But how, you will ask, does one decide what [stocks are] "attractive"? Most analysts feel they must choose between two approaches customarily thought to be in opposition: "Value" and "growth" ... We view that as fuzzy thinking ... Growth is always a component of value [and] the very term "value investing" is redundant. -- Warren Buffett, Berkshire Hathaway (BRK.B) annual report, 1993
We take Buffett's thoughts one step further. We think the best opportunities arise from a complete understanding of all investing disciplines in order to identify the most attractive stocks at any given time. We therefore analyze each stock across a wide spectrum of philosophies, from deep value through momentum investing.
This involves performing significant valuation analysis, both on a DCF and relative value basis, and assessing the firm's fundamentals (cash flow, risk, etc.), technicals and momentum indicators. The best stocks, we believe, will be attractive from a number of investment perspectives -- from value through momentum (hence our name, Valuentum). On the other hand, the worst stocks will be shunned by most investment disciplines and display expensive valuations and poor technicals and momentum indicators. In the spirit of transparency, here's how the Valuentum Buying Index, our stock-selection methodology, sorts winners and losers:
(Click to enlarge)
As part of our process, we use a discounted cash-flow model to arrive at a fair value estimate for every company within our equity coverage universe. In Microsoft's (MSFT) case, we think the shares continue to look undervalued at today's prices. Our fair value estimate for Microsoft is $41 per share (was $39; 12/2/2011), over 30% higher than where it is currently trading. In the spirit of transparency, we make available our fully-populated DCF valuation models to all of our financial advisor and institutional customers here.
As a side note, Microsoft is probably one of the best example as to why Valuentum investing works -- Apple (AAPL) is another good example. As many investors know, Microsoft had been in a trading range for many years. But only when it broke through its long-term downtrend earlier this year did its stock really start moving. At that time, we felt it was undervalued on a DCF basis, was attractive from a relative value standpoint, and we were finally getting confirmation from its technical/momentum indicators. That meant that both value investors and technical/momentum investors were starting to get on board. And when income investors began to admire the firm's 3% yield at that time, even more investors--from value THROUGH momentum--became interested. It should then be very clear to investors why Microsoft is one of the best performers this year. It met almost all of our criteria.
Microsoft's DCF Valuation Summary
We assume annual average top-line growth will average in the mid-single-digits over the next five years. We also assume that Microsoft will grow earnings at a mid-single-digit pace during our discrete five-year horizon. We expect the firm's excess returns on invested capital will fade to our estimate of its cost of capital (about 10.5%) by Year 20 in our model.
(Click to enlarge) Source: Valuentum Securities, Inc.
Our estimated fair value ranges between $33 per share and $49 per share. This considers the risks inherent to Microsoft's business as well as the future potential variability in the company's free cash flow stream. Microsoft has been one of the biggest generators of alpha in our Dividend Growth portfolio. We'd consider adding to it on any material weakness.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. MSFT and AAPL are included in our actively-managed portfolios.
