How does Apple’s Growth Alter Valuations of Other Investments?
Apple is the largest company in the world based on market capitalization. Their great run over the past few years has many investors giddy, speculating over how they will deploy their cash hoard. But there is one side effect to this explosive growth that some investors may not be aware of: the risk of over-concentration. Many indices and ETFs calculate their holdings based on the market capitalization of companies. Given Apple’s recent growth, the weighting of popular ETFs may surprise some investors.
that’s a complicated way of saying: The meteoric rise of Apple means it represents a larger portion of ETFs and market indices than some investors might realize. One of the most basic tenets of investing is portfolio diversification. Some investors who think they are following that edict will be surprised to learn that Apple still dictates how these “diversified” investments perform. One example: over 17% of the very popular spdr technology sector ETF (ticker XLK) is invested in Apple. Should something terrible happen to Apple, the XLK would be disproportionately effected. Conversely, if Apple continues to rocket higher, XLK will climb too. An investor is certainly more diversified holding XLK instead of shares of Apple. But if she owns Apple and thinks, “I need to add some diversity. I’ll add XLK,” she may not realize how much more Apple she is adding to her portfolio.
Why is over-concentration a bad thing? When you are managing your portfolio it is a cardinal sin to invest everything into one company. Should something happen to that company, think BP’s Deepwater Horizon or Exxon Valdez or the sub-prime mortgage market taking down Bank America, GE and many, many others, your portfolio could be in tatters, worth only a fraction of what it was the previous week. When things go bad, it happens really quickly and there is no way to take it back. So the best way to prevent this from happening is to diversify. Buy quality companies in different areas of the economy. If you really like one sector, buy several companies within that sector. The point is, spread your money around so your portfolio is not relying on one company to do all the work.
Is the risk that Apple could collapse really so bad? Apple seems to have a stranglehold on the tablet market and continues to gain share with its macbook air. The iPhone is a favorite, as is the iPod. And they are working on new products. (eg google “apple tv”) None of these products seems likely to lose their luster. Apple can not make them fast enough. They have dedicated consumers who will wait in line for hours to be the first to acquire some new gadget. But it is lonely at the top. Everybody is gunning for them. Samsung and HTC are creating new phones that look awesome. At some point the well of new ideas will run dry. Expectations will reach unattainable levels. And people will have enough devices that demand will slow. Apple is not disappearing tomorrow, but there is a case to be made it will some day.
I guess what I’m trying to say is not IF, but WHEN. Given that we can surmise Apple will at some point in the future fail to live up to expectation and decline, we should be weary of loading up our portfolios with ETFs that heavily rely on Apple; especially if you already own shares of Apple directly. The last 24 months have seen Apple’s share price increase by nearly $350. It might be time to take some of those gains and look for other investment opportunities.
Osborne Hazel
tacwos 
Interesting thoughts, and I agree.
Apple’s price is not determined by average investors any longer. The ETF computers determine it. When it falls from #1 to #2 in S&P500, the the ETF’s will rebalance, sell some & the price will change.
What is an spdr or an ETF?
An ETF (exchange traded fund) is like a mutual fund that trades on the stock market, so you can buy and sell it rapidly. A SPDR is a brand of ETF that tracks the S&P 500. So if the S&P 500 changes, a SPDR changes its allocation.
I’d add that Apple is an interesting example because the have a forward PE of like 10, are growing 30% YoY, have more cash than a small country, and are the strongest brand in the world. If I could only pick one stock, Apple would be the one. I think the only thing that will catch up with them is a Steve Jobs-less product pipeline in about 5 years.
Thanks everybody for the comments. As I tend to be an argumentative person I would point out that i don’t think “average investors” determine the prices of any stocks. Or maybe I have a different definition of average investor?
A small correction to Marc’s comment: SPDR is actually a company that manages several different ETFs. One of the most popular ETFs in the world, SPY, tracks the S&P 500. But they have several others that track specific sectors (eg XLK, which i referenced above, follows tech) or other indices. You can find the full list here: https://www.spdrs.com/product/index.seam
Marc is 100% correct that ETFs are like mutual funds in that they both hold a large number of securities providing diversification. The main difference is the way they are managed. Mutual funds are “actively” managed, that is, they have people who make decisions what and whether to buy and sell, while ETFs are “passively” managed. Meaning ETFs simply track an index or a sector. There is no thought (well at most, very little) that goes into what to buy or sell. This type of management means it is much cheaper to invest in. And the icing on the cake? ETFs, in the long run, tend to match or outperform most mutual funds.
Maybe I should turn this discussion into a post? Thanks again for the comments!
Thanks Oz, managed ETFs are on their way… WisdomTree is one of the leaders.
In the short run price is where supply meets demand on that dumb econ 101 curve. Institutional investors, which own most stocks, are the largest component of that. But in the long run, stock prices always approach the fair value of the company. Otherwise the company would be acquired, taken private, etc, because the company is worth more than the stock price.