Apple Inc. (AAPL) as I mentioned is one of Mr. Warren Buffett's favorite stocks, as we can surmise given the fact that it is also his largest holding. At the end of 2017, Buffett's Berkshire Hathaway Inc. (BRK.A) owned 166.7 million shares. In the first quarter, they purchased another 75 million shares giving them roughly 5% of the outstanding shares. Berkshire is AAPL's third-largest shareholder and AAPL makes up more than a quarter of Berkshire's total assets.

So the first question would be why does Mr. Buffett buy any of the companies that he buys? And to be clear, in his mind he is buying companies not shares of stock, he is buying businesses not ticker symbols.

Well, this is from Buffett's own mouth, or pen...or...um. These are his words, from the 2017 annual shareholder letter:

In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.

Cool. How do we know if a company has a durable competitive advantage? Well, the people at Berkshire look at many financial measurements and I'll check out some of those and report what I found. But Buffett also believes AAPL has an excellent product that lots and lots and lots of people use. In an interview with CNBC last year he said:

Apple has an extraordinary consumer franchise. I see how strong that ecosystem is, to an extraordinary degree. … You are very, very, very locked in, at least psychologically and mentally, to the product you are using. [IPhone] is a very sticky product.

I mentioned this in my previous article but in just my small household of three people we have five Apple devices. Apple devices make up approximately 40% of the U.S. smartphone market, almost as much as the next two nearest competitors. And the U.S. smartphone market is alive and well I would say. Has anyone ever seen a scene like this?

So let us look at some of the key metrics that the Oracle of Omaha looks at to determine whether a company is worthy of his funds.

Gross Margin

He is looking for companies that have consistently high gross profit margins. To be sure the competitive advantage is durable we want to make sure the margins have been consistently high. So let's look at the last ten years of AAPL's gross margin.

I would say these are pretty consistent numbers, as you would expect given that Mr. Buffett owns several billion dollars worth of this company.

Hoard of Cash

He likes to see a gigantic pile of cash. Specifically he likes to see a huge pile of cash that has been built up from ongoing business activities. If you know anything about this stock at all, you probably know that AAPL has mountains of cash. 

Almost $26 billion as of September 2018. This is great to see, and especially when you consider that AAPL is not just sitting on this cash, they are using it to do one of Mr. Buffett's favorite things; re-purchase stock.

Stock Repurchase

There are not too many businesses that Apple could buy that in Warren's opinion make much sense, and he likes companies that repurchase their own stock and so do I.

I think it’s extremely hard to find acquisitions that would be accretive to Apple that would be in the $50 billion, or $100 billion or $200 billion range. I’m delighted to see them repurchasing shares.

Looking at the statement of cash flows, one can see that AAPL only started buying their own shares in FY13. Since then they have repurchased well over $200 billion of their own stock.

Interest Expense in terms of Operating Income

Neither Mr. Buffett nor myself like to see a great deal of debt on a company's balance sheet. Of course most companies do carry some debt, and because of that they will incur interest expense. Firms with high interest expense tend to be either in a highly competitive environment or they are in a very capital intensive business, both of which he would like to stay away from.

Given that most companies do eventually borrow money for various things, you want to make sure that a company can cover their interest expense easily with their operating income. One of his other favorite companies, the Coca-Cola Co (KO) has a very low ratio of interest expense to Operating Income. KO's ratio is 5.2%. Apple's is even lower, coming in at 4.6%.

Income Before Tax

Mr. Buffett likes to look at the earnings before tax number of any company he is looking to purchase. Obviously (I hope) he wants to see this number increasing as the years go by. As earnings increase the price of the shares also increase - eventually.

Since Mr. Buffett is looking to buy companies and hold them for a long time he can wait out the market. Basically, wait until the market acknowledges the fact that whatever company he is buying is making more and more and more money as time goes on. So let's take a look at Apple's income before tax numbers for the last ten years:

While this line would not be straight up it is certainly trending in the right direction. I like to look at revenue per share and the last time I looked that number was growing like crazy. And since the gross margins are fairly consistent and they are buying back hundreds of billions of dollars worth of their own stock, it makes sense that this is still the case.

What About the Numbers I Normally Look At?

So these are all fine and good, and it is clear why Mr. Buffett is a big fan of Apple. I certainly understand that he looks at far more than just these numbers, but I think we have a general idea.

