In a previous discussion, I wrote about potential reasons why Apple Inc. (AAPL, Financial) is missing from the permanent holding list for Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway(BRK.A, Financial)(BRK.B, Financial). Shortly after publication, the insurance conglomerate reported that it cut its stake in the tech giant by about 13% during the first quarter.
This 13% cut is the second quarter in a row that Buffett has trimmed Berkshire's massive Apple position. The company also sold about 1% of its Apple position during the fourth quarter of 2023. Berkshire's first-quarter sale marked its largest cut in Berkshire's Apple stake since the initial purchase in 2016. I believe Buffett is very likely to continue to sell down the Apple stake over the next several quarters and years for a few reasons.
Tax rate hike concerns
When asked about the Apple sale during the annual meeting, Buffett said the following:
"Almost everybody I know pays a lot more attention to not paying taxes than I think they should. We don't mind paying taxes at Berkshire, and we are paying a 21% federal rate on the gains we're taking in Apple and that rate was 35% not too long ago, and it's been 52% in the past when I've been operating……It doesn't bother me in the least to write that check and I would really hope that with all that America has done for all of you, it shouldn't bother you that we do it and if I'm doing it at 21%, and we're doing it at a lot higher percentage later on, I don't think you'll actually mind that we sold a little Apple this year.”
Essentially Buffett said that he is selling Apple now because the capital gains tax rate is at a very low level and he thinks the capital gain tax rate may rise in the future due to the growing budget deficit. Here the guru is again subtlety insinuating that the company is not a permanent holding for Berkshire Hathaway because if it doesn't consider selling Apple at all, then the tax rate does not matter.
Peak valuation and margin concerns
Apple's current valuation, driven by years of strong performance, has reached a peak level. The following chart shows Apple's price-to-owner earnings, price-sales and price-book ratios all reached peak levels.
Not only is Apple's valuation at peak level, its margin expansion, which is driven by both improving operational efficiency and higher contribution from higher-margin service revenue, may also have reached its peak, leaving little room for future margin expansion.
Apple's potential peak margin, combined with the possible slowdown in the growth rate of the smartphone business and the heightened competition from Huawei, suggest revenue and earnings may struggle to sustain the impressive growth rate achieved in recent years. In fact, we have already noticed a slowdown in recent quarters. It has yet to be seen whether the hype surrounding Apple Intelligence, the company's version of artificial intelligence, will materially boost the sales of the next generation of iPhones.
Diminishing return from capital allocation
CEO Tim Cook started Apple's share buyback program in 2013. Since then, the company has repurchased $651 billion worth of its common stock, reducing its share count by 11 billion shares, or roughly 41% of its outstanding shares. From 2013 to 2019, Apple's stock was very cheap, making the stock repurchases extremely value-additive.
The stock got cheap again for a short period of time during 2020 and 2022. However, as I pointed out above, at the present market price, Apple's valuation has reached peak level. At this level, stock buybacks are very unlikely to be the best way to allocate capital. Nonetheless, share repurchases remain Apple's largest capital allocation option. Therefore, its return from capital allocation is almost guaranteed to decline from what it has been over the past decade.
Cook's potential retirement
Buffett has repeatedly cited Cook's leadership as a major reason for his investment decision. Cook has proven that he possesses the rare skillset of both operational excellence and outstanding capital allocation capability.
Cook is turning 64 in November. By Berkshire's standard, he is far from retirement age. However, the CEO himself has publicly said he will not stick around for many years. Concerns over Cook's retirement first emerged in 2021 when he said he "will probably be leaving Apple in the next 10 years,” A recent report from Bloomberg wrote that “people close to him” believe Cook will be Apple's CEO for “at least another three years.”
As I wrote in my previous discussion, Apple is not an idiot-proof business. Cook's potential retirement may not be imminent, but Buffett must be thinking about it.
Conclusion
Given the uncertainties surrounding capital gains tax rates, concerns about Apple's peak valuation and peak margin, diminishing returns from capital allocation and the potential retirement of Cook, it is extremely likely that Berkshire Hathaway will continue to trim its massive position in Apple. We will find out over the next few quarters.
