If You're Big in Apple, Watch Your Weight

One of the more ironic phenomenons in the investment markets is that as you get more successful, you may have to trim back on that success. Such may be the case with Apple Inc. (Nasdaq: AAPL).

With spectacular earnings results, Apple is on another fantastic run, climbing 9% just this morning, trading recently around $610 per share, up more than 40% this year alone. But this means Apple investors around the world are seeing the shares in climb as a percentage of portfolio holdings. For those investors who are big in Apple, it might be time to think about re-balancing their portfolios, taking some profits in Apple.

What's driving Apple's run? Profits. Apple once again blew away earnings estimates. The company last night announced a quarterly net profit of $11.6 billion on revenue of $39.2 billion. That compares with revenue of $24.7 billion and net profit of $6 billion, or $6.40 per diluted share, in the year-ago quarter. Gross margin was 47.4% compared to 41.4% in the year-ago quarter. These growth numbers are shockingly large.

Apple's run has been so spectacular that it is now exerting an outsized influence on everything. It is exerting a big influence on the S&P 500 Index, which is market-weighted, meaning Apple's influence grows as its price grows. As I wrote here, if you subtract Apple's earnings growth in the fourth quarter, S&P 500 earnings growth was actually negative.

Apple's Amazing Run

Does your porfolio look like Apple? If so, it may be time to cash in some of the profits in a rebalancing.

The same thing is happening in the IU25 Index, which has Apple as one of its largest holdings. You see, Apple Inc. is the largest holding in the index because the index is market-cap weighted, meaning that as a stock grows in market cap it exerts more influence on the index as a whole. This is a paradox for success for the IU25 as well: Apple has contributed immensely to our spectacular run, but now we may be in a situation in which the IU25's future is too Apple-dependent.

For example, the IU25 Index is up 24% year-to-date (YTD). You can see the performance of the individual components here. Apple is up 43% YTD and 73% over one year. The next-best performer in the IU25 Index is Priceline.com Inc. (Nasdaq: PCLN), which is up 37% YTD and 30%.

While we are proud of the spectacular performance of our index, we must admit much of it is due to Apple and Priceline. If you take those two components out, our Index would be underperforming the S&P 500, rather than outperforming it. Just one stock makes a big difference -- because it's Apple.

According to the IU value formula, which is why Apple was selected to our index, it's still not an expensive stock -- Apple's forward price/earnings ratio (12) is well below its substantial earnings and revenue growth rate, which has been more than 50% year-over-year! That is remarkable growth for a company with more than $100 billion in revenue. It has a P/E/growth (PEG) ratio of .65, which is low.

So while technically Apple is not that risky of a stock because it has a reasonable valuation in a great balance sheet, investors need to look at how much they are willing to own. The volatility has been increasing in Apple. Just in the last two weeks it has experienced dramatic swings exceeding 10% (both up and down).

Most finance textbooks recommend holding no more than 10% of a stock. Of course, people shun this rule all the time. I have a good friend who works in the financial services industry who tells me stories of taking orders from people who put 100% of their net worth in one stock -- sometimes Apple -- and "let it ride." This usually has one of two extreme results: Incredibly good or incredibly bad. According to star fund manager and investment author Joel Greenblatt, holding eight stocks eliminates 81% of the risk in owning one stock, and holding thirty-two stocks eliminates 96% of the risk.

Greenblatt, the author of several books including You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits, is a big fan of having a "concentrated portfolio," especially when one stock is on a successful run (such as Apple). In his book, he says he does not have a problem holding up to 20% of your portfolio in one stock.

But what if your Apple holdings have gotten even larger than 20%?

I believe the 20% number is a good number for the maximum investors might consider holding in one stock. If your holdings in one stock are more than 20%, it's likely that one stock will control your destiny as an investor. Investors who were lucky enough to be concentrated in Apple -- especially those at or above the 20% level -- might think about taking some of that money off the table and diversifying. After all, it's now free money, you earned it. Maybe it's time to move it to a different place and rebalance the portfolio to reduce the outsized influence Apple is starting to have on the market and your portfolio.

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