2012 In Review: Will These Market Leaders Remain in The Value Bin?

William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

On May 22, I wrote my second blog post, “When Market Leaders are in the Value Bin”. In it I discussed the fundamentals and valuations of four market leaders: Microsoft (NASDAQ: MSFT), Apple (NASDAQ: AAPL), eBay (NASDAQ: EBAY), and Intel (NASDAQ: INTC). All four of these companies sported low valuations and high free cash flow yields. Let’s go through the highlights of what was said, compare it to what’s happened since then, discuss their prospects for 2013 and consider lessons learned.

What was said…

In May, looking retroactively at software giant Microsoft, the anticipated release of Windows 8 gave hope as to the future of the company in the form of a renewed product and the transition of the company into the new tablet paradigm. The new tablets were supposedly designed with businesses in mind. Microsoft’s low valuation with a 10% free cash flow yield was also noted.

Many concerns were expressed about computer maker Apple; including the effect Steve Job’s death would have on Apple’s innovation and ability to maintain market leadership. Apple’s deep pockets were highlighted as an enabler for new innovation and investment in research. Apple’s downturn at the time gave it a free cash flow yield of 6%.

The discussion included how PayPal will increasingly drive the future growth of online auctioneer and payment platform eBay. The article also cautioned against buying its stock due to a recent run up in stock price and wait for future price corrections. It’s worth noting that eBay had the highest valuations of the four companies with a free cash flow yield of 5%. More on that later.

Chipmaker Intel was having troubles, such as the inability to get a foothold into the mobile market. Its low valuation of a 7% free cash flow yield looked like it might represent a good buy if Intel could manage slow growth in free cash flow and boost dividends in the process.

The following overall prediction was made about the aforementioned companies:

“A value investor is always on the lookout for good companies that become cheap. All four of these market leaders are poised for great price appreciation. Mr. Market may recognize the potential of some companies sooner than others, so patience is warranted.”

What’s happened since…

Looking at the chart below you can see that Mr. Market rewarded only one of the aforementioned companies, eBay, with the market beating return of 33% versus the S&P 500 total return of 9% since the May 22 publication date. The other three companies with cheaper valuations; Apple, Microsoft, and Intel not only underperformed the market but lost their investors’ money over the last six months.

<img src="http://media.ycharts.com/charts/4049987ba8413e38a25b51c07c617381.png" />

MSFT Total Return Price data by YCharts

Microsoft went through some turbulent times over the past six months. First, consumers anticipating the transition into Windows 8 held off on Windows purchases contributing to a 3% decline in its Windows and Windows live division for fiscal year 2012. Second, the reception of Windows 8 and Microsoft’s new tablets was less than stellar in the marketplace. Third, the Entertainment division saw revenue and operating income decline during its transitions from traditional console gaming to internet based gaming. Finally, the departure of Window’s chief Steve Sinofsky right after the release of Windows 8 sent shockwaves throughout the financial markets hastening the stock price decline.

Apple actually had a good year. All of its segments experienced robust growth with the exception of the iPods and desktop segments. The iPhones and iPads contributed to an increase in revenue and free cash flow of 45% and 38% respectively. A number of theories explain its recent decline in stock price ranging from post Steve Jobs innovative capability to fears of Apple falling behind in the tablet and mobile phone markets.

PayPal continues to drive growth for eBay. Payment revenue grew 23% in its most recent quarter versus the same time in 2011, more than double the 10% increase for its marketplace business. Operating income for its payment business grew 43%, nearly quadrupling the rate of growth for its marketplace business, meaning more of its profitability comes from its payment segment.

Intel suffers from the same transitional stresses as Microsoft. The decline of the PC and Intel’s inability to make inroads in the mobile computing market contributed to a decline of 8% in revenue in its most recent quarter. Revenue in its PC Client group and Other Architecture group comprised of products made for phones and tablets declined 8% and 14% respectively. All of this contributed to the 21% decline in stock price over the past six months.

The next twelve months

Microsoft Windows 8 serves mostly as a replacement product in an already existing market. The Apple iPad will continue to outsell Microsoft’s tablets by a wide margin. The iPad will cut into PC sales thus limiting the market potential of Windows 8. With that said, Microsoft will underperform the market over the next 12 months.

Apple will continue to penetrate the international markets with its iPad and iPhone. Newer generations of these products will also keep the growth flame going. Apple will outperform the market over the next 12 months.

PayPal will continue to drive growth for eBay. A few months ago the company joined up with Discover to offer a brick and mortar way to safely transact. The auction business will continue to grow; however, PayPal increasingly carries the weight of the company. eBay will outperform the market over the next 12 months.

Intel will continue with tough transitional stresses. Its CEO will retire next year which means the delay of a new guiding vision from the successor. The iPad will continue to redefine the technological landscape putting a crimp in the PC business benefitting Intel’s competitors. With this being said, Intel will underperform the market over the next 12 months.

Lessons learned

First, past results don’t guarantee future success. From 2000-2011, all four of these companies experienced robust top and bottom line growth, but that doesn’t mean it will continue.

Second, an investor needs to diversify. The gain from eBay would more or less recoup the losses of the other three companies. An investor investing an equal amount in each of these companies would have realized a 0.59% loss for the entire portfolio turning $4,000 into $3,976.40, underperforming the S & P 500 total return of 9% for the period.

Third, sometimes an investor might have to pay up for superior gains. The largest gainer, eBay, sported the lowest free cash flow yield of the whole list.

Finally, an investor must take the long term view. It’s hard to evaluate the merit of an investment based on six months of return data; however, ongoing transitional stresses seem apparent with Microsoft and Intel indicating future market underperformance for the foreseeable future.

Check back for another follow-up on these companies in 12 months. I believe 2013 will prove interesting.

stockdissector has positions Microsoft and Apple mentioned above. The Motley Fool owns shares of Apple, Intel, and Microsoft. Motley Fool newsletter services recommend Apple, eBay, Intel, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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