AAPL: Short the Bonds? Long the Stock?

Devon Shire interprets Jim Grant.


Jim Grant thinks that the actions of the Central Banks around the world are creating artificial pricing in certain assets. Specifically fixed income.

When all of that quantitative easing ends asset prices are going to go back to being priced based on market forces rather than central bank easing.

Investors worldwide are chasing fixed income yield to ridiculously low levels.

This artificial pricing in the market means that there is potential for value focused investors to profit when the Central Government intervention ends.

Grant believes that Apple (AAPL) is a perfect example of the currently distorted market pricing being created by easy money policy. It also creates a way to profit from the ending of quantitative easing.

(click to enlarge)

Why Should We Listen To Jim Grant?

Is Jim Grant a man we should listen to?

To find out for myself I went back and looked at Jim Grant’s track record to try and see how reliable he is.

Grant of course is the author of Grant’s Interest Rate Observer and a man with thirty years experience. That brings with it a 30-year track record from which we can assess his ability. So what do we know about Grant?

First off, that he makes a lot of sense. His opinions are well researched and his conclusions sensible.

Second, we know that his track record suggests he is worth paying attention to. He has made the following calls:

– When Treasury bonds were yielding 13% in the early 1980s, Grant called them a screaming buy. Everyone else was screaming too back then, but they were screaming that “cash is trash” and wanted no part in currency-based investments.

Grant figured that if inflation, then coming down, suddenly ran amok again, an investor could in the worst case give up 13% a year in principle and still break even on the coupon. If he was right then the best case was much more rewarding.

History tells us that Grant was dead on the mark. Buying Treasury bonds in the early 80s was one of the great investing opportunities of the last century as interest rates of dropped continuously since.

– In 1999 when growth and technology stocks were reaching absurd valuations, Grant wrote “Great booms… produce large abuses, which usually do not seem abusive until after the up cycle ends.” He had been warning his readers to steer clear of this sector as early as 1997.

History tells us that Grant was dead on the mark. Technology stocks collapsed in 2000 and most have still not recovered to the prices of the late nineties.

– As early as 2005 Grant was telling his readers that shorting the securitized lending market was going to be a great bet and at the very least that they should avoid exposure to it. His thinking was that if he was wrong on his short thesis the worst result was that a bond priced at $100 would go to $101, and if he was right he would make a bundle.

History tells us again that Grant was dead on the mark. Investors like Dr. Michael Burry and John Paulson made fortunes profiting from shorting garbage pools of loans.

He seems like someone we should consider an opinion from to me.

What Grant is saying today is to buy Apple stock and short Apple bonds.

Explaining The Logic Behind Shorting Apple Bonds and Buying Apple Stock

Grant believes that when investing an investor has to look at valuation of individual securities independent of the overall market.

He believes that right now most market participants aren’t doing that and Apple bonds and stock provide a perfect example of that.

Recently Apple sold the largest corporate bond deal in history when it issued $17 billion in bonds at the following yields:

– 10 years at 2.41%

– 3 years at 0.51%

– 5 years at 1.076%

– 30 years at 3.883%

There were $52 billion in offers for the $17 billion in debt being offered making it one of the most hotly desired bond issues in recent memory.

Investors literally couldn’t get enough of these bonds.

Now keep those yields in mind when looking at Apple stock.

The current dividend yield for Apple is 2.4%. That is equal to the yield on the 10 year Apple bond. The yields are exactly the same, but the equity holder gets to participate in Apple earnings going forward as well.

The free cash flow yield on Apple is even more attractive. Right now it is approaching 11%. So while the Apple 10 year bond holder gets an annual return of 2.4% the Apple equity holder is receiving a free cash flow yield of 11%.

Some of that free cash flow yield comes back to the shareholder as a dividend, some through share repurchases and the rest through reinvestment in the business which will grow value per share.

I think those numbers make it obvious that choosing Apple bonds over Apple equity is a terrible decision. Grant quantifies that for us to make it even more evident through the following hypothetical situation:

“Assume that the Apple share price goes nowhere over the next ten years and free cash flow accumulates at only half the rate of the past five years. At the end of the ten years with the build up of cash on the balance sheet the free cash flow yield on the common stock is going to have a free cash flow yield of 145%.”

While the equity holders after ten years under those assumptions Grant uses (possibly conservative ones) will be receiving a free cash flow yield of 145%, the bond holders will be receiving 2.4%.

In this ultra low interest rate world investors are doing crazy things for yield, and buying Apple bonds at these rates while ignoring Apple stock is one of them.

Grant thinks the Apple bonds are excellent short sale candidates and pairing that by buying Apple equity might be a good idea.

Makes sense to me.


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