Microsoft – A Top Choice for Conservative Investors

By Paul Franke - January 11, 2012 | Tickers: AAPL, GOOG, MSFT, ORCL, YHOO | 0 Comments

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Based on our in-house stock screens and the company’s “CREDS” score, Microsoft (NASDAQ: MSFT) qualifies as a Strong Buy for Quantemonics Investing (QI) and is part of the Relative Value portfolio on Covestor.com. In fact, with plenty of cash on hand, a high free cash flow yield, share buybacks, and a solid dividend payout supporting stockholder value, plus accelerating top-line growth, MSFT is an excellent choice for conservative, blue-chip portfolios today. Here is a quick summary of the results generated by our proprietary formula, and an explanation of why we have owned shares for most of 2011 into 2012.

Smart and experienced long-term investors should inquire about a potential stock investment’s “credentials” or C.R.E.D.S. before making a purchase. CREDS is an investing system developed by Quantemonics Investing, LLC to help determine a company’s worth. Basically, C.R.E.D.S. stands for Cash Flow and Cash (C), Relativity (R), Economics (E), Debt (D), and Sales (S).

(C - Cash Flow) MSFT’s free cash flow is enormous to say the least. At QI we measure a company’s free cash flow first by taking net income (after taxes), adding depreciation, then subtracting capital expenditures, to come up with a “free” cash flow number that is accurate and repeatable for owners of the business. Occasionally, adjustments need to be made to come up with a real world, honestly repeatable number, but in MSFT’s instance we do not need much adjustment. For Fiscal 2011 ended in June, Net Income was $23.15 billion, Depreciation was $2.77 billion, and Capital Spending was $2.35 billion.

Basically, MSFT had a simple “free” cash flow number of $23.57 billion, that the owners of common shares could either pocket (without directly affecting future profitability) or reinvest in the business. Currently, Microsoft is paying a decent dividend, reducing the number of ownership interests through share buybacks, investing in new business ventures through acquisition, re-investing in existing businesses with research and development plus capital expenditures, and accumulating cash at the bank each year. (The previous year’s free cash flow number was $19.45 billion.) 

If QI were to purchase the whole company without adjustments (100% ownership), our purchase cost would be $235 billion at the current $28 per share price. Note: this is the marketplace quote to buy MSFT today, not the price MSFT should be valued. In other words we could put $23.57 billion in our pocket each year (after taxes), excluding any business growth, on a $235 billion purchase price, for a 10.03% annual “cash yield!” This current “return” to investors is far above the alternatives available in the bond market or stock market generally, from a blue-chip, brand name, critical company in our increasingly high-technology based economy. The great news for investors in MSFT today, is that we are so far EXCLUDING the low level of net liabilities on their balance sheet, and enormous holdings of cash and liquid investments already on their books.  The company held $52.7 billion in cash (C - Cash) and short-term investments at the end of June, and this number has not changed much since then.

(R – Relativity)  The current acceptable discount investment rate to apply to different companies is part of our relative comparison analysis, which is a closely guarded, proprietary formula based on prevailing and projected interest rates in the bond and savings markets, alongside the alternative yields and returns achievable from various S&P 500 companies. Without getting too buried in the details of generating a fair value for MSFT shares, our computer models have Microsoft shares trading 25% to 30% BELOW their fair long-term value. At this stage of analysis, QI is a potential buyer of MSFT, after considering few large-capitalization, brand-name businesses, diversified in sales, have a similarly low valuation, but we have more hurdles to cross before investing.

(E - Economics)  The next point of analysis is centered in real world economics. The macroeconomics (the 40,000 foot view), the industry economics (the 1,000 foot view), and the economics of the company (the extremely close up view) are all important. As an example, investing money in any publicly traded company between 1999-2003 or 2007-2009 proved an uphill battle; this judgment would be the macro view.  At QI we use two internally developed models to gauge stock market risk overall, developed over 25 years of testing and investing in real-time. Using both backdating of data since 1970 and real-time use since 1992, the ending phase of 1970s stagflation in 1979-1982 scored the highest and proved the best times to invest long-term, while Technology Boom overvaluations during 1998-2001 scored the worst.

