negative data, by not “thinking outside the box”.  Additionally, future decisions will be unduly influenced by the desire to appear consistent with prior decisions, thus decreasing the ability to be rational and objective.  The more people state their beliefs or decisions, the less likely they are to change even in the face of strong evidence that they should do so.  This bias results in a strong force in most people causing them to avoid or quickly resolve the cognitive dissonance that occurs when a person who thinks of themselves as being consistent and committed to prior statements and actions encounters evidence that indicates that prior actions may have been a mistake.  It is particularly important therefore for advisors to be aware that their communications with clients and the press clouds the advisor’s ability to seek out and process information that may prove current beliefs incorrect.  Since this is obviously irrational, one must actively seek out negative information, and be very careful about what is said and written, being aware that the more you shout it out, the more you pound it in.

[D] Pattern Recognition

On a biological level, the human brain has evolved to seek out patterns and to work on stimuli-response patterns, both native and learned.  What this means is that we all react to something based on our prior experiences that had shared characteristics with the current stimuli.  Many situations have so many possible inputs that our brains need to take mental short cuts using pattern recognition we would not gain the benefit from having faced a certain type of problem in the past.  This often-helpful mechanism of decision-making fails us when past correlations or patterns do not accurately represent the current reality, and thus the mental shortcuts impair our ability to analyze a new situation.  This biologic and social need to seek out patterns that can be used to program stimuli-response mechanisms is especially harmful to rational decision-making when the pattern is not a good predictor of the desired outcome (like short term moves in the stock market not being predictive of long term equity portfolio performance), or when past correlations do not apply anymore.

[E] Social Proof

It is a subtle but powerful reality that having others agree with a decision one makes, gives that person more conviction in the decision, and having others disagree decreases one’s confidence in that decision.  This bias is even more exaggerated when the other parties providing the validating/questioning opinions are perceived to be experts in a relevant field, or are authority figures, like people on television.  In many ways, the short term moves in the stock market are the ultimate expression of social proof – the price of a stock one owns going up is proof that a lot of other people agree with the decision to buy, and a dropping stock price means a stock should be sold.  When these stressors become extreme, it is of paramount importance that all participants in the financial planning process have a clear understanding of what the long-term goals are, and what processes are in place to monitor the progress towards these goals.  Without these mechanisms it is very hard to resist the enormous pressure to follow the crowd; think social media.

[F] Contrast

Sensation, emotion and cognition work by contrast.  Perception is not only on an absolute scale, it also functions relative to prior stimuli.  This is why room temperature water feels hot when experienced after being exposed to the cold.  It is also why the cessation of negative emotions “feels” so good.  Cognitive functioning also works on this principle.  So one’s ability to analyze information and draw conclusions is very much related to the context with in which the analysis takes place, and to what information was originally available.  This is why it is so important to manage one’s own expectations as well as those of clients.  A client is much more likely to be satisfied with a 10% portfolio return if they were expecting 7% than if they were hoping for 15%.

[G] Scarcity

Things that are scarce have more impact and perceived value than things present in abundance.  Biologically, this bias is demonstrated by the decreasing response to constant stimuli (contrast bias) and socially it is widely believed that scarcity equals value.  People who feel an opportunity may “pass them by” and thus be unavailable are much more likely to make a hasty, poorly reasoned decision than they otherwise would.  Investment fads and rising security prices elicit this bias (along with social proof and others) and need to be resisted.  Understanding that analysis in the face of perceived scarcity is often inadequate and biased may help professionals make more rational choices, and keep clients from chasing fads.

[H] Envy / Jealousy

This bias also relates to the contrast and social proof biases.  Prudent financial and business planning and related decision-making are based on real needs followed by desires.  People’s happiness and satisfaction is often based more on one’s position relative to perceived peers rather than an ability to meet absolute needs.  The strong desire to “keep up with the Jones” can lead people to risk what they have and need for what they want.  These actions can have a disastrous impact on important long-term financial goals.  Clear communication and vivid examples of risks is often needed to keep people focused on important financial goals rather than spurious ones, or simply money alone, for its own sake.

[I] Fear

Financial fear is probably the most common emotion among physicians and all clients. The fear of being wrong – as well as the fear of being correct! It can be debilitating, as in the corollary expression on fear: the paralysis of analysis.

