Analyzing bad analysis... Apple Car vs. Beats... $10 billion diworseified away... Software and cars are different... A tale of two shoemakers... The right way to invest...
Editor's note: There are right and wrong ways to invest... Today, as the Stansberry Research team takes some time off for the holiday season, we're republishing an essay from regular Friday Digest essayist and Extreme Value and The Ferris Report editor Dan Ferris. This one – from March 1 of this year – explains a few timeless lessons about what makes a truly great investor... We hope you're enjoying the holidays. Dan will return with a new Friday essay next week...
 Apple should have listened to me (Dan Ferris) nine years ago...
In February 2015, Apple (AAPL) announced that it had several hundred employees working on designing an Apple-branded electric car in a project code-named Titan. Apple had reimagined music with the iPod and iTunes store. It reimagined phones with the iPhone. It reimagined mobile computing with the iPad. I'm not sure how anybody at the company ever thought the next logical step was to reimagine the automobile. I appeared on Money With Melissa Francis on Fox Business to talk about Apple's announcement. I naturally pointed out how the "Apple Car" made no sense and would likely cost the company a ton of money before it failed. I pointed out that Apple had a great, capital-efficient, high-margin business selling smartphones and iPads... and that making cars is a notoriously capital-intensive, highly competitive, low-margin business. Francis parroted the popular viewpoint that Apple wasn't innovative enough and needed to "do something." She said it should hire people from Tesla (TSLA), apparently oblivious to the fact that Tesla was poaching Apple execs back then. Other folks who should have known better chimed in as well. A Wall Street Journal analyst who had covered Apple for years at that time said Apple's revenues would rise 60% if it could capture just 10% of the car market. It's worth taking a moment to spell out what's wrong with that kind of analysis... If you ever hear anyone say, "If XYZ company can capture just [insert some small-sounding percentage] of the enormous market for [whatever product], it could be worth billions," they're really just telling you they don't know how business works and you can safely ignore them. The smart entrepreneurs will usually say something more like, "X is a small market, but our product is radically better than what's there and we believe we can capture a huge share quickly." That will perk up a smart venture capitalist's ears a lot faster than "diddlysquat percent of a giant, hyper-competitive market" like cars. Consider Apple's biggest acquisition: Beats, which sold high-end headphones and subscriptions for online music streaming. This $3 billion purchase in 2014 is a great example of a company that knew what it was doing. When record producer Jimmy Iovine and rapper Dr. Dre started Beats Electronics in 2006, only a very few professional musicians, record producers, and hardcore audiophiles spent $300 for a pair of headphones. The market was tiny... and as far as most regular folks like you and me were concerned, it was nonexistent. Beats released its first pair of $300 headphones in 2008. Everyone said it was crazy. Crazy. But by 2012, Beats had more than 60% of the market for headphones costing $100 or more. And the market grew 73% that year. Two years later, Apple acquired Beats for $3 billion. It was a perfect fit. Apple understands high-quality, expensive consumer gadgets like Beats headphones. Plus, music has been a key part of its business since it introduced the iPod and iTunes in 2001. Apple rebranded Beats' subscription streaming service as Apple Music in June 2015, and it had 10 million subscribers by January 2016. It had 93 million less than four years later. It generated $8.3 billion in sales in 2022, more than 6% of Apple's revenue that year. Beats is the kind of business Apple was right to get into. It meshed perfectly with everything Apple already knew how to do very well. By contrast, Project Titan was a $10 billion-plus foray into an industry where Apple should never have expected to succeed. It's no surprise that Apple said earlier this year that it's shutting down Project Titan... Fortunately, Apple is such a cash-gushing behemoth that $10 billion spent over the course of 10 years doesn't hurt that bad. Among the telling details in the announcement was the report that Apple will disperse nearly 2,000 former Titan employees, sending some over to its AI group. It felt as if they'd shut down a farm and sent the employees to go work in a law firm. The group included former NASA engineers and folks who had developed race cars for Porsche, but how does experience developing cars help with anything Apple could want to do? Maybe I'm making too much out of it, but it struck me as weird because software and cars are so different. If you were to start up a car company, would you immediately say, "First, I need to find people who are