Apple vs. Microsoft vs. Treasury bonds: battle for safe havens

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Introduction

Today, Apple (NASDAQ: AAPL) and Microsoft (NASDAQ: MSFT) are two of the most dominant tech titans on the face of this planet, and it’s only fitting that they happen to be two of the biggest companies across the globe. based on market capitalization. Due to incredible business moats, solid financial performance, strong balance sheets, and huge return on capital programs, Apple and Microsoft have established themselves as safe-haven investments in the minds of retail and institutional investors.

Apple vs. Microsoft by Market Cap

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Although Apple and Microsoft have been fantastic wealth builders over the past decade, they are unlikely to repeat the feat in the next decade. Over the long term (5-10 years), I expect Apple and Microsoft to deliver CAGR returns of around 10-12% similar to the market (SPY). However, I don’t think these safe havens are safe in the medium term (2-3 years). Why?

  • Starting Ratings: In 2012, Apple was trading at a P/E ratio of around 14x, and Microsoft was trading at a P/E ratio of around 12x. Today, Apple and Microsoft are trading at a P/E ratio of around 28-30x.
Apple vs. Microsoft: PE report

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  • Given the fundamentals of the business, I think these premium trading multiples are probably deserved. After all, Apple and Microsoft are highly profitable companies with strong track records of revenue and profit growth.
Apple vs. Microsoft: revenue and gross margin

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That being said, there is absolutely no room for multiple expansion (which has been a massive driver of outsized returns in the past).

  • Slowing of growth: After decades of sales growth, Apple and Microsoft have reached huge revenue bases. Despite clear dominance in their respective usable markets, future growth rates are likely to be lower than past growth rates. The coronavirus pandemic has boosted demand (and growth rates) for Apple and Microsoft. While these companies would continue to experience secular tailwinds, the surge in demand could dampen sales growth in the coming quarters. Also, high inflation could start hurting margins (profitability).
Apple vs. Microsoft: Estimated revenue growth for the current fiscal year

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  • Redemptions become ineffective: At high valuations, Apple’s and Microsoft’s buyback programs become less effective in increasing FCF per share (stock price). Both Apple and Microsoft have strong balance sheets and free cash flow generation; therefore, I continue to view them as infinite redemption pumps. However, these redemptions may not be sufficient to defend trading multiples in a rising interest rate environment.
Apple vs. Microsoft: Liquidity and short-term investments, free cash flow and share buybacks

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  • Rising interest rates: A slowdown in growth combined with a rise in interest rates could trigger a reversion to the mean of stock market multiples. As Warren Buffett of Berkshire Hathaway (BRK.B) said – “Interest rates are like gravity to asset prices.” Since I view soaring interest rates as the biggest downside threat to Apple and Microsoft, I’d like to discuss this topic in more detail.

The yield curve looks worrying

In early April, we saw an inversion of the yield curve (the 10-2 year treasury yield spread turned negative), which is seen as a sign of an impending recession. Although recent periods of recession have been preceded by yield curve inversions, not all yield curve inversions lead to recessions. And so, nothing is guaranteed. However, we could very well be in the tail end phase of this economic cycle and economic growth could slow in the coming quarters.

Treasury rate 2 years, 10 years

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Both Apple and Microsoft operate in the midst of multiple secular growth trends, but a recession could also hurt their growth expectations. I understand the logic (robust FCF generation and strong balance sheets) behind the perception of Apple and Microsoft as safe-haven investments during times of heightened uncertainty. However, soaring yields could change this perception very quickly, simply due to the immutable laws of money.

Mean reversion could cause investors a lot of pain

So far in 2022, Apple is down around 7% and Microsoft around 17%. Are these safe havens ready to join the bear market in tech (and growth) stocks? And if so, why ?

