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The Apple Watch Will Be a Flop: Here’s Why Apple Doesn’t Care

Rumors broke last week that the high-end version of the Apple Watch—the Edition—would have an 18-karat-gold case and could cost $4,000 or more.  Some rumors have the sales price closer to $10,000, or about on par with an entry-level Rolex.

This immediately begs the question: Who in their right mind is going to pay Rolex prices for a kitschy piece of wearable tech that will be obsolete in two years?

Seriously. I get the appeal of a high-end watch with a real Swiss movement. It’s classy and old-fashioned…and it’s something a man can pass on to his son or grandson one day. There is something infinitely appealing about that.  But a digital watch that beeps with incoming text messages kinda lacks that timeless appeal.

I’m not an Apple (AAPL) hater. In fact, I’m long the stock in my Dividend Growth portfolio, and I was practically gushing about the company’s cash hoard in an article earlier this month. I love AAPL stock, and consider it a no-brainer to own in an otherwise overpriced market. But I also think investors need a dose of reality when it comes to the Apple Watch.

The Wall Street Journal reported this week that Apple had asked its suppliers in Asia to make 5-6 million Apple Watches for next quarter’s launch, of which nearly a fifth would be the high-end Edition. We’re talking sales of about a million Edition watches per quarter…at anywhere from $4,000 to $10,000 a pop. That’s worth about $4 billion to $10 billion in revenues per quarter—big even by Apple’s gargantuan standards.  As a point of reference, Apple pulled in $74.6 billion in revenue last quarter in the biggest quarter in the company’s history. Adding an extra $4 billion to $10 billion is real money.

But is it realistic?

Probably not, at least past the first quarter or two. I have no doubt that out of the approximately 400 million people that currently own an iPhone, some number of them of will gladly fork over $10,000 for a gold Apple Watch. But 1 million sales per quarter over the course of a year would be 4 million Editions…or about 1% of the entire installed base of iPhone users.

Consider the average iPhone buyer: They are the average American. Most buy a highly-subsidized phone in exchange for a long-term contract with their carrier. Is it really realistic to assume that one out of a hundred of them will spend thousands of dollars on a gold watch?

I have higher hopes for the sport edition of the Apple Watch, which is expected to retail for about $350. But even here, is it realistic to expect sales of 2 million to 3 million per quarter? That would imply that 2% – 3% of all iPhone owners buy an Apple Watch every year. That’s probably doable. But it would also only add about $3 billion to Apple’s revenues in a given year. That’s nice, but hardly a game changer.

Here is the beauty of it: The Apple Watch doesn’t matter.

If the Apple Watch is a total flop—and I believe there is a decent chance that it will be—it will be a minor bump in the road for Apple.

Think about Apple’s old rival, Microsoft (MSFT). Windows 8 was a total, unmitigated disaster. It was almost universally hated by users, and its unpopularity allowed Google (GOOG) to get a toehold in the desktop and notebook computer markets. Topping it off, despite billions spent in development and marketing, the Windows Phone has failed to get traction, and the Surface tablet—while a solid piece of equipment—has a tiny market share compared to the iPad. Yet Microsoft has barely missed a beat. Its Office franchise is as strong as ever, and its cloud services business is booming.

Microsoft thrives because its core businesses are so strong they could survive years of awful management by former CEO Steve Ballmer. Likewise, Apple’s iPhone franchise is so strong, it could easily survive a decade of Ballmer-caliber management and still do just fine.

As I wrote earlier, Apple could fail to earn a profit for the next ten years and would still have enough cash to keep its dividend at current levels.  And despite Apple’s gargantuan $740 billion market cap, the company is reasonably cheap by standard valuation metrics. Shares trade hands at just 14 times forward earnings estimates, slightly less than the S&P 500 average.

Is there a trade here?

Maybe. If Apple Watch sales come in lower than expected, Wall Street might dump AAPL stock in a short-sighted temper tantrum. Should that happen, use it as a buying opportunity. Apple is a dividend-raising, share repurchasing powerhouse with a bullet-proof balance sheet.

