A few years ago, I recommended Microsoft (NASDAQ:MSFT) as a potential value investment. Since then, this cash cow has continued to generate enormous returns on its capital. But two unrelated developments now make it a 'sell' candidate in my opinion.
First, the company's share price has risen astronomically. In just the last 5 months, for example, shares of Microsoft are up almost 35%. Has the company's value increased commensurate with its price rise? It would be difficult to argue that it has.
What's more likely is that shares of Microsoft are up simply because Mr. Market's mood is no longer so gloomy. Whereas one could buy Microsoft at a P/E ex-cash of below 10 just two years ago, today that same deal is no longer available; shares trade at an ex-cash P/E of around 14.
The second problem is that the company's moat is being eroded. I would go so far as to argue that Microsoft's moat is in its most tenuous position in decades.
Though Microsoft is still the dominant operating system on desktops and laptops, these "personal computers" are likely becoming less and less important. Warren Buffett continues to repeat that he wants the managers of the companies he owns to focus on widening their moats. During the period in which I held shares of Microsoft, I can't really argue that the company has been successful in this endeavor.
In The Innovator's Dilemma, Clayton Christensen offers a useful model for understanding such moats. A disruptive technology (e.g. phones, tablets) emerges that can do some but not all of the tasks the incumbent (e.g. Microsoft and the PC) provides.
For a while, the new technology may not be seen as a threat. After all, all of the tasks for which we use the PC still need doing. But over time, the disruptive devices continue their technological development across a number of dimensions (e.g. power consumption/charging, applications/productivity tools, hardware speed/capability), continually reducing the tasks that can only be performed by the incumbent. Eventually, the incumbent's share and profits dwindle, as the company is forced up-market as it loses users at the margin.
The solution to falling prey to such an occurrence is active participation by Microsoft in the disruptive technology. It seems clear that Microsoft has been trying, but it may be too late to the game; its share in the phone/tablet market is appallingly low. Since the successful companies in this industry have also created network effects, coming from behind won't be easy.
As these markets grow and become more widely adopted, they reduce Microsoft's competitive advantages. This doesn't happen overnight, though; there is no doubt that Microsoft will continue to reap the rewards of the network effects of Windows and Office for many years to come. But the durability of this moat, and therefore Microsoft's future product pricing advantage, is certainly in question.
In addition, the technology improvements of PCs may have recently reached a "good enough" state in the eyes of most of its users. This slows the product upgrade cycle; why buy the newest PC when your three year-old PC can do pretty much the same job? You couldn't say that ten years ago. This factor, combined with sales of mobile devices, helps explain why PC sales fell 14% in the first quarter of 2013.
Would I still buy Microsoft if it fell to a P/E below 10? Probably. Would I have held on to Microsoft at its current P/E if it was dominating the tablet/phone market? Probably. But these two factors (price and moat) combined made me weary of holding on to this investment. I sold out as the price rose, and look to deploy capital to more compelling opportunities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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