I've just explained why I think my first guideline (increasing revenue per share) is probably still going in the right direction, but let me quickly check a few of the other guidelines I use and see if we are still in good shape now that we have another year of numbers to plug in.

Debt to Free Cash Flow

I like to look at this number to see how quickly the company could repay their debt if that was their primary focus. If AAPL took every dollar of free cash flow and chipped away at their debt, they could repay it in just over four years.

That's pretty quick, and this is not surprising. We already talked about how low the debt load is for Apple, but this is one of the metrics where I was ever so slightly concerned about the direction of the number. As we can see, the number has ticked back down because Apple brought in a staggering $64 billion of free cash flow in FY18, well up from FY17. Their total liabilities also grew, but much more slowly than the previous five years.

Free Cash Flow and Payout Ratio

I like to see a huge and growing amount of free cash flow, and we already know Apple has that. But I also like to see how much of that cash they are returning to shareholders via dividends because as we know they also use this cash to repurchase shares.

Even though AAPL has been raising their dividend rather aggressively as we will soon see, their payout ratio is still very much lower than many other companies. This means they have plenty of room to continue to raise the dividend and the risk of the dividend being cut anytime soon is almost zero.

Show Me The Money!

When I first purchased this stock it had a dividend yield of 1.55%. Apple is 35% off their 52 week high. My initial purchase was above their current price but thankfully I did not buy anywhere near the high. Because the stock is trading below my initial purchase price, and because they raised the dividend almost 16% since I bought it, the yield is now higher than it was last February.

Here are the numbers, pulled from The DRiP Investing Resource Center. The five year number is so high because five years ago Apple more than doubled their dividend. Since then the raises have been a lot less drastic, but still quite impressive.

Next month should be the last dividend payment at the current rate of $0.73 per share per quarter. In my first article I projected they would raise the quarterly payout from $0.63 to perhaps $0.69 or 0.70. A solid 10% raise, and instead as you can see above they surprised me with a nearly 16% raise.

Well I'm not going to project another raise like that, though it would be welcomed. I'm going to guess we see a hike to somewhere to the $0.80-0.82 range, which would bring the yield at today's price up to 2.1-2.2%.

Why Is Apple On Sale?

Well, on the first business day of the new year, Tim Cook cut AAPL's revenue guidance to $84 billion from a previous range of $89-93 billion. This new guidance would be a year over year decline and is definitely not something we want to see. And short term traders are probably correct in jettisoning shares of AAPL if they are concerned about the next several weeks or months.

However, once again heeding the sage advice of Mr. Buffett, we (long term investors) should not focus on quarterly variances in the shipment of the iPhone or any other product Apple sells. If you pointed out that Mr. Buffett "lost" about $4 billion with the most recent drop in AAPL stock he would probable shake his head and laugh. I haven't seen any comments from him on the most recent AAPL sales slump, but based on his past comments I can only guess he is quietly buying billions and billions of dollars worth of the stock.

In an interview with CNBC last May he commented on the obsession with watching quarterly results.

Nobody buys a farm based on whether they think it's going to rain next year. They buy it because they think it's a good investment over 10 or 20 years.

Translation? Don't worry about what Apple does from quarter to quarter or even year to year. Do you think that AAPL will be a good investment in the next ten years? Twenty? I certainly do. I expect in 6-8 years the value of the shares I bought earlier this month will be worth at least twice what they are now.

Conclusion

On January 10th I purchased 10 more shares of AAPL for $151.90 per share. I certainly didn't catch the bottom, but I'm quite happy for this opportunity to add to my position.

I should comment, before everyone tells me to mortgage my house and buy every share of AAPL I can, or before people mock me for owning just 20 shares, or anything related to that that I am not done adding AAPL to my portfolio. This latest addition brings AAPL up to 4% of my portfolio, and while I would like more I am taking a measured approach here. It's worked so far as this addition brought my average cost per share down. Patience...

That said, I consider this one of my core positions, along with stocks like 3M Co (MMM), Pepsi Co (PEP), and Walmart Stores Inc (WMT). I plan on owning these companies, among others, for a very long time and will add to them when the price is attractive (PEP is getting close and I've already made three separate purchases of MMM).

I'm looking forward to seeing how much they raise the dividend this spring and I'm curious to see how many shares of AAPL Mr. Buffett added if any.

Thanks for taking the time to read this, and best of luck to all my fellow AAPL longs. Cheers!

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