Disclosure: Long AAPL, MSFT

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog

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Realty Income: Another Solid (And Boring) Quarter From the Most Predictable Stock on Wall Street

Realty Income (O) reported fourth-quarter earnings on Tuesday, missing analyst funds from operations (“FFO”) estimates by a penny. Revenues came in at $248 million, actually beating analyst estimates of $230 million by a pretty wide margin.

And you know what? I could really care less what Realty Income did last quarter. Realty Income’s quarterly numbers don’t matter to me. At all. And I say this as a long-term holder of the stock.

Realty Income is one of my very favorite long-term stocks precisely because of its boring disposition. Realty Income doesn’t really “do” anything. It simply buys quality free-standing retail properties that, as a general rule, are already throwing off healthy cash flows and then converts those cash flows into monthly dividends for its shareholders. And as a triple-net landlord, Realty Income doesn’t have to worry about leaky toilets or peeling paint. All maintenance, insurance and taxes are the tenants’ responsibility.

I almost feel sorry for the Wall Street analyst that cover Realty Income. Following a stock that is this steady and predictable must be mind-numbingly boring!

Just for grins, let’s take a look at some of details of the earnings release. FFO per share rose 4.9% for the quarter and 7.1% for the full calendar year. Same-store rents rose by 1.5%, keeping pace with the rate of inflation. The dividend was raised by a modest 2.1%, but this followed a 20% increase the year before. In January of this year, Realty Income raised its dividend again, by 3%.

Over the past 10 years, Realty Income has raised its dividend at a 5% annual clip. That’s very solid for a company whose business model is about as exciting as watching an English cricket match on TV. But the consistency goes beyond that. With January’s dividend hike, Realty Income has boosted its monthly dividend 79 times in the past 20 years and in 70 consecutive quarters. And as a result, Realty Income was rewarded with membership in the exclusive S&P High Yield Dividend Aristocrats Index.

Realty Income is not a sexy stock and it’s certainly not one to buy if you’re looking to get rich quick. But it is one of the few stocks anywhere in the world that I believe you can really buy and hold forever. Unless Realty Income decides to merge with another REIT—or unless the Walking Dead zombie apocalypse finally happens—I can say with certainty that I expect Realty Income to look the same twenty years from now, throwing off a stable monthly dividend from a portfolio of high-quality properties.

If you’re retired, Realty Income is a no-brainer to own. Its monthly dividend is tailor-made to meet regular living expenses, and—unlike bonds—should actually keep up with inflation over time. But if you’re still saving for retirement, you can turn Realty Income into a growth machine by reinvesting the monthly dividends in new shares, putting the power of compounding to work. Between the current dividend yield of 4.4% and the long-term dividend growth rate of 5.0%, you’re looking at potential gains of nearly 10% per year, indefinitely.

Is there anything not to like about Realty Income?

Well, there is the great unknown: What happens when bond yields eventually rise?

Higher borrowing costs from rising yields will eat into profits, all else equal. But this is not something that worries me too deeply. Higher borrowing costs will mean that Realty Income will simply require higher cap rates on the properties it buys.

What concerns me is that Realty Income is essentially viewed like a bond to Wall Street. And if bond yields rise, prices of bonds and bond substitutes like Realty Income should fall.

The good news is that I expect this problem to remain theoretical for the next several years. I don’t see the 10-year Treasury yielding substantially more than 3.0% before 2020. When yields do eventually rise, Realty Income will take its knocks. But between now and then, investors can safely collect a solid and growing monthly dividend.

Disclosures: Long O

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog

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Apple: This Dividend Stock Will Never Run Out of Cash

Apple (AAPL) has been getting a lot of media attention lately and justifiably so. Driven by iPhone 6 sales that were even stronger than expected, its last quarterly release was the best quarterly release by any public company in history. As is ever, anywhere.

