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, MaxKapital (512 clicks)
Long-term horizon, value, growth at reasonable price, capital & stock allocation
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Summary

  • Microsoft remains well valued even after the recent run-up in price.
  • The stock as priced offers at least 53 basis points of growth alpha, which translates to a 15.4% gain potential to my estimate of fair value.
  • Once at fair value, investors can expect a total long-term return of near 10%.

In a prior post I looked at Microsoft (NASDAQ:MSFT), when it was trading at $37.89, because I saw it as a value opportunity hiding in plain sight. And it was hard to believe that this value would not be recognized. With the price now nearing $41.50, I am looking at whether Microsoft might still be suitable for the alpha hunter.

How do different market participants view Microsoft?

A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.

AOM Statistical Scores

The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stock's sector and the stock's industry of operation.

Microsoft scores high on value and on quality across the board, regardless of whether we compare the stock with the market, other stocks in its sector of operation, or other stocks in its industry of operation. The score for growth remains poor, thus conviction in growth has not built along with the price rise: though I believe growth scores will improve as analysts revise estimates following Intel's recent revision to revenue and gross margin expectations, which was driven by improvements in the PC market. In fact the refresh of the upgrade cycle caused by no further support for XP still has a long way to run. And the momentum is now strong in comparison with where it was a few months ago: momentum investors are likely recognizing improvements to growth potential.

Source: GetAOM.com

AOM Model Recommendation

This stock now appeals strongly to most investor stock selection styles, with one exception - growth investors who seek to allocate capital at industry level. This includes value style stock selectors. It also appeals to the balanced investor who considers value, growth, quality and momentum equally. It also appeals to momentum investors and to investors with no stock selection style bias. And it appeals to most of the typical capital allocation strategies adopted by investors in that the stock has appeal to all, regardless of whether they allocate capital at sector, industry, or with no sector/industry bias. I expect that as analysts revise growth expectations upwards, we will see the GetAOM algorithm revise growth style stock selectors allocating capital at industry level to buy.

Source: GetAOM.com

Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 85%, and an AOM Strong Buy recommendation for Microsoft.

The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.

I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool that uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.

The Case for Microsoft:

Why look at Microsoft now?

While Microsoft is no longer as cheap as it was when I last posted, valuation remains a good reason to look at Microsoft now. The stock trades at a trailing twelve month P/E below the market P/E. The P/E for 2015 is at a level that suggests that there is gain potential from earnings growth, as well as from an expansion in the multiple. With the five year forward growth expectation expected to strengthen in the coming months, I expect the elevated PEG ratio to decline somewhat. And the stock still offers an attractive dividend yield, well ahead of market yield, and yield offered by stocks in Microsoft's sector and industry of operations. This is great when considering the additional value typically returned to owners via buybacks each quarter in recent times.

Source: GetAOM.com

Except for the current year growth which has been strong in comparison to the market, as well as in comparison to stocks trading in the same sector and industry as Microsoft, Microsoft scores poorly on key growth criteria across the board. It takes a leap of faith to allow growth expectations to rise, but Intel's recent revision in revenue expectations is a positive for Microsoft. The refresh of the upgrade cycle caused by no further support for Windows XP still has a long way to run. Besides, low growth expectations are fine as long as they are priced, which in my opinion, they are in the case of Microsoft.

Source: GetAOM.com

Microsoft also continues to display characteristics consistent with a high quality company. Return on assets, equity and investments are all strong in comparison to the industry, as are gross, operating and profit margins. Institutional ownership which is well over market and sector averages provides a positive signal of sound owner quality. It is disappointing that institutional ownership lags industry averages, but the lag is not huge. Insider ownership is high, which is nice: it is nicer because normally value mega-caps tend to have low levels of insider participation.

Source: GetAOM.com

Of late, momentum has been positive in comparison with industry peers, while being in-line with the broad market and its sector peer group.

Source: GetAOM.com

Is Microsoft a suitable pick for alpha hunters?

