Wednesday, July 25, 2012

Microsoft - Value or Not (Part 2)?

Here is the response I got from the fellow investor whom I wrote my original response.  I believe other's will find this interesting.  Enjoy.

Thanks Kevin: I respect contrary views and learn from them, so please keep them coming.

I agree the financial metrics for MSFT are impressive-- as they were for RIMM, HPQ and NOK. Look how quickly that can change. Many highly respected (by me) value investors own all those companies too. The crowd isn't necessarily correct, even amongst the elites-- thank God for that or we'd never have a chance getting an edge in the market.

My view is that the technology sector is a tough neighborhood these days such that once a company loses its momentum, it is very difficult to restore it-- particularly when you are a giant like MSFT. History has borne this theme out. How many *thriving* companies in the tech sector can you name that have existed longer than 10 years? By thriving, I mean gaining market share and growing both the top line and bottom line. A handful, and some of the few that do qualify have questionable prospects, like MSFT and CSCO. 10 years from now, I wouldn't be shocked if MSFT, CSCO, GOOG and even AAPL (gasp!) no longer existed or were irrelevant. That's my opinion, for what it's worth.

Some of the other woes MSFT faces (I'm sure there are more, but I'm not an expert on MSFT):

1. MSFT has entered a gigantic partnership with NOK (!!!) to launch their phone platform. That's not exactly a blue sky situation and MSFT expects billions of dollars of revenue from the venture. NOK is in the ICU on life support with the crash cart by the bedside. Doesn't look too good....

2. PC sales growth these days is mostly sourced from emerging markets where piracy rates are high and IP protection is a low priority. Morningstar forecasts margin compression due to these very important unfavourable effects.

3. The HTML 5.0 web standard should accelerate cloud computing adoption by the same businesses that could not change over to other OS's in the past. There's no reason to believe that MSFT can transition to a cloud based SAAS enterprise easily, efficiently or effectively.

4. MSFT's size has made it a ongoing target for adverse political interventions worldwide. This has adversely affected the corporate culture as you can see from one employee review taken from

While Microsoft always tried to avoid being become large and bureacratic that's exactly what we've become. Our fear was always that we would become IBM after the DOJ settlement. Ballmer swore up and down that we would never fall into that trap, but the reality is with our size and the constant scrutiny be governments around the world we have become this generations IBM. Everything we do is scrutinzed by lawyers first, we all have to go through training to understand what we can't and can do for customers and partners, while our smaller nimbler competitors can react much more quickly than us.

I noticed that Bill Gates has sold $60MM worth of stock in late 2011 and 2012. I originally thought this was due to the funding requirement for his Foundation as part of an orderly liquidation of his portfolio; however, I see he's been buying Diamond Foods, Ecomotors and Tripadvisor in the same time period, so he may well not be a MSFT bull either.



Here is my lastest response:

I enjoy the discussion too. I was just getting tired with the comparisons to RIMM, HP and NOK that you continue to make. Let's start there.

First you said.

I agree the financial metrics for MSFT are impressive-- as they were for RIMM, HPQ and NOK.

This is hardly an accurate comparison. MSFT hasn't stumbled at all from a financial standpoint while all the rest have. Unless you can predict the future, I believe you are giving opinion and not fact. I don't have a problem with opinion, they are needed in investing. But to compare MSFT to these companies is a stretch, but is widely believed by many. That is my point. Many investors look at the chart and conclude the underlying business is struggling. MSFT hasn't struggled over the past 5 years, but instead have doubled earnings.

You also said (not in the above message):

Even more interesting is that I couldn't find a single bear case write up for MSFT on any of the investing websites I frequent (and I frequent most of them)-- not a single one. Talk about a rosy consensus.

What about your original email? Does that one count? Isn't the author a CFA? I really don't get the "not a single one" comment, in light of the article you sent.

Back in 2000 MSFT was selling for 50x earnings. That was a rosy consensus. Today they are devoid of a rosy consensus and sell for 7x earnings (net of cash). They have grown EPS 3.3x over that period.