But while plenty of others have written about Apple as a growth powerhouse, I want to focus on Apple as a dividend stock. Apple is a dividend-raising powerhouse and a dividend stock that will never run out of cash—or at least not in the expected lifespan of anyone reading this.

Apple made $18 billion last quarter. To put that in perspective, that’s only slightly smaller than the entire market cap of Twitter (TWTR) or the annual GDP of Honduras. Apple CEO Tim Cook said that Apple sold 30,000 iPhones per hour…every hour of the entire quarter.

Now, I should be clear here: This kind of growth is not something we should expect to repeat. There was a lot of pent-up demand for the larger-screen iPhones, and a lot of would-be sales from future quarters was likely pulled forward. I should also point out that not all of Apple’s news was good. iPad sales continue to disappoint and were actually down 22%. And I’m not expecting Apple Pay or the Apple watch to amount to a lot.

Guess what? None of this matters to me when looking at Apple as a dividend stock. Apple doesn’t have to give us record-breaking earnings every quarter. It simply needs to maintain a competitive position as a consumer electronics maker.  Apple’s balance sheet is strong enough to maintain Apple’s dividend from now until the end of days.

Let’s look at Apple’s cash position. Apple has a cash hoard of $178 billion. If Apple’s cash and marketable securities were a stand-alone company, they would be the 19th biggest company in America by market cap…bigger than Warren Buffett’s Berkshire Hathaway (BRK-A) and just a hair smaller than Coca-Cola (KO).

Most of this cash is sitting offshore, outside of the reach of the U.S. taxman. For this reason, investors have treated it as if it doesn’t exist on the assumption it will never be repatriated.

This is a mistake. The optimist in me believes that U.S. corporations will get some sort of tax amnesty within the next few years. But even if they don’t, and you assume that all of Apple’s cash was taxed at the full 35% corporate tax rate—which is a ridiculously conservative assumption—Apple would still have $116 billion in cash. That’s enough to pay off its existing long-term debts three times over. It would also be enough to continue paying dividends at the current rate for the next 10 years.

Yes, you read that right. Apple could simply break even for the next 10 years, not making a dime of new profit, and it would have enough cash to maintain its dividend.

What would it take for Apple’s dividend to come under threat?

I can tell you that I honestly have no idea. I suppose we could all stop using smartphones tomorrow. Or a nuclear war could take us all back to the Stone Age. Or perhaps the aliens that took Elvis away could come back for the rest of us…or a Walking Dead zombie apocalypse could overrun the company’s headquarters.

In order to find a scenario whereby Apple’s dividend came under threat, you have to dabble in the absurd.

After the recent run-up in Apple’s share price, Apple is not the high yielder it used to be. At current prices, Apple sports a dividend yield of 1.6%. Still, that’s competitive with the 10-year Treasury yield these days. And Apple has been aggressively raising its dividend, due in no small part to prodding by the likes of Carl Icahn and other activist investors. Apple grew its dividend by 9% last year and it’s up 24% since 2012.

Expect more dividend hikes to come.

Disclosures: Long AAPL

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

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Why Every Investor Should Own REITs

If you don’t have REITs as a permanent asset class in your allocation, you should. And if you do own REITs, you should probably own more.

These are bold statements, but I’m here to back them up with facts. REITs are a fantastic asset class and are appropriate for every investor—from the youngest and most aggressive to those already decades into retirement.

REITs may not always be attractively priced, and there may be times when it makes sense to underweight them or to make a short-term tactical move to be out of them altogether. But these times are few and far between, and under normal conditions an allocation of 10%-20% in REITs is completely appropriate.

Today, we’re going to count the reasons why REITs belong in your portfolio.

#1 Diversification

Let’s start with one of the fundamental concepts of modern portfolio management: diversification. The alchemy of modern finance is that you can improve returns and reduce risk simply by holding the right mix of securities and rebalancing regularly.

But there is a difference between “diversification” and “de-worse-ification.” Loading up your portfolio with exotic asset classes only makes sense if you expect those asset classes to generate competitive returns over time. Otherwise, you’re simply diluting your portfolio with lousy assets that will drag down your long-term returns. Unfortunately, this is the case with bonds at today’s pitifully low yields.