The 1995-2000 Technology and Internet industry bubble rise, that burst in 2000-2001, causing the markets and economy to tank, would be an industry-centric view. The growth and death of industry fortunes and profitability is a critical component of weighting stock portfolios, just as important as understanding stock market pricing trends overall, or the specific health of an individual company. For example, advancements in technology have forced some industries practically into extinction. The automobile’s invention made buggies, buggy whips and everything having to do with horse drawn carriages almost disappear.

Today newspapers are going extinct, with even the biggest and best financially situated corporations in that sector having a tough time growing - not because they were poorly run by management but because a cheaper, more efficient technology started to gain a foothold with the nearly free exchange of information and ideas on the internet.  Another industry health example revolves around understanding and playing the intermediate-term boom and bust cycles in gold, which we have done over the years. Knowing when to hold them, when to fold them, when to walk away, and when to run from a sector are key to long-term investment success.    

Finally, the company view involves taking an objective and honest look at an individual corporation’s prospects going forward.  Microsoft, even with fantastic fundamentals, was not a buy in 1999.  Interestingly, the MSFT price per share was around $50 13 years ago, considerably HIGHER than the 2012 quote. MSFT was rather overvalued in 1999, despite being a profitable operating business for its owners. It is critical for investors to buy strong businesses, at a discounted valuation, to earn significant profits over a period of time. An investor can buy a very good company at a very high price and not make money, even lose money, a decade later!

Quantemonics Investing searches for, reviews, and weighs the “best” mix of economics at all three levels to invest our capital on a daily basis.  Our hedged and diversified strategy on Covestor.com is focused on utilizing ALL the resources and expertise we have developed over decades of trading and investing.  This “comprehensive” and methodical approach is what sets us apart from other investment minds and portfolios.  Our buy and sell decision process for portfolio design, using the strongest combination of factors to compound our investment capital over time, is quite unique.

For the perfect investment vehicle, all three economics described above: the macro, the industry, and the company related, would be working in our favor.  As of today, the macroeconomics for Microsoft are neutral (not great, not bad, on our grading scale), the industry economics are good (according to our in-house analysis), and the company prospects going forward look good (sales and cash flow growth, with the MSFT forecast discussed in the upcoming sales section).

(D - Debt)  Debt is a very interesting subject.  Most regular operating companies (excluding Financials, Banks, Transportation and Utility type companies, plus a few other industries) do NOT need debt to function.  The use of debt to purchase another company is logical, as long as the company which incurs the debt strives to pay it down over time.  At QI we like to see very low levels of debt and overall company leverage or find a company that is paying down their debt and future liability total toward an acceptable level.  What is an acceptable level of debt and liabilities for shareholders?  Good question.  As a general rule, the higher the debt level, the less safe the company’s performance becomes during an adverse change in the industry or economy.  Higher leverage means higher risk for an investor or owner, period.   An industry or economic recession could put a company holding an abnormal level of future obligations into bankruptcy.  We prefer to accumulate companies that use little leverage, and have few liabilities, thus giving our investments a solid MARGIN OF SAFETY.  [Margin of safety investing is a successful goal and style of capital formation preached by Warren Buffett, Value investors and Ben Graham followers.]

How does MSFT fair in this regard versus its peers and other companies we review?  Total debt is short-term debt plus long-term debt.  Total liabilities include all current and known future obligations as outlined by company estimated parameters using generally accepted accounting principles (GAAP).  For MSFT, the company held $11.9 billion in total debt and $51.6 in total liabilities for Fiscal 2011.  Versus free cash flow as calculated above of $23.57 billion annually, MSFT could pay off all its debt with six months of free cash flow, and its liabilities in total over less than two years and five months!  However, the company could pay off ALL current and long-term liabilities today, with the astonishing $52.7 billion in cash and short-term investments already held on their balance sheet.  From a margin of safety and leverage standpoint, Microsoft owners are in a terrific position to actually put money in their pockets through rising dividends and share buybacks, while future acquisitions and reinvestment of profits put even more money into the coffers in 2012 and beyond.  You can review Microsoft’s full 10-K annual report and financial information filed with the SEC here: http://www.sec.gov/Archives/edgar/data/789019/000119312511200680/d10k.htm

