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I generally like to look for equity investments in smaller companies where there is a better chance of having an informational advantage or for serious mis-pricing to exist. You aren’t going to get a 3-bagger buying a mega-cap company. Make no mistake - smaller is better when it comes to trying to hit home runs.

But let’s be honest. When the stock market has gone up 100% in two years maybe you shouldn’t be trying to swing for the fences. And that is especially true if Mr. Market is willing to offer a pitch that is very easy to hit for a single.

Enough with the baseball lingo. What I’m trying to say is that you don’t always have to try and be a hero. If Mr. Market is willing to offer you a very low risk opportunity to make 10% a year you should take it. And I think Microsoft (NASDAQ:MSFT) today at $25 is just such an opportunity.

Sometimes simpler is better. And I think Microsoft is as simple as it gets.

Here is a simple look at the numbers.

Cash flow from operations over the past four years:

  • 2007 - $17.7 bil
  • 2008 - $21.6 bil
  • 2009 - $19.0 bil
  • 2010 - $24.0 bil (estimated on 6 month run rate)

To make this easy I’ll estimate the business is producing $21 bil per year.

Current shares outstanding – about 9 billion fully diluted.

Share price today - $25.

Market cap is therefore - $25 x 9,000,000,000 = $225 bil.

Microsoft has about $32 bil of net cash on the balance sheet, so the enterprise value is roughly $193 bil.

So if you are buying a share of Microsoft today you are basically buying a business that is producing $21 bil of free cash flow per year and for that you are paying $193bil which is a 10.88% free cash flow yield.

It is hard not to think that this is an exceptional price for a company with a fortress of a balance sheet and a dominant position in its key business area (Windows still has a greater than 90% market share). Yes, the days of rapid growth are long gone, but that $20 bil plus of cash flow per year will grow in the future and that $30 bil of cash on the balance sheet will be deployed intelligently.

This company has been out of favor with equity investors for a decade now and at some point the value will become too good to ignore. We may be there now.

A business like Microsoft with a dominant position should command a premium valuation multiple. Not less than 10X cash flow. I’m not saying the share price is going to $50 in the next year. But I bet the odds are very good that you get a chance to sell around $30 which would be better than a 20% return in the next 12 months. And perhaps more importantly, there is no way that you are going to suffer any permanent loss of capital buying this company at a 10% plus cash flow yield.

And eliminating the chance of permanently losing capital is 99% of the game. So don’t worry about trying to figure out if you should be buying credit default swaps on the Australian Housing Bubble. Just keep it simple and buy some Microsoft at this juicy cash flow yield, pocket the nice 2.7% dividend and enjoy some sound sleep at night.

Let everyone else work 10 times as hard and likely not find any investments that perform much better.

Source: Microsoft: Can You Really Find a Better Risk / Reward Scenario?