Sunday, May 29, 2011

Microsoft - Why it's Cheap.

You gotta love articles like this one I found on Reuters:

Hedge fund manager David Einhorn on May 25 called for Microsoft Chief Executive Steve Ballmer to step down, saying the world's largest software company's leader is stuck in the past.

"His continued presence is the biggest overhang on Microsoft's stock," said Einhorn, who founded Greenlight Capital.

Ballmer took over as CEO in 2000 from Bill Gates, who remains chairman.

Microsoft stock is down 30 percent over the past decade, and up 4 percent over five years. On a total return basis, including dividends, shareholders have lost 12 percent over 10 years and gained 14 percent over five, according to Thomson Reuters Datastream.

Including dividends, investors have lost 26 percent on Cisco Systems over a decade and are down 20 percent over five years. For General Electric, total returns have been minus 47 percent over 10 years and minus 32 percent over five

This is the problem with the media and many investors in general.  While all of the numbers are true, it doesn't paint an accurate picture of the performance of these companies.  These companies were so severely overvalued ten years ago this is hardly a fair comparison... they were price for perfection.  Now, nobody will touch them.

I am nearly finished reading the book Against The Gods by Peter Bernstein.  It is a classic financial piece about the history of risk and the mathematics of probabilities.   In chapter 10, when discussion the regression to the mean, the author says,

"The impressive evidence of regression to the mean might provide some valuable advice to investors who are constantly switching managers.  It suggests that the wisest strategy is to dismiss the manage with the best recent track record and to transfer one's assets to the manager who has been doing the worst; this strategy is no different from selling stocks that have risen furthest and buying stocks that have fallen furthest... Go ahead and follow your natural instincts."

Let me be clear, the past 10 year performance of General Electric (GE), Microsoft (MSFT) and Cisco Systems (CSCO) are the biggest overhang on these stocks and I believe David Einhorn knows that.  He's just looking at a way to shake things up, get the stock out of the rut and get the market to look deeper at the value of Microsoft.  

If you want to make money investing here is what you should do.  First, take the stock price and stock chart an toss them in the garbage.  Second, read a couple past annual reports to understand the company.  Third, examine the 10 year past financial operating performance of the company.  Fourth, determine what you would be willing to pay for the entire company.  Fifth, divide what you'd be willing to pay in half.  Sixth, check with the stock market to see if someone wants to make a deal on a part (share) of the company.  Repeat as necessary.

Do not, and I repeat, do not look at what has performed well over the past decade and extrapolate into the future. It will tell you to buy Gold, Silver, and commodities instead of General Electric, Microsoft, and Cisco Systems. 

Let me tell you how the vast majority of people select their stocks.  First, look at the immediate past and find what is the hot sector (or pick up a business newspaper).  Second, check out stock charts that are up strongly and preferable going parabolic.  Third, and only if you have time, check out the past ten year operating performance of the company.  Fourth, and only if you have lots of spare time and like to read, read the last few annual reports from the company.  If you only make it to step two make sure you at least justify it in your mind as a relative bargain (based on some unrealistic growth assumptions). 

Best Regards,
Kevin Graham

Disclosure:  Long GE, MSFT, and CSCO (Personally or in accounts I manage). 

Microsoft - Competitive Advantage

As I posted before, Microsoft appears to offer decent value at it's recent price.  You can find a decent description almost anywhere on the web that says Microsoft (MSFT) is cheap.

To summarize the idea, the entire company is selling for $208 billion.  At the end of Q1 they had slightly over $50 billion in cash equivalents, so net of cash the company is selling for $168 billion.  Over the trailing twelve month the company has earned approximately $21 billion.  So at today's prices the whole company is worth about 8 times trailing earnings.

If you take some time and look below the hood, the company has one division, online services, that is a money loser.  In the lastest quarter that division lost $0.7 billion dollars.  So excluding this unprofitable division annual profits would increase by $2.8 billion, to nearly 24 billion.   So if that division could break-even the company would be selling for 7 times earnings and annual profits would be over 13% higher.

Now 8 times earnings is good for an earnings yield of 12.5%.  At 7 times earnings the company is good for a 14.3% earnings yield.  Regardless of your future expectations about the economy that is a very cheap stock especially for a company with large very profitable divisions.  

