mobile-bannertablet-bannerdesktop-banner

Warren Buffett Could Be Wrong About Apple

Feb 16, 2017

Warren Buffett just astounded the investment world by welcoming Apple into his exclusive club of favored stocks. For decades, the Oracle of Omaha has stuck mainly to what he knows best, blue-chip banks and great consumer brands such as Wells Fargo, Coca-Cola, and Kraft Heinz, and mainly shunned the churning, science-driven field of technology.

According to most analysts and pundits, Buffett's enormous bet on Apple makes perfect sense. Apple (aapl), they argue, is the epitome of what he covets, a deep value stock offering strong earnings power at a bargain price.

But does Apple really fit the Buffett profile? To find out, let's take a deep dive into the numbers.

Buffett began accumulating Apple shares in early 2016. The gigantic purchases, however, came in the fourth quarter of last year, when his holding company, Berkshire Hathaway (brk.a), more than tripled its stake to 57.4 million shares, making Apple one of Berkshire's top ten investments. Although the exact prices Berkshire paid in the fourth quarter are unknown, Buffett displayed quicksilver timing: Apple's shares have surged 19.5% since Sept. 30 to a record price of over $36, lifting its market cap to $710 billion, an increase of $115 billion. That gain alone equals the total market value of America's four major airlines, American Airlines, United Continental, Delta and Southwest, all of which Buffett has also been eagerly buying of late.

Buffett may like Apple because it's clearly evolved from a growth play into a value stock, meaning that for every dollar you pay for its shares, you get a rich helping of earnings. For the four quarters ended Dec. 31 (Apple's fiscal year ends in September), Apple posted $45.1 billion in earnings. So its price-to-earnings ratio is a modest 15.7, well below the S&P average of well over 20. Keep in mind that Apple's P/E was a lot lower, as low as 11 in fact, during the period when Buffett was first buying it in early-to-mid-2016.

Apple's earnings, however, aren't growing. It made $41.7 billion in calendar 2012, meaning that profits have waxed just 2% a year since then, matching inflation. And its profits actually fell 16% from calendar 2015 to 2016. Apple is essentially acknowledging that it doesn't have new places to invest. For fiscal 2016, it paid out over 100% of its profits in dividends and buybacks rather than plowing billions into plants and products to drive future growth.

Given its plodding record, and low prospects, for future growth, Apple probably deserves its low multiple. Its current P/E translates to an earnings yield—the inverse of the P/E—of 6.4%. That's how much investors are expecting Apple to pay them each year. Think of that return like the interest payment on a bond, except adjusted for inflation, since Apple's prices will rise at least with the CPI.

Adjusted the number for, and you have an expected return of 8.4%.

Is that expected return realistic for the iPhone maker. Not quite. Apple has a dividend yield of 1.7%. That's part of its expected return. The rest has to come from earnings increases, and a little bit from inflation, for a total of 6.7%. If Apple's profits do expand at 6.7% for the next six years, it will boast profits of $66 billion at the start of 2023, up from nearly $46 billion in its last fiscal year. Remember, Apple's earnings have been falling lately.

The first problem: Even if it manages to hike profits almost 7% a year, and that means adding $3 billion next year, and almost $5 billion annually by around 2023, investors will only get a 8.4% return. That's far from the double-digit gains Buffett usually pockets.

Second, Apple is essentially a one-product company in a highly competitive market. Almost two-thirds of its sales flow from the iPhone, and sales of the smartphone dropped 12% in fiscal 2016.

Indeed, part of the excitement around Apple's stock is the new iPhone that will be out later this year. But it's unclear what other products are rising in Apple's labs. Given Apple's size, new iPhones alone are not likely to boost profits in the 7% range going forward. And with Amazon and Google moving into the personal AI technology and smart home space, that's leaving Apple less room to maneuver.

Apple could go the other way, and stop looking for the next big thing and just start returning all its cash to investors, likely in the form of big buy backs. But that's not going to solve the problem, either. There's not enough of it to meet investors expected return, and continue to fund Apple's growth.

Earlier this week, Buffett's longtime partner Berkshire Vice Chairman Charlie Munger acknowledged the widespread doubts expressed in the media and investment community. "We appear in the press with Apple and a bunch of airlines. I don't think we've gone crazy," declared Munger. "We're adapting to a business that has gotten more difficult." Instead of pocketing big, easy returns as in the past, he says, "Now we get little edges."

All told, Apple is a risky bet. Its big surge in price, gigantic market cap, and less than stellar outlook for growth indeed leave little margin for gain. Buffett and Munger deserve kudos for making lots of money on Apple. The issue is whether it's worth owning from here on.

But the the bigger problem for investors is this: The investment world has gotten really, really tough if a stock with Apple's singular lack of appeal, especially at these prices, looks like a buy to the world's most fabled investor.

All products and services featured are based solely on editorial selection. FORTUNE may receive compensation for some links to products and services on this website.

Quotes delayed at least 15 minutes. Market data provided by Interactive Data. ETF and Mutual Fund data provided by Morningstar, Inc. Dow Jones Terms & Conditions: http://www.djindexes.com/mdsidx/html/tandc/indexestandcs.html. S&P Index data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Terms & Conditions. Powered and implemented by Interactive Data Managed Solutions