According to Paul Karasik, there are four common investor and physician fears, which can be addressed by financial advisors in the following manner:

  • Fear of making the wrong decision: ameliorated by being a teacher and educator.
  • Fear of change: ameliorated by providing an agenda, outline and/or plan.
  • Fear of giving up control: ameliorated by asking for permission and agreement.
  • Fear of losing self-esteem: ameliorated by serving the client first and communicating that sentiment in a positive manner.

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Psychological Traps

Now, as human beings, our brains are booby-trapped with psychological barriers that stand between making smart financial decisions and making dumb ones. The good news is that once you realize your own mental weaknesses, it’s not impossible to overcome them. 

In fact, Mandi Woodruff, a financial reporter whose work has appeared in Yahoo! Finance, Daily Finance, The Wall Street Journal, The Fiscal Times and the Financial Times among others; related the following mind-traps in a September 2013 essay for the finance vertical Business Insider; as these impediments are now entering the lay-public zeitgeist:

  • Anchoring happens when we place too much emphasis on the first piece of information we receive regarding a given subject. For instance, when shopping for a wedding ring a salesman might tell us to spend three months’ salary. After hearing this, we may feel like we are doing something wrong if we stray from this advice, even though the guideline provided may cause us to spend more than we can afford.
  • Myopia makes it hard for us to imagine what our lives might be like in the future. For example, because we are young, healthy, and in our prime earning years now, it may be hard for us to picture what life will be like when our health depletes and we know longer have the earnings necessary to support our standard of living. This short-sightedness makes it hard to save adequately when we are young, when saving does the most good.
  • Gambler’s fallacy occurs when we subconsciously believe we can use past events to predict the future. It is common for the hottest sector during one calendar year to attract the most investors the following year. Of course, just because an investment did well last year doesn’t mean it will continue to do well this year. In fact, it is more likely to lag the market.
  • Avoidance is simply procrastination. Even though you may only have the opportunity to adjust your health care plan through your employer once per year, researching alternative health plans is too much work and too boring for us to get around to it. Consequently, we stick with a plan that may not be best for us.
  • Loss aversion affected many investors during the stock market crash of 2008. During the crash, many people decided they couldn’t afford to lose more and sold their investments. Of course, this caused the investors to sell at market troughs and miss the quick, dramatic recovery.
  • Overconfident investing happens when we believe we can out-smart other investors via market timing or through quick, frequent trading. Data convincingly shows that people who trade most often under-perform the market by a significant margin over time.
  • Mental accounting takes place when we assign different values to money depending on where we get it from. For instance, even though we may have an aggressive saving goal for the year, it is likely easier for us to save money that we worked for than money that was given to us as a gift.
  • Herd mentality makes it very hard for humans to not take action when everyone around us does. For example, we may hear stories of people making significant profits buying, fixing up, and flipping homes and have the desire to get in on the action, even though we have no experience in real estate.

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Your thoughts are appreciated.





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Understanding Apple Requires an Analysis of Fundamentals and Psychology

vitalyBy Vitaliy Katsenelson CFA

So many articles have been written recently about Apple — defending it or explaining why this glorious fruit will turn into a shriveling pumpkin by midnight (with Samsung’s help) — that I really haven’t felt the need to contribute to the unending debate.

But, when Apple’s stock crashed to $450 back in January 2013, we bought a little for our clients. After receiving an outraged e-mail from one of them calling the purchase “irresponsible” and proclaiming that everyone (including his neighbor) knows that Apple is going down to $300, I decided it was time to join the discourse. Clients rarely (almost never) contact us about stocks we own in their accounts. More important, this is far from the most “radioactive” stock we own or have owned.

So, here is a column on Apple, I wrote back then.  I have no intention of defending or prosecuting the company, but I would like to share some thoughts about it that many pundits have either overlooked or ignored.


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The Psychlogy

What makes Apple stock difficult to own is psychology. The company’s success since 2000 is a black swan. We tend to think of Nassim Nicholas Taleb’s black swans as significant random negative events, but Apple is a positive one. When co-founder Steve Jobs came back to the company in the late ’90s, Apple was about to take its last breath. Jobs pulled off a miracle. He revived the company’s computer product line, making Macs exciting again, and then came out with three revolutionary “i” products in a row: the iPod, iPhone and iPad. You could argue that the success of each “i” product in itself was a black swan, exceeding all rational expectations and revolutionizing, transforming and in some cases creating new categories of merchandise that had never existed before.

