MSFT - did I undershoot growth potential?

Barrons has an article that forecasts PC growth over the next several years at 10%. They are quoting this article. This has big implications for MSFT revenue growth.

I estimated a 4% volume growth in pricing MSFT at $34, does this 10% mean that I was too conservative? Not necessarily, but it is an interesting question.

Microsoft has two different sales targets - pre-installed software and upgrades for computers already in use. The first will generally track computer sales overall - thus if sales increase by 10% we can expect that MSFT products will rise with it.

More difficult to assess is the upgrade market. Slower growth in sales mean more parity between scrappage rates (which are high in a product as disposable as an old computer) and sales rates and thus a more stable installed base. At the same time, the increasing age of the installed base means that opportunities for upgrading within the installed base may increase, suggesting a continued rise in sales.

Unfortunately MSFT does not break this out entirely. The $5bn of revenue - and $3bn in operating profit - from the Windows and Windows Live divisions is likely to increase at near 10% a year, as 75% of revenue comes from pre-loaded software on new PCs. (There was a spike in 2009, reflecting the launch of Windows 7, which increased sales to the installed base significantly as people with Vista or XP upgraded).

MS Office, however, is only broken out into business licenses, (which are usually bulk) and individual licenses. These also grew nicely in 2010, but in no small part because of the introduction of Office 2010. We can expect some decline in sales there into 2012, but overall sales should remain brisk.

MSFT's third major revenue trunk - the Xbox360 is seeing massive growth, primarily from the Kinect, which enables users to be their own controllers. Sales will not continue to grow 55% per year, but a higher installed base should lead to more licensing sales of software going forward.

So, 4% growth may be a bit conservative, but then again, my 2% price increase could be a bit aggressive. Ultimately, I think it means that MSFT is likely to be able to maintain a solid growth rate over the medium term (my estimates for long term growth are around 2%).

Call it some margin of safety, and one more and more gets the sense that MSFT is truly undervalued. Not enough of a growth stock to have an I-Banking / financial media story, and requiring too much CAPX for most hard value investors.

Please tell me why I am wrong.

Refresh and Some Other Changes

So, I have decided to refresh the look of the site.

I am experimenting with a few different formats, though I still believe the three column approach is best.

Have also updated my blogroll - a long period of inactivity had allowed some links to get out of date, these have been removed. I will resume reviewing sites in the blogosphere and adding to my list of sites.

Finally, I notice that my Google Page Rank has dropped to zero.

I suppose I deserve this, somehow. I still have some good inbound links, but due to some inactivity, I think several larger sites dropped me.

On the other hand, maybe I am being punished for having criticized AdSense?

For the time being I have decided to remove all advertising and refocus on delivering quality content.

If you want to link exchange, please let me know.

Buffett's interview with Becky Quick on CNBC

Warren Buffett had a three hour interview on CNBC today.




Becky Quick, the lead interviewer, is also one of the journalists that leads the question and answer period of the Berkshire Hathaway Annual meeting.

This secgment was particularly interesting. I particularly liked his response to Joe Kernan's question about whether there are moments to be in non-financial assets (he meant commodities).

Buffett's answer is to suggest that true investment is about purchasing an asset, it could be a business, or a farm, rental real estate, or a fixed income security, that pays you income over time, irrespective of the price for which the asset could be sold. In this sense, investors do not need the market, and they do not have to worry about market prices, because the income from the underlying asset, whether through operating income or dividends, is sufficient to provide a satisfactory return. If the market is also willing to pay high prices for that income, the capital gain is gravy. This is the sense in which investing is business-like. If you own a McDonalds franchise, you don't spend your time wondering what the market price of the franchise is, you spend your time worrying about how to improve the performance of the business - as measured by the income that it throws off.

Commodities, by contrast are speculation in Buffett's view. While he admits there is nothing wrong, immoral or bad about speculation, it is NOT investing, since the asset itself, whether it be gold, silver, cotton or oil, does nothing for the purchaser directly. Instead, the purchaser has to hope that someone else will pay more in the future. In that sense, it is a bet on future attitudes towards the commodity in question.

His description of gold, a current favorite, is hilarious. Note he contrasts the value of gold with the universe of other assets that could be had for the amount equivalent to the market cap of gold (price per ounce x all ounces outstanding). Not said, but I think intended, is that assets such as farmland and businesses which have pricing power are no worse an inflation hedge than gold. True enough, earnings multiples may decline, but as income rises, risk of capital loss from inflation should be muted. Meanwhile, unlike the commodity, the farm does not have to be sold to provide income, so market price fluctuations are not really a big problem.

What does it mean when Ken Fisher is no longer Bullish?

Ken Fisher is a legendary investor. Author of many books, record holder for longest tenure as a Forbes investment advisor, a billionaire in his own right, and son of legendary investor Philip Fisher, whose book Common Stocks, Uncommon Profits is a must read for anyone who picks stocks.

