A piece of news caught my eye saying that “Apple has overtaken Research in Motion as the third largest cellphone maker in the U.S.” It interested me because as I checked last weekend with my fundamental ranking system, RIMM was ranked 97.88, slightly higher than AAPL at 97.70. Although statistically there is strong tendency of higher ranked stocks to outperform lower ranked ones over a period of 1 week, a difference of 97.88 - 97.70 = 0.18 doesn’t really mean anything. Remember that my fundamental ranking system ranks stocks by valuation, financial condition, and return on capital. The virtually equal ranks mean that there is virtually little difference between AAPL and RIMM as far as valuation, financial condition, and return on capital are concerned. In fact, they are both exceptional.

However the news is alarming. RIMM is losing competitive edges to AAPL. If the “trend” (I put quotation marks to differentiate it from technical trend) continues, it’s a sure thing that RIMM will underperform AAPL in the future. In fact the market already voted against RIMM by its feet, RIMM is about 30% off its peak now.

The news basically says AAPL grows much faster than RIMM. This is not reflected in my fundamental ranking system because I deliberately removed growth from the system. My previous post showed that growth has negative impact on the over all performance. But that doesn’t equal to “growth is a bad thing”. The difference is subtle and let me spend some words to explain it. For a given stock, the ranking system will first give it a rank for valuation say 90, a rank for financial condition say 85, and a rank for return on capital say 95. Then it averages the three numbers to give a final rank which is (90 + 85 + 95) / 3 = 90. (Actually it’s a weighted average. But for the purpose of this post, it is OK we forget this inconvenient fact.) If we put growth into the mix, then the system will give the stock a rank on growth, and then average it with the other three ranks to produce the final one. It could happen that a stock that is less sound on valuation, financial condition, or return on capital will get a higher final rank because of its high growth rank. And this type of stocks will hurt the overall performance. So it really means that sacrificing valuation, financial condition, and return on capital for growth is the bad thing. Or, in plain English, growth is less important than valuation, financial condition, and return on capital.

Now let’s look back at RIMM and AAPL. They are almost equivalent on the other aspects. For this particular case, we should look at growth if we want to differentiate between them. There are other fundamental aspects we could look at. But because growth is so popular for these two stocks, as well as other hi-tech names, it pays to watch it closely.

When evaluating growth, value investors will not just look at the numbers. They look at stability and predictability of the growth numbers. There are math formulas devised for measuring stability and predictability. But let’s look at the charts first. Below are the charts of the earning growth for RIMM and AAPL, respectively.

Comparing the two charts, RIMM’s growth is volatile: it moves randomly and sees big ups and downs. It sees one negative growth number in the last 3 years. AAPL’s growth is more stable: it is closely clustered to a constant value, i.e., the straight line in the chart. All growth numbers are positive, and the minimum is 11.5, way above zero.

Value investors commonly use coefficient of variation (CV) to measure the stability of earning growth. CV is the standard deviation divided by the average. Large CV means that variation is relatively high, which implies bad stability and it would be hard to predict future values by historical data. Numbers and calculations are listed below.

Over the past 12 quarters, AAPL’s average earning growth is 63%, higher than that of RIMM at 55%. AAPL's CV is 0.55 while RIMM’s CV is 0.71. So AAPL’s growth number is better and furthermore its growth is more stable and predictable.

I’d like to point out one difference here that a fluent investor may have already noticed. Usually value investors look at CV on annual growth numbers for a long period of time, such as 10 years. What I have here is trailing twelve months growth number for each quarter and I only look at data in the past 3 years. I’m doing this because hi-tech is a fluid industry and under constant changes. 10 year is a very long period that’s going to average out a lot of changes. But some changes are game changers that are highly important. When did AAPL introduced iPad?

So if I have to pick one between AAPL and RIMM, I’ll pick AAPL. Some traders may view the 30% drop of RIMM a speculative trading opportunity because even a dead cat will bounce. That might be the case. But long AAPL is a better choice. AAPL’s fundamental quality is at the same level as RIMM, and AAPL’s growth is more stable and more predictable than RIMM. Go long AAPL may see better return than that of RIMM.

Does that mean a trader should chase the downward momentum to short RIMM? As discussed at the beginning of this post, RIMM’s fundamental quality is as exceptional as AAPL. Yes one can short, but fundamental is not on his side.

Because RIMM and AAPL are close competitors in the same industry, and RIMM and AAPL have almost the same fundamental quality, and AAPL’s growth potential is much better than RIMM, a trader may consider a pair trade strategy: go long AAPL and short RIMM in the same dollar amount. Personally I wouldn’t do this. Yes it is very likely that RIMM keeps losing market share to AAPL. But RIMM already fell 30%. At this price level, the risk of going short is way too high if anything unexpected happens.

**Disclosure:**I don’t have any position of AAPL or RIMM but is likely to establish a position of AAPL in the next 72 hours.

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