As I’ll show in the next section, REIT returns are very competitive with those of mainstream stocks.

But importantly, for diversification to work its magic, returns are not enough. You also need those returns to be “non-perfectly correlated.” In other words, while you expect all of your asset classes to do well over time, you need some of them to zig while others zag.

Luckily, this is very much the case with REITs and mainstream stocks. Over the past six months, the correlation between the returns of the Vanguard REIT ETF (VNQ) and the S&P 500 SPDR (SPY) was only 0.51 (1.00 would suggest they move in lockstep). As we saw during the 2013 “taper tantrum,” REITs and mainstream equities can move in opposite directions for months at a time.

#2 Returns

Over time, REITs have generated total returns that were very competitive with mainstream stocks. Part of this is due to certain tax advantages that REITs enjoy (more on that later). But REIT returns say a lot about the attractiveness of real estate as an asset class.

The FTSE NAREIT Equity REITs Index, a broad index that covers most of the equity REIT universe, has delivered 5, 10 and 15 year compound annual returns of 12.6%, 3.7% and 7.0%, respectively. This compares with total returns of 15.5%, 7.7% and 4.6%, respectively, for the S&P 500.

And remember, this period includes one of the worst real estate bear markets in U.S. history!

Real estate also has value as a long-term inflation hedge. Personally, I would take solid, income-producing real estate over other inflation hedges like gold coins, commodities or TIPs any day of the week.

#3 Income

Before they were embraced by the wider investing public, REITs were popular with retirees because of the income they throw off. Outside of leveraged—and risky—closed-end bond funds, REITs tend to be some of the highest-yielding securities on the market (see next section for the reason).

The FTSE NAREIT Equity REITs Index currently yields 3.6%. That’s about double the 10-year Treasury yield and more than 80% higher than the dividend yield on the S&P 500. And among individual REITs, it’s easy to assemble a solid portfolio with yields of 4%-6%.

As an asset class, REIT dividends also tend to be safer because rent payments are less volatile than corporate profits. Things have to really get bad for the rent check to bounce.

All the same, not all REIT dividend payers are created equal. For a good combination of current yield and dividend growth, try to focus your buying on REITs with yields above 4% and FFO payout ratios below 80%.

#4 Tax Efficiency

Once in a blue moon Congress actually gets something right. Congress created REITs as we know them today in 1960 as a way to allow ordinary investors to invest in real estate. But as a sweetener to encourage capital to flock to the new asset class, they made dividends non-taxable at the company level so long as the REIT pays out at least 90% of its taxable income as dividends.

This needs a little clarification. Dividends for regular corporations are subject to double taxation in that the earnings are taxed first at the corporate level, at rates as high as 35%, and then again at the individual investor level. REITs avoid that corporate level of taxation, which effectively means that they have an extra 35% available to share with stockholders.

As a general rule, investors pay a lower tax rate on regular “qualified” dividends; 15% to 20% depending on their tax brackets. REIT dividends are usually not considered “qualified,” so they are taxed at whatever your marginal tax rate happens to be. For this reason, I recommend you hold your REITs in an IRA or other tax-advantaged account if at all possible.

#5 REITs are VERY Democratic

Because REITs are required to constantly pay out their profits as dividends, they generally have to raise funds for new projects via new debt or equity offerings. This requires discipline that most companies simply do not have. It also effectively gives shareholders a “vote.” By constantly having to go to the markets for capital, management gives shareholders the chance to “approve” new projects by buying the new shares or bonds.

One of my biggest complaints about tech companies like Google (GOOG) is that they are undisciplined with investor money. Because Google is flush with more cash that it knows what to do with, it tends to fritter a lot of it away with harebrained ideas that never get off the ground. Google was reportedly working on making a jetpack last year, not unlike the one used by James Bond in Thunderball. They also allegedly had plans to build a space elevator that would transport people from the Earth’s surface to a space station in orbit…and a teleportation device based on the transporters in Star Trek.