Anyway, I agree that the tech sector is a difficult neighbourhood these day but that is mainly a function of market sentiment. Technology will continue to change our lives. I agree it is difficult to predict the future, but my argument is different. It's that MSFT is so cheap and generates so much cash that your getting a *free* wild card on the future. I'm not paying up for a rosy consensus, I'm getting any future upside for free.

1. Nokia's partnership. If Nokia fails this will have little bearing on MSFT. It will suffer a blow to MSFT in the phone market but they don't exactly have anything to lose, do they? Again this offers upside and I don't have high hopes but who really knows. You believe that it will be negative, I don't know.

2. PC sales. This has been a headline story for some time. The only problem is that it really hasn't impacted the financial results all that much. I understand PC sales are flat and the trends are moving toward cloud computing, but MSFT does have a strategy for cloud computing.

On the topic of PC's, I am in some training this week with some staff from Intel. I have been quizzing them up on the ultrabook, among other things. The have a strong belief that the laptop won't be going away for some time. I would tend to agree.

3. HTML 5 and cloud computing. I don't understand the sector well enough to make a call on how this will play out. Office 365 is being utilized by many large companies such as Lowe's, Quantas, Japan Airlines and Hallmark Cards. The biggest adoption of Office 365 will likely come from small businesses, which is a huge market.

4. Political risk has been around for decades. The business has grown through it anyway. Company culture may very well suck. I hope it does suck. That is something that can always be changed and improved. Just ask IBM or read the book "Who Says Elephant's Can't Dance."

I find it amazing that a business that enjoys 80% gross margins is a business that people think is a poor one. It's not like they have huge competitors in many of their lines of business. Once competition shows up you will see this needle move significantly... just ask RIMM. And RIMM didn't have anywhere near those types of gross margins. Apple's gross margins are less than 50% for pete's sake.

As for Apple, that is a stock where I would have concern. It's purely a consumer show and sales can rise and fall much quicker than expected. The quarter released today is evidence of that. Despite the headline nonsense, revenue and profits were up nicely. The problem is the forecast doesn't look good. The sales of the ipad and iphone can rise and fall as quickly as the ipod has. What are the entrenched advantage of AAPL? Consumer loyalty? That can change overnight as we saw with RIMM. All it takes is the next "cool" device, crackberry's were the rage before the iphone. MSFT has much stronger ties to business and that doesn't tend to change very much. It's too costly to change and re-train everyone. In some cases it's nearly impossible to change.

As for RIMM I don't have high hopes for the future but QNX (the wholly owned software company) does have a strangle hold on vehicle software market. Something like 65% of new vehicles use their software. If RIMM can leverage that they may have a hope. That said, they also better have good devices going forward.

Anyway I should probably quit with the comments on tech. I'm no expert.

Maybe I should just stay away from MSFT but the math is just too good for me. I also believe I have a margin of safety.

Thriving 10 year tech companies: MSFT, IBM, ORCL, CSCO, INTC, ADBE, ANSS, SAP... to name a few. 
Disclosure:  Long MSFT

Monday, July 23, 2012

Microsoft - Value or Not?

I was recently sent a link to an article on Why Windows 8 Made me Sell Microsoft (MSFT).  The article says that Windows 8 sucks and is going to be bad for Microsoft.  Maybe it will suck...  I don't know that for sure.  This was my response. 

I am long MSFT. Let me tell you why.

Over the past 10 years they have grown revenue by 13%, earnings by 10%. Over the past 5 years they have grown revenue by 14% and earnings by 13.5%. Yes it is value stock, as we will see, but by those numbers you would think MSFT is a growth stock... but anyway.

Last year they generated $31.6 billion in cash from operations and the capex forecast is $3 billion in the coming fiscal year. That means the owner earnings are running around $3.40/shr. They are generating $2.4 billion in free cash per month and have 63 billion of cash at end of the last quarter. I understand the markets believe they will squander some of their cash on dumb acquisitions (they have before), but let's get serious MSFT is a licence to print money.

