Value Investing 5: Thinking Through the Tech Mega Cap Conundrum

by: Philip Mause

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One of the fiercest debates raging these days is whether mega cap tech stocks like Microsoft (NASDAQ:MSFT) are seriously undervalued or whether, on the other hand, these stocks are fairly priced because of the bleak future they face. Certainly, the last several weeks have not been kind to the bullish side of this debate. To provide some perspective, I am listing 8 stocks and providing Monday's closing price, the amount of net cash per share, this year's consensus earnings, the ratio between the "enterprise price" (market cap minus net cash) and earnings, and dividend yield.

  1. Microsoft (MSFT) (24.04) (5.80) (2.66) (6.8) (2.7%)
  2. Google (NASDAQ:GOOG) (504.73) (106) (33.90) (11.8) (0)
  3. Apple (NASDAQ:AAPL) (326.60) (71) (24.78) (10.3) (0)
  4. Intel (NASDAQ:INTC) (21.34) (2.40) (2.29) (8.3) (3.4%)
  5. Cisco (NASDAQ:CSCO) (15.06) (4.90) (1.61) (6.3) (1.6%)
  6. Hewlett Packard (NYSE:HPQ) (34.65) (0) (5.02) (6.9) (1.4%)
  7. Dell (NASDAQ:DELL) (15.78) (4.50) (1.89) (6.0) (0)
  8. Western Digital (NYSE:WDC) (33.58) (12.50) (3.09) (7.0) (0)

These stocks look very, very cheap. Value investors can make a decent argument that backing out the cash and valuing the enterprise itself is a reasonable method of calculating private market value. On this basis, many of these companies are now trading for 6 or 7 times earnings and probably a lower multiple of free cash flow as depreciation is higher than Capex for many of these companies. In a world of zero short term interest rates and 3% ten year treasuries, a company that has a cash flow yield in the 14%-15% range would seem like a screaming buy.

There is a well established algorithm for valuing companies - the discounted cash flow method. It basically works like this. You climb into a time machine and set the date for 2036, exit the time machine and proceed to the nearest Bloomberg terminal. Then, you obtain the earnings, Capex and other information necessary to calculate the free cash flow of the company for each of the 25 years between 2011 and 2036. Go back to the time machine and return to 2011. Enter the data into a discounted cash flow calculator and determine the value of the company in 2011.

Of course, the problem with this (other than figuring out in advance how much money you will have to take with you to pay for the right to use the Bloomberg Terminal in 2036) is that we unfortunately do not have time machines available. Anyhow, the method requires making estimates of future cash flow and, of course, the results depend completely upon how those estimates are made. We can reason in reverse and determine what assumptions about future cash flow are consistent with the market's pricing of stocks. If the stock is priced at a very low multiple of cash flow, then the market "thinks" that cash flow is likely to decline.

In trying to estimate future cash flow and use it to value a company, the reality is that there are generally a variety of estimates and predictions. Strictly speaking, given the uncertainty associated with the task, we should take each possible level of future cash flow, associate a probability with it, multiply each possible level by its probability, and add up the results to produce an Expected Future Cash Flow.

Just if you flipped a coin one hundred times, it might come up heads 0 times, 100 times or any number of times in between. However, the "expected" number of heads would be 50. Sorry for this diversion into probability but I believe it is necessary to understand what is going on with these stocks and, perhaps, how to play it. The Tech Sector has produced enormous economic growth and benefits for the population. It has also produced some enormous fortunes. Unfortunately, it has also littered the ground with train wrecks and investor disasters; companies which were once major players have quietly (and sometimes not so quietly) passed into obscurity - think of Data General, whoever invented the ENIAC, DEC, Nortel, Control Data. IBM even suffered through a long eclipse and AAPL had a near death experience.

This phenomenon doesn't mean that Tech is like the airline business in which nobody ever seems to make money or like the newspaper business, which is in a long but inexorable decline. Tech as an industry has a very bright future. New products and applications are constantly being developed. Look at statistics on penetration levels of smartphones, PCs, and internet usage in emerging market countries and you will see an enormous growth trend and enormous room for further growth. And something else important has changed. 30 years ago you probably could have sold computers in Brazil but you couldn't find anyone who could pay you with real money. Now many of these countries have strong currencies, which are steadily appreciating against the dollar creating a powerful tailwind for corporate earnings. Ever wonder why these companies are building up such enormous piles of cash overseas?

So for the Tech Sector in general and for many of these companies, the Expected Cash Flow will be growing. The problem is that the range of possible outcomes for many of these companies is wide and some of the outcomes are very, very bad (just as it is possible that if I flip a coin 100 times I will get only 25 heads). And due to the rapid pace of change in the Tech World and the potential for disruptive innovation, the probabilities of some of these extremely negative results are not trivial.

I wish I had a dime for every time I have read that Intel will be killed by the transition to mobile devices, that Microsoft Windows will be rendered obsolete by the Cloud, that the PC will disappear because of the tablet, etc. etc. And, of course, there is some probability of these things happening. If only we had that time machine!

The stocks listed above have matured to the point that their main constituency is a group of relatively conservative, risk averse investors - these are folks looking for the next Proctor & Gamble (NYSE:PG), not folks looking for the next (NYSE:CRM). Trying to sell risk in this crowd is like putting racing stripes on a minivan. This group of investors penalizes these companies for the fat tail risk of a fiasco even though the probability of that outcome may not be very high and may be well balanced by significant potential for better-than-expected outcomes. And - in the Tech Sector - no one really knows what will happen.

So - where does this leave us? As I suggested in a previous article, looking at the tablet/PC debate, it is very hard to predict exactly what will happen but you can probably be relatively certain that it is very unlikely that BOTH AAPL and MSFT will crash and burn and, since MSFT is priced for a precipitous decline in earnings and AAPL is priced for virtually no growth, why not buy them both? The same analysis might be applied to CSCO and HPQ. At this point, even GOOG is looking pretty cheap - so buy MSFT, AAPL, and GOOG to be sure you participate in the smartphone market. As a general matter, the best strategy may be to buy a group of these companies and accept the risk that one member of the group could be the next Nortel. Looking the group over, I don't think that is actually going to happen but you can certainly limit risk that way.

I think that some of these companies will experience surprising growth and the stocks will pick up on that as a combination of higher earnings and multiple expansion creates upward momentum. Some of these companies will grow total dollar earnings more slowly but will improve per share earnings by aggressively buying back shares over the next couple of years and will start paying decent dividends (INTC has already done this). Of course, the lower share count will make it easier to pay the dividends. They have the cash to increase the dividends every year even if earnings dip a little and some of these stocks will cluster around a 3 percent dividend yield. Of course, each time the dividend is increased, in order to keep the dividend yield at 3%, the stock must go up. This will begin to build momentum and the expectation of appreciation and some of these stocks will be "rediscovered." And one or two of these stocks may crash and burn - or, more accurately, resemble a whale beached at high tide. I am reasonably confident that an investor in the group will do very well in the long term but in the short term anything can happen and it may make sense to tip toe in and see if you can buy at even lower prices over the next few months.

Disclosure: I am long MSFT, AAPL, GOOG, INTC, HPQ, CSCO, IBM, PG.