The science-fiction-loving geek in me thinks these projects are cool. But if Google had to go to the investing public to ask for funding for its James Bond gadgets and Star Trek toys, it would be laughed out of town. Don’t underestimate the importance of this aspect of REIT investing. The constant need to access the public markets creates discipline that you rarely see elsewhere.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog

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Are Energy Stocks Finally a Buy?

Is this the time to buy a basket of energy stocks?

Yes. Though I should start by stating the obvious: We are awash in oil, and this market looks to be oversupplied for quite some time. On Thursday, the Energy Information Administration rattled energy stocks by reporting that U.S. crude inventories just saw their highest weekly jump in at least 14 years.

Still, this is not the first time we’ve seen a bust in the oil patch. We will almost certainly see business failures as high-cost and highly indebted shale producers go belly up. But the beauty of an ETF like XLE is that it is dominated by mega-cap supermajors and pipeline operators—the kinds of companies with the balance-sheet strength to buy productive assets on the cheap if we do see forced selling.

Let’s take a look at the energy stocks that dominate XLE’s portfolio.

XLE Top Ten Holdings

CompanySymbol% Assets
Exxon Mobil CorporationXOM16.63%
Chevron Corporation CVX13.63%
Schlumberger N.V.SLB7.22%
Kinder Morgan, Inc. KMI4.51%
ConocoPhillipsCOP3.95%
EOG Resources, Inc.EOG3.87%
Occidental Petroleum OXY3.43%
Pioneer Natural Resources PXD3.16%
Anadarko Petroleum APC3.06%
Williams Companies, Inc.WMB2.68%

 

At the top of the list is, of course, that juggernaut of all oil supermajors, ExxonMobil Corp (XOM). Exxon accounts for 16.63% of XLE’s portfolio.

Exxon will take its licks when it reports earnings. Consensus estimates have Exxon’s earnings dropping by about 29% when it reports. Yet Exxon’s dividend is more than adequately covered, and it’s worth noting that Exxon has raised its dividend for 32 consecutive years. Yes, even during the dark days of the 1980s and 1990s, when crude oil traded at generational lows, Exxon managed to keep growing its dividend. Furthermore, at 3.0%, Exxon is a relative high yielder in a word in which the 10-year Treasury yields just 1.9%.

Moving on, Chevron (CVX) makes up another 13.63% of XLE’s portfolio. Chevron has raised its dividend for 27 consecutive years and currently yields 3.9%. Like Exxon, Chevron’s dividend is more than adequately covered. The dividend payout ratios for Exxon and Chevron are 33% and 38%, respectively. There is a lot of room for crude oil prices to go lower before either of these stocks see their dividends at risk.

Schlumberger (SLB) takes the third spot, at 7.22%. As an oil services company rather than a supermajor, Schlumberger is riskier than Exxon or Chevron. As oil companies slash exploration, the service providers stand to absorb more of the loss in revenue. That’s ok. Schlumberger has lived through its share of both energy bull markets and bear markets, and it’s still here to tell the story. I wouldn’t aggressively buy Schlumberger as a stand-alone stock right now, but its 7.22% weighting here is more than acceptable.

I really wish that Kinder Morgan Inc (KMI) has a larger weighting than its current 4.51%. Kinder Morgan is one of the biggest and best-capitalized pipeline operators in the business, and I fully expect Kinder to go on a buying spree if some of its weaker competitors go bust. It’s worth noting that company founder Richard Kinder started the company by buying unwanted pipeline assets from Enron for a song. Long after Enron bit the dust and became a byword for all that is wrong with corporate American, Mr. Kinder’s creation is going stronger than ever.

Has the price of crude oil finally hit bottom? Probably not. But I’m ok with that. Energy stocks remain one of the few cheap sectors in an otherwise expensive market, and XLE provides a fine way to get exposure to the biggest and best.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

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This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities.