Microsoft: Caught Between Value And Growth
In my opinion, Mircosoft (NASDAQ:MSFT) is oscillating between value and growth: too expensive for a value stock while its multiples do not seem to fully reflect its potential growth yet.
Microsoft gained over 20% in 2015. It currently trades at a trailing P/E of 35 and forward P/E of 17. Its PEG ratio of 2.08 is higher than Apple (NASDAQ:AAPL), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), or Facebook (NASDAQ:FB), which all have PEG ratios below two. Microsoft returns a dividend yield of 2.6%, too low for dividend investors. It seems that MSFT's valuation has started to move into levels consistent with a growth stock. As such, the stock performance will be determined by the successful execution of its stated growth strategy in mobile and cloud. Disappointment is this area could lead to downside. However, unlike pure growth stocks with much loftier valuations, Microsoft's price tends to be supported at lower levels by its dividend yield and established cash flow (Source for all numbers in this paragraph: Yahoo! Finance).
Due to the stock-specific situation as well as the macroeconomic environment of rising interest rates and increased volatility, Microsoft's price might experience setbacks over the coming months, even as its long-term growth prospects might remain intact.
The following rule provides a systematic method for any investor to manage an existing position in a more volatile environment. The idea is to add to an existing position on cheaper prices and reduce in higher territories. Rule-based trading encourages trading discipline and - once specified - takes a certain subjective element out of the trading decision.
Maintain a target dollar amount invested in the asset (in this case, Microsoft). When the value of the assets rises above a threshold: sell. When the value of the asset falls below a threshold: buy.
An example: I hold $10,000 worth of Microsoft shares. When the value of the investment rises to $11,000, I sell $1,000 worth of shares to bring back my exposure to $10,000. If the value sinks to $9,000, I buy $1,000 worth of shares to return my exposure to $10,000. A cash account collects the proceeds from sales and provides liquidity for investments.
I call this the constant-exposure strategy.
Initially, two parameters need to be determined. The threshold at which the investment should be brought back to its target exposure, and the initial cash reserves.
In my opinion, the trading threshold should ideally be chosen such that on average only every one or two months a trade occurs; not to burden the trader with too frequent trading and transaction costs. Of course, the trade frequency will depend on market volatility.
The initial cash allocation requires an assessment as to how much downside might be expected from current market levels. This analysis is very individual, and could involve fundamental valuation, technical analysis or historic drawdowns.
For example: Let's assume my target exposure in Microsoft is $10,000. I set the rebalancing threshold at $1,000 (i.e., 10%, up or down) and set aside $3,000 in my cash account. My total assets (investment plus cash) are thus $13,000. I can re-buy three consecutive times (after a 10% decline each) before I run out of cash and 100% of my assets are invested.
With a reference price of $53.00, three such 10% declines would bring Microsoft's price to $38.64 (= 53 x 0.9^3). At that level, the shares would sport a dividend yield of 3.7%, enough to attract the attention of conservative investors.
Here's the backtest of the strategy described above, as benchmark serves a buy-and-hold investment in Microsoft.
These are the assumptions of my backtest:
- Cash does not carry any interest.
- No transaction cost. Given the moderate amount of trades, the low execution cost of most online brokers and the tight spreads in MSFT, this seems a reasonable simplification.
- The backtest period is from December 31, 2014, to January 5, 2016. This period presented itself as an example of a sideways market with a breakout upwards in the last two months. The years prior can be characterized as a trending bull market for MSFT not suited for the strategy; see Risk section below.
- Only daily closing values are observed (i.e. not intraday monitoring).
- Dividends are reinvested.
For the purpose of the backtest, the closing value of every day is taken to determine whether the rebalancing threshold has been reached. If so, the rebalancing will take place at the close of the following trading day to allow for a lag between observation and trade.
The initial parameters are: $10,000 in shares and $2,000 in cash with a rebalancing after each 10% move in the stock price. The price level of Microsoft at December 31, 2014, was $46.45. These parameters would have ensured the ability to invest down to a decline to about $37.62 (= 46.45 x 0.9^2).
The red line in the chart below shows the value of a buy-and-hold position (including reinvested dividends). The green line shows the total value of the constant exposure strategy (shares plus cash). Also indicated are trading days (blue) and cash ratio of the constant exposure strategy (purple).
There are only five trading days over the 12-month period: two buy signals, and three sell signals. The constant exposure strategy outperforms for most of the period until the massive price-gap upwards after the most recent quarterly results after which the buy-and-hold strategy takes the lead.
The following table summarizes performance, volatility, Sharpe-ratio (return/volatility), maximum drawdown and return/maximum drawdown (ReMaD):
Constant exposure strategy
CES vs. buy and hold
On a risk-adjusted basis, the strategy looks superior: While it underperforms the buy-and-hold strategy in pure performance, it does so with much less risk. Its volatility and maximum drawdown are 4.4% and 3.3% lower, respectively.
The constant exposure strategy scores especially high on the return in relation to maximum drawdown (ReMaD), an asymmetric risk measure that puts upside potential in context with downside risk.
Of course, a backtest based on historic data does not guarantee any future returns. It is simply an illustration of how the strategy might have behaved in a certain market environment.
The results shown in the backtest stem from the mean-reversing nature of a sideways market. However, the constant exposure rule performs badly in a strong trending market. A steady upward trend leads to continuous selling, reducing exposure without ever being able to re-buy in the absence of corrections. Similarly, a continuous bear market leads to buying on the way down; in absence of a recovery, this is a bad strategy (catching a falling knife). The constant exposure rule is best suited for sideways markets, that is markets with frequent corrections and peaks.
Variations And Extensions
The constant exposure strategy can be modified and tweaked. For example:
- Asymmetric thresholds of rebalancing in up- and down-moves can be chosen.
- Constant proportions instead of constant exposure: instead of a constant USD amount, the investment ratio (and cash ratio) is held fixed.
- Calendar-based rebalancing instead of rebalancing based on price movements.
Do you have other suggestions to improve this rule? Would you like to see a backtest of this rule on one of your stocks? Let me know.
Disclosure: I am/we are long MSFT.
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.