Analyst price expectations

Recently Microsoft traded at $41.50. From Yahoo Finance, we know that twenty-seven analysts expect an average price target of $42.10 (median $43.00), with a high target of $50 and a low target of $33. This is a wide dispersion in expectations, which suggests risks are high. So far, the bulls have it.

One of the classic conundrums for value investors is that value stocks tend to go from being very cheap to being rightly valued and back to being cheap. When a stock is rightly valued, it is priced to hold. When it is cheap, it is priced to buy. And one way to determine whether it is cheap or not is to estimate the alpha available with the stock as currently priced.

Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. So we will really never know the extent of alpha created until the actual return is earned. But we can always try to estimate alpha.

Mathematically, the worth of Microsoft is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. If you do use the above formula, please read this explanatory note.

So let us have a closer look at the different parameters used to determine value.

Beta, co-efficient of determination and alpha intercept considerations

Value Line reports a beta of 0.85 for Microsoft. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one. Value Line also has a 2017-2019 price range of $45 to $55: this reflects an annualized return of 7% to 12%, which in addition to a 2.7% dividend yield, indicates a total return expectation of 9.7% to 14.7%. This clearly suggests that they expect that there is much to play for.

I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 0.90, and I adjust it to 0.95 on account of the beta's tendency to converge towards one. This low beta adds defensive characteristics to the stock, which is always nice in what is perceived as an over-valued market.

The coefficient of determination for Microsoft is 36.23%. This suggests that only 36.23% of the price movement in Microsoft is explained by movements in the market: the residual price movement is based on company-specific factors. This average coefficient of determination suggests that the market related risks are average. And because company-specific risks can be diversified, Microsoft is a great pick for most portfolios at the present time.

Disappointingly, Microsoft has an alpha intercept of (0.01%), which means that if the S&P 500 returns 0%, the stock can be expected to return (0.01%). But because of the average coefficient of determination, the raw beta and alpha are less meaningful.

Over the past five years, the average weekly price change on Microsoft has been 0.26% (median 0.30%). The standard deviation over the period has been 3.04%. Thus for Microsoft, the range of normalcy (average plus or minus one standard deviation) for weekly returns is between a gain of 3.3% and a loss of 2.8%. The stock has remained in this range of normality since the week off 3/17, when it spiked 6.53%. This rise represented a rare average plus two standard deviation event. It was driven by Nadella's planned press conference for 3/27, and caused by an enthusiastic response to rumors (subsequently proven to be true) of Office for iPad. In my view further gains with normal volatility are possible: even likely.

(click to enlarge)

Source: MaxKapital Beta Calculator

Valuation

We might believe that Microsoft is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Microsoft is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in-line with our long-term expectations on a standalone basis and regardless of broad market valuations.

Mathematically, the worth of Microsoft is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].

What is our long-term return expectation for a stock with a beta of 0.95, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Microsoft, we should be targeting a long-term return of 9.96%. Is the stock priced to deliver that return?

Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. This chart below displays normalized trailing twelve month earnings over the past five years, together with analyst expectations for the current and coming three years. It also shows Microsoft's historic revenues and sales estimates for the current and coming fiscal years.

(click to enlarge)

I am very comfortable with $1.85 in 2013 marking a bottom in as reported earnings, and expect growth to accelerate with a pick-up in the global economic cycle and the PC replacement cycle.

Nineteen analysts included on Reuters data estimate average operating earnings of $2.70 (High: $2.76, Low: $2.61) during the year ended June 14, with twenty-one analysts estimating that it will rise to an average of $2.87 (High: $3.18, Low: $2.64) for the year ending June 15. Four analysts assess long-term growth rates at 6.78% on average, with a high estimate of 8% and a low estimate of 5%. I expect these estimates will be revised upwards in response to Intel's recent upward guidance and the start of a refresh cycle as people shift to Windows 7/8 from XP, which is no longer supported by Microsoft.

I am comfortable with $2.70 as a fair and conservative estimate of sustainable earnings.