Revenue and Market Capitalization

Apple’s revenue and market capitalization deservedly surpassed those of almighty Microsoft Corp. — the hairy monster with stinky breath that performed CPR on dying Apple in the late ’90s by injecting liquidity into the company by buying its preferred stock. We have a hard time processing this highly improbable success and an even harder time imagining that there is another black swan about to take flight from the Apple labs, especially with no Steve Jobs around to sit on the egg.

Black swans come out of nowhere, unannounced, but their impact may be long-lasting. The wildly successful “i” gadgets dug a formidable moat around Apple. They created the most valuable and still most inspirational brand in the world, funded an enormous research and development effort, enabled huge buying power (Apple locks up supply and pays much lower prices than many of its competitors for parts), filled out a mature product ecosystem and stuffed Apple’s debt-free balance sheet with $137 billion — half the market capitalization of Microsoft. The moat is wide, deep and unlikely to be breached any time soon.


Ex-Cathedra black swan


High Price

One reason the psychology of owning Apple stock is so difficult: it’s high price. (Note: I am talking not about its valuation but purely about its price.) Apple has had only one stock split since the late ’90s, when it was trading in double digits, and it now changes hands at about $450 (down from $700 just a few months ago). Stock splits create zero economic value in the long run — absolutely none. Apple could split its stock ten to one and you’d have ten $45 shares, and nothing about the company or its business would change. But, I’d argue that a 3 percent “slide” of $1.35 would grab fewer headlines than a $13.50 “drop” — there is a media magnification factor that is hard to ignore.

Hardware versus Software

Is Apple a hardware or a software company? This is a very important question because Apple’s net margins of 25 percent are dangerously higher than those of Microsoft, a software monopoly that, with the minor exception of the Xbox and its new venture into tablets, sells only software, which has a 100 percent incremental margin.

Apple is either a smart hardware company or a software maker dressed in hardware company clothes. Take a look at the PC businesses of traditional “dumb” hardware companies like Dell and Hewlett-Packard Co. (I am not insulting these companies, I am just highlighting their lack of PC-directed R&D.) They buy hard drives from Western Digital Corp., graphic cards from Nvidia Corp., processors from Intel Corp. and an operating system from Microsoft, then they have contract manufacturers put together these parts in Asia and ship PCs all over the world. Dell and HP engineers design the PCs but contribute minimal R&D to their boxes; most of the R&D is done by the suppliers. Dell and HP are really asset-lite marketing and logistics companies — this explains their razor-thin margins. (Side note: Because of a lack of fixed costs, Dell and HP can remain profitable despite the ongoing decline in PC sales.)

Same Surface

On the surface, Apple’s personal computer business is not that much different from Dell’s or HP’s: It uses the same highly commoditized hardware and it also outsources manufacturing, but Apple spends much more on the R&D of its own operating system and creates distinctive, innovative products. Apple gets to keep a slice of revenue that would otherwise go to Microsoft for the operating system. Also, Apple is able to charge a premium (usually a few hundred dollars per PC) for the aesthetic appeal and perceived ease of use of its products.

However, when it comes to the “i” devices, Apple is a much smarter hardware company; its value added goes further than just basic design and software. Though there is a lot of commoditized hardware that goes into an iPhone or iPad, Apple’s skill at fitting an ever-growing number of components into ever-shrinking devices constantly increases. Add world-class touch and feel, superior battery life and durability, and you have a package that turns what would otherwise be commodity items into highly differentiated, and undeniably sexy, products. Apple has even gone a step further and is designing its own microprocessors.

But — and this is a very important “but” — as phones and tablets mature, processor speed, battery life and weight will tend to become uniform across all devices. It is arguable that the competition has already caught up with Apple in the hardware race. As the hardware premium goes away, there will be only two premiums left: Apple’s brand and its ecosystem. (I will go into detail about the “i” ecosystem and what it means for Apple’s margins and profitability in my second essay posted below).

Note that I did not mention the software premium. Unlike Microsoft, which charges for the Windows operating system installed on PCs, Google gives away Android to anyone who dares to make a phone or a tablet. Unless Apple can maintain the operating system lead against Android, that premium will go away.


Recently, I spent a few days playing with Nexus 7, Google’s Android-powered 7-inch tablet, which retails for $200 ($130 cheaper than Apple’s iPad mini). Nexus 7 is a good product, but I kept remembering that humans and monkeys share 98 percent of their DNA, and the Android operating system is missing the 2 percent that makes Apple iOS so special.