really good at writing software"? And yes, I'm fully aware that, as tech entrepreneur/venture capitalist Marc Andreessen once put it, "Software is eating the world," including the car industry. But that doesn't come anywhere close to meaning that writing code is similar to building a car. In the car business, the software guys work for the car guys, not the other way around. The end product is a car, a giant hunk of painted metal with wheels and a motor (electric or otherwise). The end product in AI is whatever the software does. And no matter how you look at it, people ultimately make the decisions that go into car building, not machines or software programs. Surely you get the point that physical stuff is not software, no matter how integral to the process of making physical stuff the software might be. (I can't help noticing that the widely touted use of AI to power self-driving cars is a flop so far.) Ultimately, Apple's decision to shut down Apple Car is good for shareholders. It'll waste no more money on this project. And at least with AI, Apple is in more familiar territory as a techy consumer-products company that also produces a lot of software. I bet it could even use AI to make Apple Music better. As the Wall Street Journal correctly pointed out, Apple's failure is confirmation of how hard it is to succeed in the car business and how unlikely Tesla's success has been. Making cars and consistently selling them at a profit is hard enough. Doing it without any history of car making or other heavy-machinery design, engineering, and manufacturing with an entirely new brand is exponentially harder. Thinking about Beats and Apple Car reminds me very much of what so many huge companies have done in the past... Eager for growth and apparently short on good ideas, Apple engaged in the time-honored practice of "diworseification." As far as I can tell, investing legend Peter Lynch invented the term diworseification in his must-read 1989 investment classic, One Up on Wall Street (buy it right now and read it cover to cover if you haven't done so). Lynch used the term to describe companies that made acquisitions fitting two criteria: - Overpriced
- Completely beyond the understanding of management
You don't need to be the CEO of a big company or a billionaire investor to understand Lynch's point. If you've ever owned a large, expensive boat, you understand what Lynch was talking about better than most folks ever will. The pool we installed in our backyard has given me a bit of a diworseification hangover, too. Any time you say, "If I had it to do over again, I'd avoid spending all that money on..." you're in diworseification territory. Lynch gave plenty of examples from the corporate world in the decades before he wrote the book, including Mobil Oil's purchase of retailers like Marcor and Montgomery Ward. He also listed various business lines that packaged-food giant General Mills owned over the years, including steakhouses, Parker Brothers toys, Izod shirts, coins, stamps, travel companies, and Eddie Bauer stores. Lynch wrote: The 1960s was the greatest decade for diworseification since the Roman Empire diworseified all over Europe and northern Africa. It's hard to find a company that didn't diworseify in the 1960s, when the best and brightest believed they could manage one business as well as the next. Lynch told one tale of diworseification that's particularly valuable for investors... He compared two shoe manufacturers – Melville and Genesco – that both diversified into other businesses, with radically different results... In the late 1950s, Melville made shoes for its Thom McAn shoe stores. It put shoe departments in other stores, including Kmart. Melville's earnings soared after Kmart started expanding rapidly in the 1960s. Through Kmart, Melville gained experience in discount retailing. It used that to acquire discount drugstore chain CVS in 1969, discount-clothing retailer Marshalls in 1976, and Kay-Bee Toys in 1981. As foreign manufacturers took over the shoemaking industry, Melville transitioned its business. By 1982, it was down to just one shoe factory. Next, let's consider Genesco. Starting in 1956, Genesco went nuts with acquisitions. First, it bought department stores Bonwit Teller and Henri Bendel, jeweler Tiffany, and variety chain Kress... Then it got into all kinds of different businesses it couldn't possibly have known much about: security consulting, knitting materials, textiles, blue jeans, "and numerous other forms of retailing and wholesaling," according to Lynch. Sales rose, but the company wasn't becoming more profitable. Both stocks fell in the bear market of 1973 to 1974. Melville rebounded and was a 30-bagger by 1987. Genesco never recovered. So it's possible to be a shoe company and eventually get into selling toys, clothes, and medicines. But if your expertise is making and selling shoes, maybe security consulting and textiles (a low-margin, highly cyclical commodity business) aren't your thing. But that doesn't mean nobody can have all kinds