Given the extent to which we talk and write about our quest to find sustain-ably advantaged businesses, we believe this quarter provides us with a great opportunity to point out that “we put our money where our mouth is”. That’s because we believe the three stocks we bought were each good businesses as evidenced by their underlying attractive economics. The additions we made were Aon, Microsoft, and 3M. Each has produced returns on invested capital that are either already high or improving dramatically, each is capable of serving an increasingly global client base, each has relatively new yet highly respected management teams, and each is optimizing its balance sheet. In short, we believe that each of these high quality businesses represents a very good investment, at the price we paid...
Microsoft (NASDAQ:MSFT) - With a dominant and arguably near monopoly position in its most important businesses, Microsoft is a remarkable company. It is the largest software company in the world and is a company that we expect will grow sales in excess of ten percent and earnings per share in excess of 20 percent this year on superior operating margins and returns on capital. This company, purportedly in danger of being “buggy whipped,” also is expected to generate more than $17 billion in operating cash flow this fiscal year and has $29 billion in cash on its balance sheet.
Microsoft’s Client Division, which represents the Windows operating system, is still the largest segment in terms of sales and operating profits. Close behind is the Microsoft Business Division, which encompasses the sale of Office products and other collaboration tools. These two divisions represent approximately 60% of sales and have operating margins near 70%, and the third-largest segment, Server & Tools, represents one of the world’s leading franchises in business and server software. xxx
The other business segments—the ones that seek to extend the Windows franchise into PDAs, mobile phones, video game consoles (Xbox), and online services (NYSEMKT:MSN), are smaller in terms of sales and contribution margin but are no less important in terms of strategic value and growth potential. These businesses are still in the early stages of their life cycles, and as one ought to expect, Microsoft has been plowing money back into these areas. In our view, the market is penalizing Microsoft for investing in its future.
While founder and Chief Software Architect Bill Gates will retire from his day-to-day responsibilities in 2008, the company will continue to be led by Steve Ballmer who has been CEO since 2000 and Chief Software Architect Ray Ozzie who joined the company in 2005 when Microsoft acquired Groove Networks. In addition, CFO Chris Liddell appears inclined to continue to pair down the company’s overcapitalized balance sheet. In sum, we believe that this great business will remain a great business for years to come and that as long-term investors we will benefit from buying the shares of this well-managed and increasingly shareholder-friendly company...
A key component of our “good businesses with good management at attractive prices” philosophy is that of valuation. As a reminder, our goal is to invest in advantaged businesses when Mr. Market offers them up to us at prices that we believe offer an attractive margin of safety. We typically draw this line in the sand at a 30-35% discount to our estimate of the company’s intrinsic value. In our estimation, the allocation of the Fund’s collective capital to these businesses during the quarter clearly met this threshold.
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