Many people look at the share price for the past ten years and have no idea about the underlying business performance of the different divisions. I don't know the future, but today you can buy MSFT at 6.4 times owner earnings or a 15.5% owner earnings yield (net of cash). That is cheap, dirt cheap. If I quoted these figures without giving the name of the business, most every investor would be chomping at the bit to know what company I am talking about. Tell them it's MSFT and they aren't interested.

I can't predict the future but I do know the company's operating performance over the past 10 years has been phenomenal. The past 5 years have been even better. Windows 8 may be great or it might be a flop, Vista was a flop too. I do know that Windows is so entrenched in businesses and consumer PC's that they are not going anywhere. Growth in Servers and Tools has been good and Entertainment has been fantastic. The Windows division was down slightly last year.

I just listened to the conference call and came away with the complete opposite impression regarding the outlook of the company.

So let me highlight my reasons why I believe differently:

1) My opinion was based on financial performance that have yet to show any hint of let up, while this guy "thinks" that Windows 8 will be a flop.

2) Secondly even if he proves correct that Windows 8 is a flop and earnings fall flat or down in the Windows division, I still have an large margin of safety. (My cost is also 25% lower than current market prices)

3) I have different opinion of MSFT's entrenched moat, particularly in businesses. Change just isn't an option.

4) While this goes counter to my recent blog posts on social metaphysics, it still is a fact... MSFT is the most widely held stock by value investors and the second most widely held business by % of assets (the first is Berkshire).  You can see the list at the link below. 

Best Regards,

Disclosure: Long MSFT & BRK.b

Thursday, July 19, 2012

Salida Capital - Death of a Hedge Fund?

Salida Capital, the once loved commodities hedge fund may be nearing death. 

See the link below for details why.

They also released this additional commentary on their performance for May.

I don't know how any investor can withstand that kind of wild ride.  Hedge funds have no advantage over an individual investor provided that investor has the right character traits.  Intelligence not required.

In the addition commentary they discuss how loyal their investors are.  Appealing to your investors loyalty seem pretty desperate to me. 

I particularly enjoyed this quote from the commentary letter.  

Though we have reduced our exposures to weather this volatility storm, we believe timing the market is an impossible task. We believe we must “take a side” in order to generate wealth over the long term.

Maybe it's just me but I have a hard time making sense of these two statements.  On one hand they don't believe in timing the market yet on the other hand they must "take a side" (or speculate) in order to generate wealth.  What if they continue to be on the "wrong side?" 

They continue to speculate that the US Federal Reserve will do QE3 and investors will flock to commodity investments. 
I believe they won the ebay auction to have dinner with Buffett a few years ago.  Not sure what they learned but it doesn't seem to be paying off. 

Best Regards,

Tuesday, July 17, 2012

Bank of Canada Statement - Translated

The Bank of Canada (BOC) press release today had some interesting tidbits of information. Many of these issues have been discussed on my blog here before so I won't belabor the points. 

I will quote from the release and then give you my translation of what the BOC statement really means.

While the economic expansion in the United States continues at a gradual but somewhat slower pace, developments in Europe point to a renewed contraction.

Growth in the US is slow. The growth is slow but it is still growth. Europe is a mess and headed for a slow down.  Many Europeans don’t understand that production comes before consumption, but don’t worry they will learn their lesson.

In China and other emerging economies, the deceleration in growth has been greater than anticipated, reflecting past policy tightening and weaker external demand. This slowdown in global activity has led to a sizeable reduction in commodity prices, although they remain elevated. The combination of increasing global excess capacity over the projection horizon and reduced commodity prices is expected to moderate global inflationary pressures. Global financial conditions have also deteriorated since April, with periods of considerable volatility. The Bank’s base case projection assumes that the European crisis will continue to be contained, although this assumption is subject to downside risks.