If we further tinker under the hood we find that they have absolutely huge gross margins of 80% and net profit margins of 30%.  There are so few companies in the world that have such absolutely huge margins like that.  Over the last 10 years the revenue and profits PER SHARE have grown at 13.5% and 11% respectively, not too bad for largecap.  The market obviously does not believe the company has a very strong future, I beg to differ.  I think the speculators have watched the P/E ratio come down from the nose bleed levels of 50 times in 1999 to today's modest level and are frustrated by the flat share price. 

I have even seen some analysis that suggest the market is currently pricing in low single digit declines in earnings for the foreseeable future. If you capitalize the earnings at 10%, assuming zero growth indefinitely, the company is worth $25/share (it's current price).  Now the company may well be worth this amount, or significantly more or less depending on what the future holds.  If the company has a poor future, something like print newspapers, the company may be worth much less.  So what about Microsoft, does it have any competitive advantages?

Competitive Advantage

With all that as introduction, I have been reflecting quite a bit lately on whether Microsoft has a strong competitive advantage or not.  First off, you don't have to be all that intelligent to realize that if a company has gross margins of 80% they clearly have a strangle hold on the market.  Competition may exist but they have a strangle hold on the market.  That is a clear starting point. 

It's funny much you hear people complain about Microsoft's products but what do you really expect?  In the PC market they have something like 95% market share in operating systems.  I don't know anyone that owns or uses a different operating system (except maybe a few Mac's).  So then it really doesn't surprise me that you don't hear people complaining about other systems... what other system is there to complain about?  To be clear, if 95% percent of people eat red apples over green ones, I would bet a very large percentage of complaints would be about the red ones.

In the same way I have read that many people are indifferent to Microsoft Office suite.  The biggest exception is Excel.  It seems a lot of individuals and companies couldn't live with Excel.  At the company I work at we are so tied to Microsoft Excel and Access databases we really couldn't make a change to anything else.  Excel is so embedded in so many procedural and company processes it would require so much work to make any change.  I can only imagine how that is also the case at millions of other companies.  As a company, we are far more tied to Microsoft products than we realize.

Beyond these small examples... the other major issue with making changes to computer software in the workplace is the huge amounts of work that would be require to train everyone on the new system.  I can think of one system, made by IBM, that we use at work.  A few years back a change was contemplated but pulled at the last minute because of the problems that would be created from a major change like this.  Software and certain computer systems have more competitive advantages that one realizes if you think about it.  (We are updating the IBM system this year, I will be watching the change-over with keen interest)

In the same way, I find it really interesting that Firefox so closely resembles Microsoft's Internet Explorer.  If you asked the average person what the difference is between the two they likely would have a difficult time explaining.  I find that remarkable as Firefox has to essentially copy IE and then begin to make minor changes to the browser so as not to upset the apple cart.  (I have tried Google's Chrome browser, but to be honest "it just doesn't look right")

The next reason why it is difficult to change from Microsoft is because of widespread usage.  Just think about it, can you really use ABC's generic word processor in the business world?  You wouldn't be able to communicate with any other business or get anything done.  Our company is still using an older office version and the newer versions are just not compatible.  This has created numerous headaches for us, but thankfully for us Microsoft allows free viewers for many programs.  We have the same issues with other software we use, you constantly have to stay up to date or you risk not being able to communicate effectively with other companies.  You just can't use old or uncommon software. 

Lastly, many businesses simply cannot afford to have major interruptions with computer issues.  Change, if any, would have to be gradual so as not to interrupt the normal course of business.  I could go on but enough said. 


We'll the case for the value in Microsoft is quite clear.  The stock is selling very cheap.  I like to say it's like buying a bond paying 12.5% interesting, whose coupons will likely increase in the future.  I believe the company has numerous competitive advantages, but I wouldn't want to be lulled to sleep.  Technology is constantly changing and things like cloud computing will change things no doubt. 

In the case of Microsoft, management is very shareholder friendly with current dividends are running at 2.5% and the company is buying back 4% or better of the share outstanding.  I know David Einhorn is calling for the CEO's head because he wants to make a quick buck.  Many shareholders are frustrated with the stagnant stock price but the the underlying performance of the company has been good.  The P/E has gone from 50 to the current 8 times, which means despite the flat stock price the company has performed very, very well over the past decade.  What more does he want the company to do?  All they can do is keep buying back the cheap shares and growing the business as they have with little to no capital.  Management can't make people buy the shares. 