The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution on account of employee and other issuances. I expect Microsoft will pay out approximately 60% of earnings via dividends and buybacks (approximately 35% to 45% via dividends and another 25% to 15% via buybacks) over the long term. An adjusted payout ratio of 60%, assuming nominal earnings growth of 6.3%, implies a return on incremental equity of 15.75%: the 40% of earnings retained, invested at a 15.75% return on equity, delivers the required 6.3% (40% * 15.75%) growth. This return on incremental equity is not a challenge, considering that the recent return on equity is 27.33%, and it has averaged 35.73% over the past five years. Indeed, Microsoft's payout ratio could rise higher still.

If we use a very long-term growth expectation of 5.83%, Microsoft is worth $41.50. Microsoft Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 105.83% * $2.70 * 60% / (9.9625%-5.83%) = $41.50. At this price, it is likely that an investor with a return expectation of 9.9625% will be satisfied.

The growth estimate implied by the current market price of 5.83% is low. And until recently, it has been low with good reason. However, there are catalysts such as the operating system upgrade, as well as Intel's upward guidance which must mean good news for Microsoft, which suggests that this estimate of 5.83% for long-term growth is on the low side.

Alpha is estimated as the difference between actual returns and the risk adjusted return expectation. If we accept analyst estimates of forward five year growth of 6.78%, we get a composite very long-term (fifty-year) growth rate of 6.3% assuming that following five years growth at 6.78%, growth reverts to a 6.25% growth rate for the next forty-five years. If Microsoft grows at a long-term rate of 6.3%, we have growth alpha of 0.47%. And an investor buying at present levels can expect a long-term return of 10.43%.

There is however a small matter of an expectation of revisions to earnings growth following Intel's updated guidance. If we expect the forward five years growth estimate to converge towards today's 8% high estimate, and we assume that growth reduces to 6.25% for the following forty-five years, we get a composite very long-term growth rate of 6.42%, growth alpha of 0.59%, and the total long-term return expectation goes to 10.55%.

An 8% growth estimate for the forward five years is possibly too optimistic to expect. And so I will use a 7.39% forward five year growth estimate. This represents the mid-point of the present average and high analyst expectations of 6.78% and 8% respectively. And based on this I get a composite very long-term growth rate of 6.36%, growth alpha of 0.53%, and a total long-term return expectation of 10.49%.

Microsoft is capable of sustaining a composite very long-term growth rate of 8%, which is essentially in-line with global potential nominal GDP growth rates. But to achieve this they must retain their competitive advantage through innovation, and they must succeed in the mobile, tablet and phablet market. And we cannot presume that they will. Thus, I will go with a composite very long-term growth rate of 6.36%, as calculated above.

If we use a very long-term growth expectation of 6.36%, Microsoft is rightly valued at $47.88 [106.36% * $2.70 * 60% / (9.9625%-6.36%) = $47.88]. So at present, we have 0.53% of long-term alpha, which translates to a 15.4% upside to "rightly valued," after which you can expect a very long-term total return of 9.9625% from the stock.

I don't believe a $47.88 fair value estimate is overly optimistic. However, the fair value estimate ($47.88), together with a 7.26% (Total Return Expectation of 9.9625% less 2.7% via Dividends) annualized three year return results in a projected value of $59.08 by mid-2017. This is higher than the high end of the Value Line range of $45 to $55 for 2017-19.

A fair value estimate of $41 together with a 7.26% (Total Return Expectation of 9.9625% less 2.7% via Dividends) annualized three year return results in a projected value of $50.59. This is close to the mid-point of the Value Line range of $45 to $55 for 2017-19.

Based on my estimate of the implied Value Line fair value, I think it is fair to say that while Microsoft remains well valued for the alpha hunter, for those of you who took aggressive over-allocations to Microsoft when it represented value hidden in plain sight, the time to eliminate those aggressive over-weights and return to allocation is near, if not here. The easy money has been made.

Source: Microsoft For The Alpha Hunter