% price change Apple vs Microsoft

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Apple and Microsoft’s business fundamentals have never been stronger. However, their evaluations are quite rich. As Treasury yields soar, Apple and Microsoft are becoming less attractive to investors seeking safety from decades-high inflation and the growing threat of an economic recession. The 2 year old [2.5%]10 years [2.9%]and 30 years [3%] Treasuries hit three-year highs, which is enough to change the math for investors. If the risk-free rate rises to 3.5-4%, why would a sensible investor buy Apple or Microsoft at FCF yields below the risk-free rate?

2-year Treasury rate

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Apple Free Cash Flow Yield and Microsoft Free Cash Flow Yield

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The last time 2-year Treasury rates were at 2.5%, Apple and Microsoft offered FCF yields of 6% and 3.5%, respectively. Today, Apple offers 3.7% and Microsoft offers 2.8%. The risk premium here is too low, and if growth were to slow down, the probability of a reversion to the mean would be very high.

Throughout the 2010s, Apple and Microsoft traded at P/E ratios of 10x to 30x. Today, Apple and Microsoft are trading at the high end of this range, and if we were to see an average return to, say, ~15x P/E, we could be looking at around a 40-50% drop on both Apple and Microsoft. Now, that’s not my baseline scenario, and I think high-quality companies like Apple and Microsoft deserve a premium. However, I’m looking at the Meta P/E of ~15x, then downside risk is impossible to ignore.

Apple Pe Report

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In my view, investors are not fairly compensated for the short to medium term downside risk of Apple and Microsoft. In the long run, I think Apple and Microsoft could deliver double-digit returns to shareholders. However, they may not serve as a medium-term safe haven. In summary, taking 40%-50% downside risk in exchange for 10-12% CAGR returns does not appeal to me as an investment. So where do we deploy capital in this environment?

For starters, Treasury bonds are not the way to go. With very negative real yields, bonds are simply uninvestable. Period

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Inflation has been at multi-decade highs, and my followers know that I’ve forecast “higher inflation for longer” as the Fed’s most likely path since late 2021. So maybe should investors buy defensive stocks?

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Unfortunately, this boat sailed far too far from shore to board. Defensive “value” names like Costco (COST), Walmart (WMT), Chevron (CVX) or UnitedHealth (UNH) are all trading well above their historical averages. Markets are looking to the future and there is no way we will make money over the next 3-5 years buying Costco at ~48x P/E.

Final Thoughts

In this hunt for safe haven, there is really no good alternative among investments widely perceived as safe. Cash is rapidly losing value due to high inflation of around 8.5% over several decades, so it’s not an option. As we have seen, bonds always generate negative real returns, which makes them uninvestable. Defensive value stocks offer no value. And perennial safe havens like Apple and Microsoft have 40-50% downside potential. How does an investor deploy capital in this challenging market environment?

I believe the best investment opportunities to generate alpha and beat inflation are available in the high-growth tech space. Our strategy is to invest in fast-growing small-cap companies operating at the heart of secular growth trends, as these stocks could be big winners going forward, regardless of economic factors. And there hasn’t been a better time to buy these stocks in the past two years.

Here are my top ideas for 2022:

  • My Top 5 Stock Ideas for 2022

and a recent update on these ideas:

  • Down 40%, but I’m doubling down on my best stock ideas for 2022

If you want to know more about my view of the macroeconomic environment and my logic for buying fast-growing small companies in this market, please read the following notes:

  • Inflation hits 7%, but the Fed is stuck between a rock and a hard place
  • Don’t try to rationalize Mr. Market’s irrationality, use it to your advantage

In the battle for safe havens, there is currently no winner. Apple and Microsoft are both decent long-term investments, but I think the potential downside risk isn’t built into their current prices. With negative real yields, treasury bonds are simply uninvestable. Although Apple and Microsoft give investors a sense of security, I don’t see them as safe havens at current valuations. Therefore, I am not deploying fresh capital into these stocks. If you are determined to find a safe haven for the next 2-3 years, I recommend looking at Meta (FB).

Takeaway key: I rate both Apple and Microsoft as Hold at current levels. Since real returns are negative, treasury bills cannot be invested.

Thanks for reading and happy investing. Please share your thoughts, questions and/or concerns in the comments section below.

About Troy McMiller

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