It looks like I just I cannot stay away from the Apple story, with Tim Cook making a splash (or a belly flop) with his speech in New York yesterday and David Einhorn's proposal coming in for scrutiny from investors and the press. This article in the New York Times DealBook does a pretty good job of summing up the proposal and its underlying thesis, and I was surprised to see my name mentioned, with Mr. Einhorn quoted as having said that my analysis "brings to memory the old joke about the economist who refused to pick up a $100 bill on the street because in an efficient economy, there can’t be $100 bills lying around.†I am flattered that I was even part of this conversation, given that Mr. Einhorn has probably never heard of me nor read my thoughts about market efficiency. I am also grateful that this was all he said about me, because I have been accused of far worse than ignoring hundred dollar bills on the floor. (Just take a look at the comment section of my prior blog posts). My motives for this post are not defensive but I do have a weakness of not being able to let an analogy go, especially when it can be used to good effect. So, at the risk of being labeled an egghead, here is what I think about hundred dollar bills on floors.
Location, location, location: Is it possible that you could find $100 bill on the street? Sure, but you have to get very lucky and the likelihood that you will find one is also going to vary depending on what street you are walking on. Your odds are probably better on Rodeo drive in Los Angeles, where there are wealthy shoppers and relatively few pedestrians (since no one in LA walks more than a block) than on a busy street in New York, where there are literally thousands of people, most of who don't have hundred dollar bills, walking with you.
Apple is one of the most highly followed, most talked about stocks in the world and is more like Penn Station in New York City than Rodeo Drive. I have gone through through Penn Station twice every week day, on my commute, for the last 20 years and have never found a hundred dollar bill on the floor. In fact, I don't think I have even found a twenty. I have found a few dollar bills, several quarters, lots of dimes and thousands of pennies. It is entirely possible that this is because I am a finance professor and am blinded by my belief in efficient markets, but most of the readers of this blog are not. So here are my questions for you: Have you ever found a hundred dollar bill on the floor? How about a twenty dollar bill? Do you find a lot of these? (If so, could you please let me know the street that you walk on... I am willing to relocate... Incidentally, I put this question to my class of 400 today and there were three people who said that they had found $100 bills on the ground. Two of them were in bars at the time. There is a great analogy in here for investors but I am afraid to even go there.... So, I will leave it to your imagination....)
There is a cost to looking for "free" money: Perhaps, Mr. Einhorn's point is that those of us who have never found hundred dollar bills on the floor have just not been looking, but there are people who do and I am not sure that it is a lucrative enterprise. Using the Penn Station analogy again, there are still a few public phones left in the station, and every day as I walk through, I see people doing the phone scan, where they check the change alcove for money that callers have left behind. Could you make money doing this? I guess so, but it depends upon how much value you attach to your time.
And watch your back pocket: I have spent more of my life now in New York City than any other part of the world, and I guess that some of the native New Yorker has rubbed off on me. If I did see a hundred or twenty dollar bill on the floor in front of me, my scam detection antenna goes into high alert. From experience, I know that when something in this city looks like easy money, there is a catch. In this particular case, I would not be surprised to find out when I bend to pick up the "free" hundred dollar bill that it is (a) a fake bill and (b) that my back pocket will be picked while I am bending over.
Don't build expectations around luck: If I did find a hundred (or even a twenty) dollar bill on the floor and I felt safe enough to lean over and pick it up, I would feel "lucky" that I found it, but I would not mistake serendipity for skill. I would certainly not build my household budget on the assumption that I will find not one but three hundred dollar bills on the floor every month in Penn Station. That would be not only foolhardy but a recipe for a unbalanced budget.
I have nothing personal against Mr. Einhorn, other than the standard New York lament that he is a Mets fan and not a Yankee fan. I have agreed with him more often than not and shared his disdain for the over-the-top assumptions that analysts were making for companies like Green Mountain Coffee. In fact, I will offer an argument for Mr. Einhorn's proposal that I think is more substantive than any that I have heard made yet. His suggestion that Apple issue preferred stock to its common stockholders is built on the presumption that, with interest rates at historic lows, there is a void in the market now for investors (perhaps institutions that need the cash and get a break on taxes on preferred dividends) who would like to make a reasonable return on a safe investment. The assumption is that these investors will pay a premium (over and above "fair" value, given the risk of the cash flow) for the 4% preferred stock that Apple will issue, and that common stockholders will capture this premium (by selling the preferred shares that they are granted by Apple to these "premium paying" investors). That is not an unreasonable argument, but my skepticism is based on two considerations. The first is that if this is true, we should be able to see the evidence in the preferred stock market, where preferred stock issued by companies that have solid balance sheets and substantive cash flows should be trading at premium prices. Is that happening? I don't know, but if Mr. Einhorn wants to make his case stronger, he should present evidence of the phenomenon, perhaps by comparing preferred dividend yields to earnings yields on common stock and corporate bond spreads.
The second is the question of scalability. It is possible that Apple's common stockholders may be able to capture some of this premium with the first $50 billion of preferred stock issue, but will the premium persist as the issue gets scaled up to $100 billion or to $430 billion? I don't think it will, but I remain willing to be persuaded otherwise, and the onus is on Mr. Einhorn to provide the justification. In fact, much of the noise around this proposal comes from the misconception that a company can choose both the face value of its preferred stock and the dividend yield. If Apple issues $500 billion (face value) in preferred stock and sets the dividend yield at 4%, that preferred stock will not have a market value of $500 billion.
I started this post with the note that Tim Cook was in San Francisco yesterday, delivering a speech to a conference. Listening to what he said, I was reminded of why I continue to be frustrated with Apple's management. First, I don't think any CEO should be labeling a proposal by one his leading stockholders as a "silly sideshow", even if he disagrees with that plan. (Correction: As some of you have noted, Mr. Cook labeled the lawsuit as a silly sideshow, and not the proposal itself. A little more palatable, but Einhorn has the right to sue and Apple has the right to show, in court, that the lawsuit is frivolous and get it thrown out... ) Second, Mr. Cook made a highly publicized speech and told investors nothing of substance. I know that he dropped nuggets of information that may or may not be useful to investors, but talking about how much more money Apple will pay developers next year is the equivalent of a dinner party host with an elephant in the dining room talking to his guests about the the quality of the place settings. At the moment, investors in Apple are centered on the $137 billion in cash that the company has accumulated, and continues to add to, and they want to know what Apple's plans are for that cash. I am sure that Tim Cook has plenty of well paid consultants, giving him advice, but I will offer mine for free, knowing that it will be ignored. Mr. Cook, if you have nothing of substance to tell investors, it is best that you not talk at all, because if you do make more speeches like the one you delivered yesterday, you will more damage than good (as the market response showed)!
Returning to my central theme, what would I do if found a hundred dollar bill on the floor? First, I will check my surroundings to make sure that I am not the sucker in a con game, and I will then bend down and pick it up. Second, I hope (to be ethical is easy in the abstract, much more difficult in practice..) that I will remember what my mother taught me and look to see if I can find the legitimate owner of that cash. If I do not, I will think of it as my lucky find and treat it accordingly. I will, however, not spend the following days searching for hundred dollar bills on the floor, nor will I build my investment portfolio on the assumption that I will keep finding more free money on the floor.
(Aswath Damodaran is a professor of finance at the Stern School of Business at NYU.)
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