China is a mess.   The Chinese economy has been artificially manipulated for a long time.  The Chinese real estate bubble has burst and the long held belief that real estate prices only rise will soon be a myth.  The real estate and infrastructure bubble in China has led to a dramatic rise in commodity prices.  China consumes the vast majority of commodities in the world while only contributing a much smaller percentage of global GDP.  Europe is also a mess along with many other emerging countries.  All of these factors are aligning such that commodity prices will fall, and fall hard.

While global headwinds are restraining Canadian economic activity, domestic factors are expected to support moderate growth in Canada. The Bank expects the economy to grow at a pace roughly in line with its production potential in the near term, before picking up through 2013. Consumption and business investment are expected to be the primary drivers of growth, reflecting very stimulative domestic financial conditions. However, their pace will be influenced by external headwinds, notably the effects of lower commodity prices on Canadian incomes and wealth, as well as by record-high household debt. Housing activity is expected to slow from record levels.

Despite a huge real estate bubble in China and Europeans who think they can continually live off the backs of others, Canada is in for a wild ride.  Lower commodity prices will lead to lower inflation.  Being that Canada is a huge commodity producing country, the economic impact here will be widespread.  The effect of lower commodity prices will reduce incomes and wealth in Canada. The record level of household debt bodes well for a dramatic increase in bankruptcies.  Housing activity and prices will also fall, perhaps the hardest in Toronto and Vancouver.

The Bank projects that the economy will grow by 2.1 per cent in 2012, 2.3 per cent in 2013 and 2.5 per cent in 2014. The economy is expected to reach full capacity in the second half of 2013, thus operating with a small amount of slack for somewhat longer than previously anticipated.

The Bank has no idea how of the economy will perform.  We previously anticipated faster growth but we were wrong.  Don’t worry though we now have it all figured out and you should believe us going forward.

Best Regards,

For more information on what is happening in China, here is a good place to start:

Disclosure: I have limited exposure to Canadian equities.  I fully expect the Canadian Dollar to fall relative to the US Dollar.

Ben Graham on Social Metaphysics

Here is a quote from Ben Graham,

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused by other persons’ mistakes of judgment.

---The Intelligent Investor p. 203

Ignore the market.

Best Regards,
Kevin Graham

Monday, July 9, 2012

Social Metaphysics & Warren Buffett

In my first post (Click Here), I introduced the topic of social metaphysics as defined by psychologist Dr. Nathanial Branden.  I won't repeat the definitions that were developed but wish to continue them in this post.  In short, Social Metaphysics is the process by which men hold the thoughts, values and ideals of others as their source of objective reality.  Social Metaphysicians ask not what is true but what others say is true. 

For example, I constantly hear people say, "Is there a regulation for this or that OR are you certified to do this or that."  Unsure of making their own decisions or learning the answer for them self, they constantly look to others to make judgements.  Often that other person is the government (perhaps my next post will be about Social Metaphysics & Government Reliance).

Moreover, most people believe that the stock market is esoteric or magical.  It's as if some special group of people are the only ones to can decipher its inner workings.  I can assure you it is no such thing.  Anyway, I think you get the point. 

So what does Social Metaphysics have to do with investing.  Well, it turns out quite a bit.  In fact all value investors should be happy that people follow other people.  The herd mentality of wall street is what allows for ridiculous valuations to occur from time to time. 

Because people refuse to trust their own judgement the constantly look to others for guidance and often those "professionals" are similarly misguided.  It's the blind leading the blind.

Social Metaphysics & Warren Buffett

Where I really want to turn this discussion is to investing and Warren Buffett. After I read Buffett's autobiography, "The Snowball", I was struck by his innate self esteem. This is something he calls his inner scorecard. Here is what Alice Schroeder said about Buffett's inner scorecard in an interview:

Schroeder: "In The Snowball, I point out that his father had a 100% inner scorecard about everything. His mother had a 100% outer scorecard about everything. She cared desperately what people thought of the family, of their image. The kids were raised with both of these streams of perception coming in on them. Warren is the product of that. When it comes to investing, business, his principles, his ethics, 100% inner scorecard; he knows what's right. He lives by it. When it comes to how he feels about himself, he is very tender and easily wounded, and other people can make him feel differently. He doesn't have that inner scorecard. And there is a complete separation between the two."

