Do You Have a Deterministic Or Probabilistic Approach To Investing?

June 7, 2017

Do You Have a Deterministic Or Probabilistic Approach To Investing?


The human mind is wired in a deterministic way. A proposition is either necessarily true or it is false.

For example, you either like a person or you don’t. There isn’t an in-between where you would say that there is a 67% probability you like someone. The same principle applies to investing, we either think the market or a stock are going to go up or down. What very few can do is to think in a probabilistic way. But mastering a probabilistic way of thinking would do wonders for your portfolio.

Today I’ll quickly analyze Apple (Nasdaq: AAPL) as both a strong bullish and a strong bearish case can be made to explain the probabilistic and deterministic approach to investing.

Apple Stock, Is It Safe To Take A Bite Now?

Apple is the biggest company on the market with a market capitalization of over $800 billon. Even Warren Buffett, who had never previously invested in technology stocks, has invested $18 billion in Apple in the last few years. But the question remains, is AAPL a good buy at these levels? There are, of course, two answers.

I’ll discuss Apple’s business and how it affects the stock price, what is expected from Apple to justify the recent stock price jump, the stock’s fundamentals, and the risk and rewards to give a good, comprehensive view of what can be expected. I’ll try to be as objective as possible as I don’t own the stock.

Let’s start with Apple’s stock price which has really surged in the last year.

Figure 1: AAPL’s stock price in the last 12 months. Source: Yahoo Finance.

In the last 12 months, Apple’s stock price has gone from $92 to the current $155 which represents an increase of 68%. This would be a huge performance for a penny stock so the fact that Apple is the biggest company in the world by market cap makes the performance even more remarkable. However, such a surge isn’t unusual for Apple and raises the concern of whether it has gone up too much.

Figure 2: AAPL’s stock is no stranger to cyclicality. Source: Yahoo Finance.

In 2012, Apple’s stock was relatively high as the new iPad had just been released and was showing good sales numbers alongside great sales of the iPhone 4 and exuberant expectations over the iPhone 5. However, sales slowed down in 2013 and the stock price dropped considerably.

In 2014, the story repeated itself. Expectations of great iWatch sales and good iPhone 6 sales pushed the stock price even higher than it had been in 2012. Then in 2015 and the beginning of 2016, investors became pessimistic again as iPhone sales slowed down and AAPL hadn’t come to the market with an extremely innovative new product. In the last 12 months, things have changed again as investors expect the iPhone 8 to be revolutionary and older iPhone sales have stopped declining.

To sum up, AAPL is the perfect example of the deterministic mindset that plagues investors. When the stock goes up, most market participants create stories about exhilarating products while when the stock price drops, stories about how the company can’t innovate without Steve Jobs and headlines touting “The End of Apple” are all over the place.

A Realistic View Of AAPL – Positives & Negatives

In order to think in a probabilistic way, we must look at both the positives and the negatives.

A positive is that AAPL has reached a position of stability with a high customer retention rate. Given that more than 250 million people have an iPhone that is older than 2 years and that the number is expected to increase to almost 300 million next year, AAPL will enjoy a stable stream of revenues in the next few years.

Figure 3: Number of people with an iPhone older than two years. Source: Wall Street Journal.

Other positives come from the potential of exciting new products like the one shown in this image borrowed from the United States Patent and Trademark Office (USPTO).

Figure 3: Investors get easily excited when AAPL announces new products. Source: USPTO.

I must say, I’d be excited as a customer if AAPL could make a phone that has the same power as a laptop and then sell the laptop case for a symbolic price.

On the negative side, such a product would quickly be copied by other producers and the profitability would also be questionable as it could cannibalize current laptop sales.

What could also hit AAPL’s revenues and profits is a recession as many companies would buy less hardware and customers’ credit lines wouldn’t allow for everyone to own a $1,000 laptop or an $800 phone.

To conclude the business analysis, an investment in Apple is highly dependent on the next iPhone or any other new product, and on the economic situation. I’d say that there is a 45% chance that the new iPhone really delivers and that AAPL’s stock goes beyond $200, while there is also a 45% chance that the new iPhone isn’t so extraordinary or that a recession hits the economy and AAPL’s stock price drops to $100 again. I’d attach the remaining 10% to AAPL’s stock price remaining near current levels.

How To Invest With A Probabilistic Mindset

A probabilistic mindset allows you to lower your risks and increase your returns.

The case for AAPL is the same today as it was a year ago when the stock was trading at $90, however the probabilities were much different then because of AAPL’s fundamentals and stable streams of future revenues coming from loyal customers.

I would say that at $90, there was only a 20% chance for the stock to drop much lower as the dividend yield was above 2%, stock buybacks were adding another 7% as an indirect yield, and there was always the huge stash of cash on AAPL’s balance sheet. Not much has changed since then in the fundamentals, however the stock price has increased 68%. What has changed in the fundamentals is that the current dividend is 1.62% while the buyback yield is down to 4.5%, and the price earnings (P/E) ratio went from below 10 to the current 18.18.

By allowing yourself to have both a bearish and bullish perspective on an investment, you will train yourself to find low risk, high return investments. Those who are certain that AAPL will make an amazing iPhone might get burned when future sales don’t meet euphoric expectations as was the case in 2013 and 2016.

As always, the price of a stock is the main factor that determines investment returns. The lower it is, the higher the probability of higher returns is. While the higher the stock price, the higher the chance for something to go wrong.

Attaching probabilities based on experience, past performance, and proper, objective due diligence is essential for sustainable long-term healthy investment returns. Make sure you aren’t using your hard earned money to bet on the stock market, make responsible investments into businesses, and allow for the underlying business’ earning yield to determine your returns.

By Sven Carlin Apple Investing Strategy Investiv Daily Share: