A couple of weeks back I was reading about the former trials and tribulations of a certain British closed-end fund. This fund had underperformed its benchmark over the past few years, with some talk of it possibly losing a continuation vote at its AGM. Drilling down a bit further, it seemed like the managers’ preference for high quality, value-type stocks was to blame. Or rather, the absence of “growth” names relative to the benchmark had hurt the fund’s performance.
I kind of felt sorry for the managers. Patience is not a virtue they are allowed to have, and the fickle nature of the market is something I guess they have to live with. As it turns out, they overhauled their stock selection process (probably relaxed things to allow more of these momentum plays in) and have since outperformed.
This leads me to Microsoft (MSFT) stock. This seems like another good example that fits in quite well with Mohnish Pabrai’s quote:
The single biggest advantage a value investor has is not IQ. It is patience and waiting.
It wasn’t all that long ago that folks took pot shots at this one for being too stodgy. It’s easy to see why too. I mean, its stock chart had been almost comically flat going all the way back to the dot-com era. The $37 that folks paid to own one share in mid-2000 could have bought them the same share in early 2014. Inclusive of reinvested dividends, they just about broke even in real terms.
None of that was a particularly damning indictment of Microsoft’s business. It had grown per-share earnings at an 8.5% per annum clip going back to 2000. Moreover, the business was, and still is, a massive money spinner. That was underscored by the fact that it had racked up a $60,000m net cash position, which it still holds today. No, the entirety of that poor performance was down to the fact that folks were paying a lot less per unit profit earned. At the start of that period, Microsoft stock traded for north of 40x annual profit. By early 2014, the equivalent figure stood at around 14x profit. The implied headwind was also worth around 8.5% per annum if my math is right, so you can see why the share price went nowhere.
Anyway, 14x earnings? Yeah, a very good bargain given the 10-year Treasury yield hovered in the 2.5% area at the time. In the year before, it went as low as circa 10.2x forward earnings! If you backed out its excess cash from the stock price, Microsoft traded closer to 7.5x underlying profit at its 2013 low. That was nuts. I mean, I know this is rear-view mirror investing and all, but still. To link that to the opening paragraphs, I imagine there were many stoic fund managers and retail investors pounding the table for the value case. Hopefully they didn’t give up, because they would have came away with something special. The stock is up by a factor of 4 over the past five years, equivalent to circa 34% per annum.
There’s another reason I decided to cover Microsoft right not. After periodically checking the blog’s analytics, I noticed that it is an increasingly popular search term. I’m not all that surprised given the returns here recently,.
Now, the company has basically doubled its profit over the past five years. It made circa $20,000m in annual income back then, which has grown its current level of around $40,000m. This growth explains less than half of the total returns. The company’s own shareholder returns program takes up another chunk: the dividend stream kept on flowing – that was worth north of $8 per share – while buybacks added around 175 basis points to per-share profit growth in that time.
The rest stems from an expanding valuation multiple. If Microsoft traded at 14x earnings, its stock price would be $80 rather the $187 it trades at now. That doesn’t necessarily mean the stock is expensive. It has grown earnings at an average rate of 10% per annum over the past two decades by my count. Not only that, but its earnings growth has actually accelerated in recent years. We also have to contend with the fact that interest rates and bond yields remain exceptionally low.
All-in-all, the above leads me to conclude that it can carry on doing well in the short-term. It could also do very well in the long-term (check out returns from the Nifty Fifty, some of which traded at 60x earnings or more). However, there might be a sticky patch someplace in the middle if it experiences another contraction to its valuation.
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