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How Much Would You Pay for the Apple Ecosystem?

Apple’s ecosystem is an important and durable competitive advantage; it creates a tangible switching cost (or, an inconvenience) after Apple has locked you into the i-ecosystem. It takes time to build an ecosystem that consists of speakers and accessories that will connect only via Apple systems: Apple TV, which easily recreates an iPhone or iPad screen on a TV set; the music collection on iTunes (competition from Spotify and Google Play lessens this advantage); a multitude of great apps (in all honesty, gaming apps have a half-life of only a few weeks, but productivity apps and my $60 TomTom GPS have a much longer half-life); and, last, the underrated Photo Stream, a feature in iOS 6 that allows you to share photos with your close friends and relatives with incredible ease. My family and friends share pictures from our daily lives (kids growing up, ski trips, get-togethers), but that, of course, only works when we’re all on Apple products. (This is why Facebook bought Instagram for $1 billion. Photo Stream is a real competitive threat to Facebook, especially if you want to share pictures with a limited group of close friends.)

The i-ecosystem makes switching from the iPhone to a competitor’s device an unpleasant undertaking, something you won’t do unless you are really significantly dissatisfied with your i-device (or you are simply very bored). How much extra are you willing to pay for your Apple goodies? Brand is more than just prestige; it is the amalgamation of intangible things like perceptions and tangible things like getting incredible phone and e-mail customer service (I’ve been blown away by how great it is!) or having your problems resolved by a genius at the Apple store.

Of course, as the phone and tablet categories mature, Apple’s hardware premium will deflate and its margins will decline. The only question is, by how much?

Let me try to answer

From 2003 to 2012, Apple’s net margins rose from 1.1 percent to 25 percent. In 2003 they were too low; today they are too high. Let’s look at why the margins went up. Gross margins increased from 27.5 percent to 44 percent: Apple is making 16.5 cents more for every dollar of product sold today than it did in 2001. Looking back at Nokia Corp. in its heyday, in 2003 the Finnish cell phone maker was able to command a 41.5 percent margin, which has gradually drifted down to 28 percent.

Today, Nokia is Microsoft’s bitch, completely dependent on the success of the Windows operating system, which is far from certain. Nokia is a sorry shell of what used to be a great company, while Apple, despite its universal hatred by growth managers, is still, well, Apple. Its gross margins will decline, but they won’t approach those of 2003 or Nokia’s current level.

For Apple to conquer emerging markets and keep what it has already won there, it will need to lower prices. The company is not doing horribly in China — its sales are running at $25 billion a year and were up 67 percent in the past quarter.

However, a significant number of the iPhones sold in China (Apple doesn’t disclose the figure) are not $650 iPhone 5’s but the cheaper 4 and 4s models. (Also, on a recent conference call, Verizon Communications mentioned that half of the iPhones it has sold were the 4 and 4s models.) Apple’s price premium over its Android brethren is not as high as everyone thinks.

What is truly astonishing is that Apple’s spending on R&D and selling, general and administrative (SG&A) expenses has fallen from 7.6 percent and 19.5 percent, respectively, in 2003 to a meager 2.2 percent and 6.4 percent today. R&D and SG&A expenses actually increased almost eightfold, but they didn’t grow nearly as fast as sales. Apple spends $3.4 billion on R&D today, compared with $471 million in 2001. This is operational leverage at its best. As long as Apple can grow sales, and R&D and SG&A increase at the same rate as sales or slower, Apple should keep its 18.5 percentage points gain in net margins through operational leverage.



Growth of sales is an assumption in itself. Apple’s annual sales are approaching $180 billion, and it is only a question of when they will run into the wall of large numbers. At this point, 20 percent-a-year growth means Apple has to sell as many i-thingies as it sold last year plus an additional $36 billion worth. Of course, this argument could have been made $100 billion ago, and the company did report 18 percent revenue growth for the past quarter, but Apple is in the last few innings of this high-growth game; otherwise its sales will exceed the GDP of some large European countries.