(S - Sales)  Microsoft has passed all of QI’s research criteria for investment so far.  The last decision point is sales.  Are sales increasing, stagnating, or falling?  Also, are sales diversified?  We prefer companies having greater than one or two major products or customers, for margin of safety reasons.  Another aspect of analyzing the sales outlook, includes an honest appraisal of what the competition is doing.  For some reason, conventional wisdom seems to believe MSFT’s sales prospects are horrible.  At QI we think just the opposite.  Did you know out of the five divisions under the MSFT umbrella, four of them had double digit top-line growth (11.2%, 14.9%, 16.3%, 44.5%) and the other division was only down 2.4% in Fiscal 2011?  Overall sales for MSFT increased 11.9% for the business year ending June 2011.  (A year earlier in 2010 sales increased 6.9%.)  Without drowning the reader in details, MSFT has very diversified sales with operating systems like Windows 7 and the Internet Explorer browser, software products like the Microsoft Office suite of applications, Windows Server and Cloud Computing operations, one of the leading Internet Search products in Bing, perhaps the top gaming XBOX system and hardware, and the expanding Windows Phone effort.  Not only are product line sales coming from various divisions, but also a diversify list of customers - businesses, governments, and personal buyers globally use Microsoft every day.

Sales are increasing, but how are competitors like Apple (NASDAQ: AAPL), Google (NASDAQ: GOOG), Oracle (NASDAQ: ORCL) and Yahoo (NASDAQ: YHOO) performing?  Apple is, well, Apple.  Apple may be winning the battle for now against the Windows smartphone effort, but do you really think this trend will continue indefinitely, after contemplating MSFT’s resources to invest?  On the operating system front, Apple is gaining ground, but the increasing speed of overall market growth in smaller device and overseas sales still allows for strong performance by Microsoft offered systems, in our opinion.  The great thing about MSFT is they can lose the phone war short-term and still make a rather huge pile of cash, while figuring out how to compete in this market space correctly as a guest at the party. 

How about Google?  GOOG is a great search engine company trying to compete in the cloud space against Microsoft Office products and the browser space with Chrome.  On the flip side, MSFT is trying to expand competition against GOOG’s search engine space with Bing partnerships.  GOOG is investing ever larger percentages of revenue to keep search on top, and this is affecting profit margins, falling year after year.  MSFT has a strong hold in the business environment with Microsoft Office and GOOG is finding it difficult to grow their business productivity offering. 

Oracle is a strong competitor for server services and business software, but ORCL’s main focus is enterprise management software.  ORCL had a good 2011 but they did not have much of an impact on MSFT’s performance in related divisions.  Yahoo is interesting in that they are more of a content provided, more like a newspaper selling advertisements next to print stories, instead of a search engine centered business model like GOOG (which also sells ads). 

YHOO has actually teamed up with MSFT to see if they can find a way to better sell ads and increase focused search results.  In summation, credible competition exists in many product lines, but MSFT’s unique brand name position and growing investments backed by huge cash flows help it to stay in the lead or be a top competitor in each of its divisions.  By our estimates, sales going forward may be tied more to macroeconomic growth in the world and steady investment in existing products, than any ground breaking discovery or innovation.  Overall, we give MSFT a better than S&P 500 company typical, sales growth outlook the next 3-5 years.

Putting it all together, Microsoft has (C) large sums of profits and cash flow coming in the door, (C) well above average levels of cash on hand, (R) better than “average” relative valuations of the business for new buyers of its common stock, (E) a decent outlook based on our review of related economic trends, (D) exceptionally low levels of debt and liabilities to provide a high margin of safety for the ownership valuation and long-term viability of the business, and (S) a sales trend rising considerably faster than Wall Street is giving it credit.  Continuing stock buybacks, plus a rising and strong dividend rate highlight the worth of the MSFT business model long-term, and support another level of margin of safety for its owners.  Microsoft has been a core holding in the QI Relative Value portfolio on Covestor.com throughout most of our existence, as it qualifies as one of the best values we can find for our investment capital.

Chart courtesy of StockCharts.com

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