I think if you gave a MBA student the last ten years of financial statements and removed the name "Microsoft" from them all and asked for an appraisal of the value of the company, they would all conclude the company is worth much more than the current price.  It's interesting how once you put the name Microsoft out there the company gets an undeserved discount. 

If I could get one final dig in.  Why would one waste time on such a difficult and risky investment like PBN when a Free Cash Flow machine like MSFT is available at a reasonable price?  The answer is mental bias that believe risk equals return (and overconfidence).  It's why people buy lottery tickets... what my brother calls a tax on the mathematically incompetent. 

Investing isn't difficult, but thinking clearly is.  Thinking clearly is far, far more difficult that you realize.  You likely disagree, thus proving my point.  If you disagree, your probably the type of person who always has the right answer.  Anyway, enough for now. 

Did I mention that Bing is my new favorite search engine?  

Best Regards,
Kevin Graham

Disclosure: Long MSFT (Both personally and for accounts I manage).

Monday, May 16, 2011

Commodity Bubble

Well I haven't had much time lately to post but thought I would stop and share a few thoughts.  I was about to write an article a few weeks back with the same title but Goldman Sachs beat me too it.  They made the call that oil prices were bound to fall and that they have.  UBS securities has subsequently put out a much more thorough piece on the unwinding of the short dollar/long commodities trade.  Beyond this I will share a few ideas about where I currently see value despite the pain that is bound to come in the commodity sector. 

Commodity Bubble

One question that seems to constantly be bothering me is this.  If the low interest rates from the Alan Greenspan era helped ignite the housing bubble, in what areas today are the even lower interest rates potentially causing a bubble?  The only area I really see trouble is commodities.  I often look in the rear view mirror and see what has done well the past few and try to avoid it (and similarly I look at what has done the worst and look for bargains).  Commodities have definitely done well the past decade. 

Warren Buffett has said he learned an important concept from Ben Graham  that I have never and will never forget.  It is this, "you can get into far more trouble with a sound premise than an unsound premise because you'll just throw out the unsound premise."  At my work, senior management has placed a strong emphasis on critical thinking and I think the single largest principle I have learned through the process is to carefully examine everything you believe.  Our biases obviously play a crucial part blurring our thinking but our innate egocentric nature can also play tricks on us.  Of course we believe what we believe to be true... for why would we want to believe a lie?

To make this complex topic a little clearer I will use an example.  I have seen many bloggers post that oil prices only has one way to go and that it up.  The thinking is something along the lines of supply is maxed out and demand is ever growing.  Now this sounds good but may or may not be true, no one knows for sure.  It may be egocentric thinking blurring our reasoning and the person wants to believe it is true because it is in their selfish interest to believe it to be true (Innate Selfishness).  This is why constantly questioning your assumptions is important and why Buffett has said sound premises can get you into trouble. 

I recently read that the CEO of Exxon Mobil said that if the price of oil sold for the marginal cost of production, that is the cost to find the next barrel, it would sell for between $60-70 per barrel.  So where will oil be in a years time?  I have no idea, but I do know what the cost of a marginal barrel is and that will act somewhat like gravity on the price of oil.  This is why Warren Buffett called it a mistake to purchase ConocoPhillips when oil was selling for $140/barrel.

So what about other commodities compared to the marginal cost of production?  Well, copper for instance sells for close to $4/lb and it's marginal cost is $1/lb.  Gold is another example selling for $1500/oz and we can dig it out of the ground for $450/oz (only to foolishly put it back into the ground a Fort Knox).  Clearly many commodities are selling for many times the marginal cost.


Here is where things get interesting.  Many point to the sound premise that China is consuming vast amounts of commodities and thus their prices are only going to go to the moon.  This may or may not happen but one thing is becoming more and more clear is that China is in a real estate bubble.  I have now seen far too much evidence of this and believe things are getting out of hand.  I have heard an account of a school teacher who owns 3-4 properties and could sell out for a handsome sum today but doesn't want to.  Why you might ask?  Because she sold one a property two years ago and prices have doubled since then.  Now if that doesn't sound like the USA around 2005 I don't know what does.

