Ryan Leggio: Switching gears a little bit to maybe a different type of consumer, and that is the tech consumer, Apple, which is the largest holding in RS Growth, the large-cap fund you help run, has been in the news not just because of iPhone, but also the iPad.
And I read an interesting statistic, which I wanted to get your reaction on, and that was, within two months of the April 3 release, Apple sold 2 million iPads more than IDC expected for the entire tablet industry for all of 2010.
And I guess the question there for even large-growth companies, like an Apple, how hard is it to model in growth expectations for a firm when there is such a wide range of outcomes and really what does that do to the valuation and the 2-to-1 risk reward requirement that you require?
Allison Thacker: Well, I mean Apple has been a phenomenal success, and it's one of these relatively rare large-cap companies where they are a true innovator and secular grower. It's been amazing to watch Apple over the last five to seven years basically creating whole new categories, taking a static cell phone industry that was a walled garden environment where the carrier completely controlled your experience, and watching Apple through – appealing to the consumer basically to break the walls down, and effectively the cell phones are all moving towards an open platform. And I think the iPad is another great example of them coming up with a product, which was almost inconceivable 12 months ago.
I think people are still trying to figure out where does this product fit. Is it a notebook replacement, is it an entertainment device, is it going to be somewhat of where smartphones are headed? And I guess what the 2 million in sales number tells you is that consumers find this compelling and that maybe this is a whole new category. I think mostly we view this as likely to be an incremental device at this point. It's somewhat more entertainment-oriented. It certainly can't replace a business PC.
So, Apple has been a long-term holding in our fund. We started investing in it significantly with the start of the iPod. And our view had been, wow, Apple has launched a very innovative product at a low price point where they can get a lot of people to try it, and there will be knock-on benefits to their Mac sales. So their market share can go up within their core PC business, which has basically been exactly what's happened over time. And so, the very interesting thing is it's not only the 2 million iPads you sell, but it's the people you get interested in the iPhone and the MacBook and the desktops.
And so, we don't see any end in sight to the halo effect that Apple is generating off of this, and the iPad is definitely something we're watching. You mentioned we're based in San Francisco, and I do think that that's been one of the advantages, geographically being located close to all this innovation, because in addition to investing in Apple and the fund, across all of our funds we are able to find other investments which are benefiting from Apple's innovation as well maybe they sell products or services on the iPad.
So, we own a stock called LogMeIn right now in our small-cap as well as our technology sector funds, and they have one of the top 10 grossing applications sold on the iPad. And what it actually allows you to do is download this app and it's basically a direct connection into your work PC. So you may have heard of GoToMyPC: it started out as that type of application. But they launched this Ignition app for the iPad, which allows you to simplistically get to your work PC and do some work-related tasks on the iPad. And it's been very successful selling at $30 an app, which is probably the most expensive App on the iPad.
And as the Internet analyst and kind of consumer software analyst at RS Investments, I am very excited to see over the next three to five years, a number of innovative companies coming public or announcing to the market new business lines that they have by virtue of being part of the Apple ecosystem.
Leggio: And you mentioned the iPad maybe not even conceivable 12 or 18 months ago, even though Steve Jobs has now said that they were thinking about it almost a decade ago, do you find yourself changing your price target even on a company like Apple more frequently than you might expect, given the rate of innovation and change involved in that company?
Thacker: And the rate of earnings growth. That's the amazing thing, as I believe Apple is a less expensive stock today than it was two years ago or four years ago. The P/E multiple has somewhat contracted over time as the earnings have gone up. And so, with Apple we have, in general, kept a pretty steady valuation range that we were comfortable paying in. And so, given the earnings have risen so much, we haven't had to adjust upward our multiple at all over time to continue to invest in this growth story.
Leggio: I want to stay on Apple for just a little bit longer but in a different perspective, and that is how you think about portfolio position sizes? And I know for the RS Growth Fund, the large cap fund, for example, you won't own a position that's more than 5%. But, for example, Apple is one of your largest positions, and as you said, very cheap on a free cash flow yield to enterprise value basis, right around 6%, and then compare that to your 10th or 12th largest holding, a Microsoft, which has over a 10% free cash flow to enterprise value basis, not growing nearly as fast, obviously, but much higher returns on invested capital. And so, why wouldn't, I guess, a Microsoft be closer to the top than it is now, and maybe give us your thinking about that?
Thacker: Well, I do think fundamentally what we're looking to capitalize on in the RS Growth Fund is companies that have secular growth opportunities that are continuing to gain market share through product innovation or service innovation. And so, this is probably the most significant position that we've had in Microsoft over time within the Technology Fund or the RS Growth Fund from a total position size, because there are actually quite a few innovations going on at Microsoft and quite a lot more than historically.
However, we are in the futures business, and so we tend to look 12 months, 24 months, and 36 months out. And I would propose to you that on a 36-month out basis that Microsoft would not trade at a free cash flow significant discount to Apple if you project out several years, given their relative growth rates. And so, I believe we're setting price targets more based on where we believe the stocks are going to be two years out as opposed to where they are today.
So, we like Microsoft. In particular, I've been very impressed with what they've been able to do in the gaming front, and I think that their innovations around search are very exciting. And so, if they can take their Internet business from being a low return on invested capital, low return business, and make it closer to their software businesses, that could be a big win for the company. But it is less clear to me that the culture of innovation that's driving Apple exists at Microsoft today.
Leggio: Well, great, Allison. Thanks so much for joining us today.
Thacker: Thank you for having me.
Leggio: And thank you for joining us. This is Ryan Leggio for Morningstar.