If you treat Apple as a pure hardware company, you’ll miss a very important element of its business model: recurrence of revenues through planned obsolescence. Apple releases a new device and a new operating system version every year. Its operating system only supports the past three or four generations of devices and limits functionality on some older devices. If you own an iPhone 3G, iOS 6 will not run on it, and thus a lot of apps will not work on it, so you will most likely be buying a new iPhone soon. In addition — and not unlike in the PC world — newer software usually requires more powerful hardware; the new software just doesn’t run fast enough on old phones. My son got a hand-me-down iPhone 3G but gave it to his cousin a few days later — it could barely run the new software.

As I wrote above, Apple’s success over the past decade is a black swan, an improbable but significant event, thanks in large part to the genius of Steve Jobs. Today investors are worried because Jobs is not there to create another revolutionary product, and they are right to be concerned. Jobs was more important to Apple’s success than Warren Buffett is to Berkshire Hathaway’s today. (Berkshire doesn’t need to innovate; it is a collection of dozens of autonomous companies run by competent managers.) Apple will be dead without continued innovation.

Jobs was the ultimate benevolent dictator, and he was the definition of a micro-manager. In his book Steve Jobs, Walter Isaacson describes how Jobs picked shades of white for Apple Store bathroom tiles and worked on the design of the iPhone box. He had to sign off on every product Apple made, down to and including the iPhone charger. His employees feared, loved and worshiped him, and they followed him into the fire. Jobs could change the direction of the company on a dime — that was what it took to deliver black i-swans. Jobs is gone, so the probability of another product achieving the success of the iPhone or iPad has declined exponentially.


Steve Jobs RIP


What is really amazing about Apple is how underwhelming its valuation is today — it doesn’t require new black swans.

In an analysis we tried very hard to kill the company. We tanked its gross margins to a Nokia-like 28 percent and still got $30 of earnings per share (the Street’s estimate for 2013 is $45), which puts its valuation, excluding $145 a share in cash, at 10 times earnings. We killed its sales growth to 2 percent a year for ten years, discounted its cash flows and still got a $500 stock.

There is a lot of value in Apple’s enormous ability to generate cash. The company is sitting on an ever-growing pile of it — $137 billion, about one third of its market cap. Over the past 12 months, despite spending $10 billion on capital expenditures, Apple still generated $46 billion of free cash flows. If it continues to generate free cash flows at a similar rate (I am assuming no growth), by the end of 2015 it will have stockpiled $300 of cash per share. At today’s price [2013] it will be commanding a price-earnings ratio (if you exclude cash) of 4.

Of course, the market is not giving Apple credit for its cash, but I think the market is wrong. Unlike Microsoft, which does something dumber than dumb with its cash every other year, Apple has a pristine capital allocation track record. It has not made any foolish acquisitions — or, indeed, any acquisitions of size. Other than buying an Eastern European country and renaming it i-Country, Apple will not be able to acquire a technologically related company of size, nor will it want or need to. The cash it accumulates will end up in shareholders’ hands, either through dividends or share buybacks.

What is Apple worth?

After the financial acrobatics I’ve done trying to murder the valuation of Apple, it is easier to say that it is worth more than $450 than to pinpoint a price target. When I use a significantly decelerating sales growth rate and normalize margins (reducing them, but not as low as Nokia’s current margins), I get a price of about $600 to $800 a share.

Growth managers don’t want Apple to pay a large dividend, as though that would somehow transform this growing teenager into a mature adult. But I have news for them: Apple already is a mature adult. Second, when your return on capital is pushing infinity (as Apple’s is), you don’t need to retain much cash to grow. Two thirds of Apple’s cash is offshore, but that doesn’t make it worthless; it just makes it worth less — only $65 billion, maybe, not $97 billion, once the company pays its tax bill to Uncle Sam.





In the short term none of the things I am writing about here will matter. Remember, “Everyone knows Apple is going to $300,” as a client recently e-mailed me, as everyone knew it was going to a $1,000 a few months ago when Apple’s stock was trading at $700. The company’s stock will trade on emotion, fundamentals will not matter, and growth managers will likely rotate out of Apple, because once the stock declined from $700 to $450, the label on it changed from “growth” to “value.”

But ultimately, fundamentals will prevail. Like the laws of physics, they can only be suspended for so long. And so, do these retrospective thoughts on Apple hint of future prospects?

More: Should You Buy Apple Stock Ahead of Its September Event


Vitaliy N. Katsenelson CFA is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley 2007) and The Little Book of Sideways Markets (Wiley, 2010).  His books were translated into eight languages.  Forbes Magazine called him “The new Benjamin Graham”.  


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