3 Reasons Apple Is a Warren Buffett Stock

By Markets Fool.com

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According to regulatory filings, Warren Buffett's Berkshire Hathaway has recently purchased a $1.1 billion position in Apple stock. Buffett has traditionally stayed away from most tech companies, and he even discarded the possibility of investing in Apple a few years ago, so this comes as a surprise.

It's important to note, however, that Buffett himself didn't make the decision to buy Apple. The Oracle of Omaha explained in an email to The Wall Street Journal that the decision was made by one of his investing lieutenants, Todd Combs and Ted Weschler, so the fact that Berkshire Hathaway now owns a considerable position in Apple doesn't necessarily mean Buffett has changed his mind about investing in tech companies in general or Apple in particular.

On the other hand, even if Buffett didn't pick Apple, he did personally pick Combs and Weschler to make investment decisions with Berkshire Hathaway's money. When analyzing Apple in terms of competitive advantages, financial soundness, and valuation, the stock offers many of the traits that Buffett appreciates in an investment.

Rock-solid competitive advantage

Buffett is all about investing in companies with big and sustainable competitive advantages. In his own words:

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"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

Brand value is one of the most powerful sources of competitive advantage, and Apple comes second to none when it comes to brand differentiation. Based on data from Interbrand, Apple is the most valuable brand on Earth, with an estimated brand value of $107.3 billion. This enormously valuable brand means superior pricing power and above-average profit margins for investors in Apple.

Apple's integrated ecosystem of services and applications is also remarkably sticky, meaning that consumers are particularly loyal to the company. According to a recent survey by Kantar, loyalty rates among iPhone users in the U.S. are in the area of 95%.

One of the main reasons Buffett is traditionally reluctant to invest in tech companies is that the industry is always changing, and today's winner can easily turn out to be tomorrow's loser. However, when you incorporate Apple's competitive advantages into the equation, the company doesn't look like a typically fragile tech company by any means.

Unquestionable financial strength

Buffett typically gravitates toward companies generating tons of cash and with pristine balance sheets, and Apple fits that description remarkably well. The company is sitting on nearly $233 billion in cash and liquid investments on its balance sheet. Even after discounting debt, the net cash position is an impressive $161 billion.

In the last quarter alone, Apple produced $11.6 billion in operating cash flow and $9 billion in free cash flow. This provides enormous financial resources for Apple to invest in all kinds of projects and technologies, and it allows management to reward shareholders with growing cash distributions over the years. From the inception of its capital-return program in August 2012 through March 2016, Apple has returned over $163 billion to shareholders through dividends and buybacks.

Many of the most iconic Buffett stocks have long-standing trajectories of capital distributions. Among them, Coca-Cola has raised its dividends for 54 consecutive years, and IBM has increased dividend payments for 21 years in a row, more than doubling the dividend amount from 2010 to 2016.

Apple is no match for Coca-Cola or IBM in this department, as the company has a relatively short trajectory of capital distributions. Nevertheless, Apple is strong enough to sustain growing dividends and buybacks for years to come, and this says a lot about the company and its fundamental quality.

Apple stock looks undervalued

Buffett loves to buy solid companies at discounted prices, and he believes that short-term pessimism can create compelling opportunities for long-term investors. The Oracle wrote in a New York Times piece in 2008: "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful."

There is a lot of fear currently surrounding Apple stock. The smartphone industry is maturing, and the iPhone 6 was a booming success for Apple in 2015, making year-over-year comparisons remarkably challenging in 2016. In this context, Apple reported a 13% revenue decline during the quarter ended in March.

Reflecting investor pessimism, Apple is currently trading at a price-to-earnings ratio of around 10 times earnings over the past year, a huge discount against a P/E of around 19 for the average company in the S&P 500. The average P/E ratio for Apple over the last five years is around 14, so the stock also looks quite undervalued by its own historical standards.

Sales numbers will remain challenging over the coming quarters, but the long-term picture doesn't look that dismal for Apple. When considering first-time smartphone buyers, customers switching away from Android, and renewal sales to current iPhone owners, chances are that iPhone sales will move in the right direction over the long term, even if the years of explosive growth are already in the past.

Investors should always do their own homework, as opposed to blindly replicating the investment decisions of others. However, when looking at key aspects such as competitive advantage, financial soundness, and valuation, it's quite easy to understand why Apple is now a Warren Buffett stock, even if Buffett himself didn't make the decision to buy it.

The article 3 Reasons Apple Is a Warren Buffett Stock originally appeared on Fool.com.

Andrs Cardenal owns shares of Apple, Berkshire Hathaway, and International Business Machines. The Motley Fool owns shares of and recommends Apple, Berkshire Hathaway, and Coca-Cola. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.