of totally different businesses under one roof... When I mentioned how diworseification ran rampant in corporate America in the 1960s... did one particular company that started buying other businesses during that decade by any chance come to mind? Yes, I'm talking about perhaps the greatest and perhaps most disparate set of businesses ever to exist under one roof: Berkshire Hathaway (BRK-B). Warren Buffett started buying shares of Berkshire Hathaway, then a textile maker, in 1962. (Maybe you're even old enough to remember "the man in the Hathaway shirt.") He accumulated enough shares to take control of the company in 1965 and remains chairman and CEO today. He kept the textile business open until 1985. But by then, Berkshire had become something quite different. Buffett opened his 1985 shareholder letter excitedly discussing the company's recent purchase of a large position in media giant Capital Cities/ABC... its acquisition of home products manufacturer Scott & Fetzer... and its 7% stake in the Fireman's Fund insurance group. Only later in the letter did he discuss exiting the textile business that gave Berkshire its name. The reason was simple: It was losing money and had no hope of ever doing otherwise again... Berkshire kept buying all kinds of business. And today, of course, it is a powerhouse. It owns See's Candies, Geico insurance, the Dairy Queen fast-food chain, Fruit of the Loom undergarments, BNSF Railway, Benjamin Moore paints, Acme Brick, Clayton Homes, NetJets private-jet service, Pampered Chef kitchenware, Ben Bridge and Helzberg Diamonds jewelry stores... and dozens and dozens of other companies, more than 60 in all. It owns partial stakes, either privately or through the stock market, of many more. As of the end of 2023, Berkshire's biggest stock holdings were a huge position in Apple worth $173 billion, Bank of America ($34.8 billion), American Express ($28.4 billion), Coca-Cola ($23.6 billion), and Chevron ($18.8 billion). All in all, Berkshire owned about $353.8 billion worth of stocks at the end of 2023. The businesses it owns generated $37.4 billion in operating earnings last year. The company currently has a market cap of nearly $1 trillion. The obvious lesson is that acquiring businesses is a separate skill from running a business and can be a great business itself. But it's like anything else... You have to focus on it intensely over decades to become really successful. And that brings us to what you and I do with our hard-earned, diligently saved capital... You and I are, like Buffett, in the business of acquiring stakes in other businesses... Never forget that owning stocks is the same as owning businesses. You want to own the best ones, and you don't want to pay such an exorbitant price that you'll never make a good return... even if you're right about the business being great. Nvidia (NVDA) is the easiest example of a company that's firing on all cylinders but very likely priced to provide a lousy (if any) return over the next several years. The stock market being the emotional roller coaster it often is, Nvidia will likely collapse at some point... probably when everybody realizes that AI has been hopelessly overhyped and that Nvidia's growth is on an unsustainable trajectory. Trying to branch out from smartphones into the automotive industry is another example of a bad bet... which Apple figured out only after wasting more than $10 billion. In addition to quality and price, you should probably learn to be more careful investing in certain industries, like biotechnology, mining... and any stock that doesn't yet have a viable business. You should probably learn more about industries like software, insurance, health care, financial services, and other places where lots of good businesses can be found. And take a page out of Lynch's book by learning to invest in things you know well. If you own a motel or a hotel, you should probably learn more about publicly traded hospitality companies. If you sell clothing online, maybe you'd want to learn more about all the clothing-related companies. If you're in banking, check out publicly traded banks. If you sell cars, look at carmakers and auto dealers. You get the picture. You can become a good generalist investor who, like Buffett, doesn't focus on one industry (though his love of insurance is a huge, important part of Berkshire's success). But you'll probably be a better generalist by taking Lynch's advice and starting with industries you already know something about. From there, you can diversify throughout your investing career into other industries, just like Buffett has done. Just make sure you aren't diworseifying into businesses you don't understand.
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With our offices closed today, we're taking a break from our 52-week highs list and the mailbag. But, as always, send your comments and questions to feedback@stansberryresearch.com. Good investing, Dan Ferris
Medford, Oregon
December 27, 2024 | 
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