Now if we look back to the original definition of social metaphysics, Mr. Buffett clearly does not suffer from this mental condition. When it comes to investing, he does not care what others think or what others are doing.  He beats to his own drum.  This is perhaps the biggest reason he has been the most successful investor of all time.  He makes his own value judgements and these judgements are often quite rational because they aren't influenced by others (value meaning valuation, not moral judgements).

When it comes to investment decisions, Mr. Buffett is 100% inner scorecard. Charlie Munger is similar to Buffett in this way. Buffett has said many times that Charlie is one of the few people he has met who would tell him his ideas are stupid. Likewise, in most corporations, most junior executives are simply "yes-men" to the CEO.  Dr. Branden would say such individuals lack the sixth pillar of self esteem, namely personal integrity. Buffett and Munger have both personal and mental integrity.  They don't violate their principles in order to stroke a social metaphysician's ego.

It should be abundantly clear why many people struggle when it comes to investing. Amateur investors run around the internet looking for investment ideas from others and that is perhaps why you are reading this blog. Now I'm not suggesting you shouldn't read, you should, but what you read and how you think is much more important.  You should also look to yourself, and only yourself to make value judgement.

Professional money managers, like mutual funds, are generally only concerned with one thing, career risk.  These people run around making sure they don't under perform their peers since that would cost them their job. As Buffett has repeatedly said, nobody ran around and told him what was a good deal.  He had to find those himself.  He just had the rational capacities to make strong value judgements on his own. He wasn't swayed by the lemmings that make the stock market run up and down.

This is a point that needs to be emphasized. Do you buy a stock and then watch what the market does the next hour to see if everyone else agrees with you? How about the next week or month? What if the prices gets cut in half?   Buffett has repeatedly said the market is there to inform you not instruct you, yet countless millions are at the mercy of what other people think. 

What you need to do is independently value a business, buy at a large discount to that value, and ignore the market until it smartens up OR you determine an error in your thinking that led to your valuation.   

A few quotes from Mr. Buffett that relate to our subject.

They (investors) get excited when others get excited, they get greedy when others get greedy, they get fearful when others get fearful... you must detach yourself... from the crowd.

(Speaking about Bill Gates regarding philanthropy)  - He doesn't care if his name is on buildings, I can assure you of that.

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

Wild swings in share prices have more to do with the "lemming- like" behaviour of institutional investors than with the aggregate returns of the company they own.

A public opinion poll is no substitute for thought.

Risk comes from not knowing what your doing.

Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.

We enjoy the process far more than the proceeds.

You do things when opportunities come along. I've had periods in my life when I've had bundles of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing.

Beware of geeks bearing formulas.

The ability to say "no" is a tremendous advantage for an investor.

There seems to be some perverse human characteristic that likes to make easy things difficult. 

Yes Mr. Buffett, it's called Social Metaphysics.


As seen in the quotes above, to be a successful value investor you must be able to:

1) Stand alone & ignore the crowd. 
2) Rely on your own mental faculties and value opportunities independently (then go check what the stock market says).  Be confident in your judgement.
3) Enjoy the (mental) process far more than the proceeds.

Why do people hold the thoughts and values of others above their own?  Mainly, it's to avoid taking personal responsibility.  When you rely on the opinions and ideas of others, it's really easy to blame other when things go wrong. 

I learned this the hard way when I blindly invested in technology back in 1999 and I can assure you it will never happen again.

When you make a mistake once, it's a learning opportunity.  When you make the same mistake twice, it's your fault. 

Best Regards,

Disclosure: Long BRK.b