Temporarily Bullish on Microsoft

As in politics, you can't have permanent friends or foes in business. Most of my readers know that I have been bearish on Microsoft (MSFT) shares these few months but I am changing my opinion temporarily.

The stock market works in mysterious ways and I would beg to differ from my friends who believe in efficient market theory. Despite the market increasingly becoming better at closing the gap of attractively priced securities, there is enough time for individual investors to take advantage of some of these mis-priced equities. People who bought Apple (AAPL) around 120 or Google (GOOG) around 420 know what I am talking about.

I believe that a similar situation has presented itself in Microsoft shares. Microsoft has been doing really well for the past few quarters and with some of the new initiatives doing well, we believed that Microsoft's share price was finally breaking out after being in the pit for over five years.

Then came Microsoft's unsolicited bid for Yahoo (YHOO) and things changed. Mr. Market did not like the idea of a high valuation Microsoft put on Yahoo and responded with shaving off over 3$ from Microsoft's share price. Then in the last quarter, despite beating the Street's expectations, the market punished Microsoft for not making enough money from Windows.

Finally Microsoft withdrew its bid for Yahoo. We expected the market would reward Microsoft's share price but it punished both Yahoo and Microsoft shares. This time Microsoft was punished because it could not close the deal. Analysts can't have it both ways, first punishing Microsoft for placing the bid and then withdrawing it.

With over $23 billion in its coffers and a forward P/E of 13, Microsoft seems to be mispriced. Even with a generous discount factor and cost of capital, Microsoft has a net present value. Microsoft at current levels is what Mohnish Pabrai calls a 'dhandho' investment, with lots of uncertainty and little risk. If Microsoft doesn’t revisit a Yahoo purchase, its share have at least 3$ of value built in. If it does end up buying Yahoo, then the market has priced Microsoft as if it will buy Yahoo at $35 a share with no value in return from this purchase. As for Microsoft, I believe this is an ideal time for the company to repurchase its own shares and finance any Yahoo deal with debt if necessary.

Disclosure: None

Comments

[Marcel McSweeney]

You write you differ from those who believe in the efficient market theory, then for the rest of your article you describe the efficient market theory working flawlessly in the market. This is a contradiction that makes your message unclear.

[Muddling Investor]

Microsoft is a sell. It can't continue as a strange conglomerate of software production for businesses, software for homes, game consoles and internet. Something has to go. From my point of view, they have to get rid of MSN and all internet-related activities, spin off game consoles business and maybe even split software business. Then software part will be a great value play (dividend, please!).

Of course, it's never gonna happen with current management. Sell.

[Marcel McSweeney]

To Muddling Investor:
I wish it were that simple.

[Vikas Agarwal]

Dear Marcel,
Can you point out, where am I describing the efficient market working flawlessly? The entire essence of the article is that microsoft is mispriced by market due to the uncertainty and lack of interest.

[Marcel McSweeney]

Dear Vikas,
You disavowed the efficient market theory and then espoused its workings. The market is efficient because of the mis-pricing like the one you described. Mis-pricing is a prerequisite to the efficient market. If no mis-pricing ever occurred, there would be no opportunity and investors would not be interested. You described the efficient market working flawlessly.
I enjoyed your article. Many articles about MSFT are almost humorously biased. Every adjective and adverb used to describe MSFT is negative, and every adjective and adverb used to described MSFT’s competition is flattering. Your article has none of this foolishness that I have read in many previous article by other authors.

[Vikas Agarwal]

Dear Marcel,
It seems by efficient market theory we understand different things. What I understand from EMT is that since the market participants are very intelligent and rational, the prices of all the securities in market reflect all the known knowledge about the companies. If we follow this than all the securities are priced 'fairly' at all times. What I am contending is that this does happen most of the times but not all the times and one can indeed beat the market fairly consistently if he is willing to put efforts and resist the urge of action.

[Marcel McSweeney]

The EMT as you describe would be a theory I would not agree with, so it appears that we do agree: the EMT is no realistic.

[chicagopride]

Studying for the CFA and we just covered EMT in detail.

EMT can be thought of as existing in three forms: weak, semi-strong, and strong. Weak EMT holds that all public historical information is baked into a stock price so charting and other technical analysis doesn't work. Semi-strong believes that the market responds rapidly to any new public information and therefore not only does technical analysis fail, but fundamental analysis is also useless. Strong form EMT takes this all a step further and posits that all knowledge about a company, both private and public, is already accounted into the stock price; only new information changes the price of the stock and that happens randomly. In strong EMT, no investor acheives above-normal risk-adjusted rates of return.