I am not a professional investment manager, and I am not a CFA, but I have been around the block a couple of times by now. I have come to recognize that broad "macro" themes emerge around whole categories of stocks, and then change, and while they are presented in real-time as "sophisticated views," in reality they are mere fads, nothing more. For example, in the late 1990's tech companies could do no wrong. (They were going to infinity. Less remembered was that people thought the same of pharmaceutical companies, back when Lipitor was launching.) Meanwhile, tobacco companies were then thought to be two inches from extinction.
Then those theses/fads collapsed, and in 2004-2007 houses were the "can't miss" investment. We all know how that ended. As another example, in the 1990's the big strategic thing was for oil companies to merge (ExxonMobil (NYSE:XOM), etc), and to "vertically integrate" and create "synergy." Now, the big strategic thing is for them to split up, to "unlock value." Thus, ConocoPhillips (NYSE:COP) split into two companies is hailed as visionary and people want ExxonMobil to do so as well. Folks, these are fads and manias, waves and tides, and little more.
Similarly, it is now very sophisticated to think all tech companies are "inherently unstable" and part of a "no moat industry" and that every tech company, no matter how big, is inches away from some tiny or large competitor blowing them up. And after all, Nokia (NYSE:NOK) just got pasted, and Research in Motion (RIMM), too. Never mind the fact that in the late 1990s, when these companies could do not wrong, even more companies were failing. Remember this one? But now the pace of change seems overwhelmingly scary to people.
Anyway, all of this is why most of the tech and drug companies were a predictably terrible place to invest in the late 1990s, when I was buying, among other things, Philip Morris (sadly, I also picked up a few shares of Eastman Kodak and GM, though much less of them), and why houses were terrible investments in 2007, when I was putting my life savings in a 5% rate one year FDIC-insured CD, and why, astoundingly, Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT), and Apple (NASDAQ:AAPL), the last of which I have already written about, are all simultaneously some of the most undervalued stocks in the market today.
I would submit to you that everyone thinks each one of these is on the cusp of destroying the other one (or being destroyed by Amazon (NASDAQ:AMZN), etc.), or cannot grow because of the success of the other company. As a consequence, nobody is willing to pay up for the value in any of them. Because paying up does not match the fad du jour.
I own Apple, Google, and Microsoft, among other stocks. For a long time now, Microsoft has been the largest position in my portfolio. I first added around $19/share during the financial crisis. That was based on more of a knee-jerk "holy tamales, that's cheap and, no, the world is not ending" analysis. Later, I did a lot more real analysis, after which I added around $24/share, and I added in late 2010 at around $28/share, in March 2011 at around $25.50/share and last Fall around $27/share. Today I think the stock is still either: 1) stupid cheap (as in, undervalued by 30% or possibly much more); or 2) Windows 8 and everything else is actually going to fail and it is going to go into terminal decline. You pick. Here is my updated free cash flow spreadsheet, which shows Microsoft is basically priced for the apocalypse.
Discount Rate: I assume a calculated WACC of 9.2% for Microsoft in the sheet.
Cash on Hand: In my sheet I also discount all $59.3 billion in cash and equivalents on hand by 35% to account for foreign-to-U.S. repatriation tax, even though not all of the cash is held abroad, and no tax may ever be paid even on what is held abroad if there is another foreign tax holiday. I also deduct the nearly $12 billion in long term debt from cash on hand.
Assumed Growth Rates: It shocks many people to hear that even during what I call the "iPhone era," and which is now the "iPad" era, Microsoft has grown free cash flow at a 12% clip from June 2007 through June 2011. That is reflected at the top of the spreadsheet above, but you can also check it here. Many people have never bothered to look at the actual numbers. That level of growth is well into Peter Lynch's "stalwart" territory, not a slow grower at all, and Microsoft did this through the worst recession since the Great Depression. Let's set that 12% growth rate aside for a minute, but keep it in your head.
Conclusions and Thoughts: Based on the above, to be fairly priced today you have to believe that Microsoft's free cash flow will basically contract from here on out. Seriously. The numbers are right there. And that is assuming free cash flow growth starting from June 2011's annualized figure, even though the currently listed trailing twelve month figure for free cash flow indicates that through June 2012 free cash flow will have risen significantly.
If, on the other hand, you assume Microsoft can grow its free cash flow by just 4% per year for ten years, which is one third of what it has grown it on annualized rate through the past four years, then Microsoft is around 28% undervalued. The sheet is presently set up to reflect this assumption. Under those assumptions, it is a buy up to about $36.20/share, and it is a screaming buy today.
Not only that, dear reader, but I only give MSFT a post-ten-year 1% perpetuity growth rate, which is a population growth rate that is below inflation. And I think Microsoft can manage more than 4% growth going forward. In short, this is a conservative calculation.
What's going on here? I suspect people will scream about how much better Apple is than Microsoft. People will say that Microsoft is going to go the way of Research in Motion. People will say, related to this, that the WACC (discount rate) is too low (and therefore favorable to Microsoft), because Microsoft is just not as stable as it seems. People will say that Microsoft wastes its free cash flow so you can't count all of it.
I get it. And I think Apple is better right now, and it is my fourth largest position. But remember this: there is room in the world for both Coke and Pepsi, for both BMW and Mercedes. Yes, there is cash flow wastage -- Bing has been a huge waste so far. And even more frighteningly, there was titanic attempted wastage: the failed Yahoo acquisition for tens of billions of dollars. Yes the PC market is mature in the United States, and being eroded by the iPad.
But there is a lot of organic growth left to be had around the world. Microsoft has grown healthily even during the iPhone era so far. I am sorry to frustrate the "story," but that is just what the numbers say. Many businesses have not even upgraded to Windows 7 in part because they are happy running Windows XP, service for which will be phased out by 2014. So even if businesses do not want Windows 8, they will be upgrading to Windows 7 for years to come. And at least at this point Microsoft still has a chance in tablets and phones. It has expanded its gaming business. Kinect is a hit. Office is going strong, cloud notwithstanding. Servers and tools is now a huge portion of the company, and growing.
So you have a choice with Microsoft: do you think it's going to fail? Based on what, your story or prejudice? I very well could be wrong, but I think the it is going to be fine, and have thought it for two years. Believe me, I watch the numbers carefully to see if I am wrong. I believe that there will be pretty clear signs that Microsoft is truly losing its Windows and Office franchises, if it happens. But so far, in the two years I have been closely following it, including this past quarter, which included record revenue, I have seen nothing to indicate Microsoft is going down the tubes. And I still do not. The stock price continues to think otherwise.
Disclosure: I am long MSFT. It is my largest position, and comprises more than 10% of my total individual-stock investment portfolio. I am also long AAPL (fourth largest position), GOOG, PM (third largest position) and XOM (second largest position).