What Do Apple, Facebook, Alphabet and Hedge Funds Have in Common?

My thesis was simple. Apple Inc. (NASDAQ:AAPL) is mainly a single product company that is very likely to face increasing price competition. Consumers pay a premium for iPhones because of their superior quality and exclusivity. Competitors caught up in terms of the quality gap. Consumers are slow to learn and react. I thought it would take a recession to bring consumers and Apple shares back to the reality. Financial turmoil in China seems to have done the job.

Apple Inc. (NASDAQ:AAPL)’s market is global but it isn’t infinite in size. Only a small percentage of people can afford to buy iPhones and only a certain percentage of those people will buy iPhones. Apple’s marketing prowess has played a crucial role in securing a large share of the market together with high margins but this moat isn’t insurmountable. I don’t know of any industries where market leader maintained large market share as well as large margins when the barriers to entry are so low. Sooner or later Apple will have to slash its price and profit margins to protect its market share. That’s why Apple shares lost more than 25% of their value since I appeared on CNBC last year.

Alphabet Inc (NASDAQ:GOOGL) and Facebook Inc (NASDAQ:FB) haven’t felt the effects of limited market size yet because search and digital display ad markets are still growing at a healthy clip and will keep growing at least until we hit a recession. Even in the case of declining sales, Alphabet and Facebook may be able to grow their advertising market share, so the threat of limited market size doesn’t have any effect on their share prices. The problem with these two stocks is their earnings multiples. Alphabet’s trailing price-to-earnings ratio is more than 30 whereas Facebook’s P/E is more than 90. This means the market is already counting on a large increase in their earnings over the next few years. I wouldn’t short these stocks at this point, but I definitely don’t think they are “sure bets”. Buyer beware. Sooner or later, these companies will reach the boundaries of the advertising market and their multiples will shrink dramatically.

Hedge funds as a group face the same market limitation. Every year there are some winning stocks and some losing stocks. Some of the investors will invest the majority of their assets in winning stocks, some of the investors will unfortunately invest the majority of their assets in losing stocks, and passive investors will invest pretty much equally in both winning and losing stocks. Historically, retail investors, most of whom are naive part-time investors, used to invest the majority of their assets in losing stocks and hedge funds were able to capture a large chunk of alpha by picking winning stocks.

The problem with this picture is that sooner or later, the patsies at the poker table recognize their shortcomings as the pile of chips in front of them shrinks and start doing two things. First, hand their money to hedge funds that have shown skill in picking winners. Second, they may not able to afford hedge funds and invest their money in passive index funds like the ones that are offered by Vanguard and Fidelity.