If we step back and look at the macro side of things, commodities could be in for a world of hurt if China starts to stumble.  The consume 48% of the world's production of iron ore, 47% of the production of coal, 45% of the production of steel, and 39% of the production of copper.  Secondly, investment makes up 70% of GDP and consumption the rest.  This level of investment is unheard of and is why renowned short seller Jim Chanos is short China.

Here is a very interesting article discussing on the topic and how the USD will appreciate.  The UBS article is also a good read..  The end of QE2 may spell the end to the commodity bubble as capital starts for flow back toward the USA.

Stocks on Sale

If one is looking for bargains in this market, I believe the following offer decent value. 

Warren Buffett commented at his annual meeting that Microsoft (MSFT) is cheap but he is restricted from buying because of his ties to Bill Gates.  I doubt he would buy anyway.  Microsoft's stock has gone nowhere for 10 years and it's P/E has gone from 50 to under 10 times after tax earnings.  The company is a cash generating machine.  I like the company but it's recent move to buy Skype for $8.5 billion is definitely a head scratcher.  That price is something like 10 times sales and 32 times EBITDA.  I will give Bill Gates the benefit of the doubt as he is a smart guy, but as many other people have commented... this purchase is equivalent lighting $8.5 billion in cash on fire.  I don't know, Microsoft is well run and many laughed a few years back when Microsoft entered the video game business and lost money doing it for several years.  Today the Xbox is very popular and gaming contributes 13% of Microsoft's sales. 

I also also like Goldman Sachs (GS) at 1.2 times tangible book value.  Today uncertainty is definitely weighting highly on the shares but they are doing well given the climate.  The company is the premier investment bank in the world and it is selling cheap.  Similarly, Wells Fargo (WFC) has also moved back to where it was in Q3 last year when Warren Buffett was busy buying the stock.  I have written on the company before, they are a money making machine.  Another interesting aside on Wells is that they really seem to be making a push into insurance.  The annual report highlighted a number of small acquisition they have made into this area. 

Finally, Berkshire Hathaway (BRK.A) is selling on the cheap.  It is a company I currently do not own but may in the near future.  To break down the valuation, the company has $94,730/share in investments and operating earnings per share before taxes (EBT) of $6000/share.  Whitney Tilson has suggested Warren Buffett uses a 12 times multiplier on the EBT, and thus the intrinsic value is in the neighborhood of $167,000/share.  Tilson then looks out 12 months and adds 5% growth in the intrinsic value and the cash build of $7000/share and comes up with a valuation of $182,000/share a year out.  This is over 51% higher than the current share price of $120,000/share.  I would also add that that many of the investments Buffett holds are very blue chip companies who share prices have gone nowhere for the past decade.  Many of them sell for 10 times earnings adjusted for cash on hand.  Similarly, many of the companies Berkshires owns are outstanding as well. 

Beyond these Cisco Systems is a buy but I don't know the company well enough to make an intelligent decision.  Clearly the market thinks the company is in trouble but they have an impressive track record.  Over the past 10 years sales have grown 13% and earnings have grown 12% annually.  They have a huge stockpile of cash equivalent to $5/share (net of debt).  Today the shares sell for $16.60 so net of cash they are selling at 8.9 times earnings.  If anyone knows the business and has a serious analysis I would be interested, send me an email. 


Hopefully this wets the appetite for a while. 

While I hope the commentary is interesting don't feel it is some sort of forecast.  It is almost certain I can or will be wrong but I do believe the troubles in China are the making of a bubble that may have a dramatic effect on the price of commodities.  If anyone has an interesting perspective on how to short commodities I would be very interested, drop me a line. 

As for bargains, I present them for your entertainment but don't feel compelled to trade.  I will be examining my investments to see if I can maybe purchase some Berkshire.  The company is as of the highest quality you can find and the price is attractive.  My motto is buy right and sit tight.  Many feel like they have to jump into and out of the market, but all that does is make your broker rich.  When, not if, the China situation blows up the entire market may be quite a bit cheaper. 

Best Regards,
Kevin Graham

Disclosure - Long GS & WFC.