He is also a near perma bull. He favors lots of cyclical measures - presidential cycles, bull market cycles and the like. I must admit, I criticised him when he predicted the 2009 bull market, (heaping on the point that he had utterly failed to see - or at least to write about - the implosion of the financial sector. He was right, and I was wrong.

But even he is now predicting a much slower growth period, and with slower returns, it becomes more important to select value and quality. He has some interesting picks. Couple of drug companies, which I usually avoid, since I cannot evaluate their pipelines, and a few other odds and ends. Most instersting picks in my view, are CL and ENL - Reed Elsevier, a company that publishes lots of academic and legal journals. In the US you are more likely to have heard of its LexisNexis service. Incredibly expensive, it allows folks like PhDs and laywers to search reams of documents for specific terms. Definately one to investigate.

I continue to own CL, and have yet to publish my DCF for it. I must say that at $78 - it isn't so far away from intrinsic value, in my opinion. Still, I believe it is a good place to earn a yield of year 3% with little risk of capital loss, since the underyling business is strong. Growth prospects are better than one might imagine, because the company is well positioned in global markets, particularly South America and Asia, where newly middle class populations are focusing more and more on proper healthcare and homecare, it's core product segments.

But ultimately, when Ken Fisher gets cautious, I start to think that the markets are really headed for a fall.

Given my current cash-heavy allocation, this would suit me just fine - I believe there will be another March 2009 like moment. Seriously, valuations are hardly at levels that indicate stocks are cheap. I still believe that after the biggest secular bull market of all time, we are in a secular bear. When that next moment comes, with S&P500 below 800, I will be a buyer. For now, I just pick around the margins, and remain defensive.

Is there hope for Microsoft?

I recently did a DCF on MSFT, and concluded that investors seem to undervalue the firm (disclosure, I do not own, but am considering a purchase of the stock). Either they have huge a huge discount rate (indicating high uncertainty), or they believe the company will not grow again.

Personally, I believe that rumors of Microsoft's demise are greatly exagerrated. The company is massively profitable, earns great returns on equity while having no net debt and maintaining mountains of cash. It has made some brilliant investments, and has seen the nexus between entertainment, mobile, and desktop software.

Moreover, it still controls the single best suite of productivity tools, and ensures that the various programs work well together. Even Apple had to cave (which is why they have moved toward hardware and the infrastructural software that operates that hardware).

Above all, Microsoft has generally proven that a fast follower is among the best technology strategies to have, particularly if you have mountains of cash you can deploy to get your version to market quickly. It means that you can avoid total write offs of technology ideas that have gone nowhere, of which there are quite a few. Often pioneers simply lack the resources to keep innovating, and a fast follower has the luxury of learning from the mistakes of the category creator, without the cost of adapting a set of code that already exists.

All of this is really to say that the idea that cloud computing and open source are about to kill MSFT's Office franchise seems really, really premature. Let's not forget that even in the 1980s when personal computing was a new-fangled rage, destined to change how we live and work, mainframes still did a thriving business. Desktop computing is not going away, and MSFT is likely to continue to dominate it.

It turns out that open source is quite expensive.

Firms and individuals may be less inclined to deal with the hassle and cost of maintaining integration of the various pieces. Sure, IBM can insist that "the future is open" - they make billions selling consulting services to help companies integrate their various IT platforms and to deploy "open source" solutions. It might be cheaper to pay the license fees than to pay staffs and consultants.

Indeed, even if the desktop business is destined for slow growth, might it not be the case that as the growth of the business slows, that returns actually improve? True, slow growth environments require discipline, but Microsoft has shown discipline in its capital deployment. Potentially slower innovation, as other "hotter" areas of the market get wads of cash thrown at them could mean that cashflows improve as CAPX declines as a share of revenue.

I am talking myelf into buying the stock, would appreciate some contrary feedback.

Some numbers about China

So, clearly, the scope and scale of Chinese economic activity is breathtaking, no less than its speed.

Some big numbers, but also numbers looking in the rear-view mirror.

Going forward, it makes no sense to project China's recent economic development into the future.

Other voices on the future of China, India and the US

Apparently, some senior economists at some pretty big banks, Citigroup, HSBC and UBS share my scepticism about the future of Asian economies, and like me, believe that the Jeremiads decrying the decline of the West suffer for want of analysis.

Maybe they have been reading the Strategic Investor? If so, I don't see any attribution....

Follow up on Glassman's new book

As I said, I haven't read it, nor have I any intention of doing so, but apparently, it is something of an apologia for his monumentally bad call in 1999.

What I find amazing is that in spite of acknowledging lower growth going forward (according to the review), Glassman fails to believe that thtis will manifest itself in lower earnings growth and lower stock returns.

I always wonder about the conflicts between the authors of investment newsletters and their readers. I mean, who pays for the advertising in personal finance magazines? Asset managers. Asset managers have a vested interest in explaining why you should invest NOW. There is always a reason - usually it is compound interest and the argument that you can't time the market. So "no time like the present". But this means that real deep analysis, partiuclarly bearish analysis, must be frowned upon, since the last thing an asset manager wants is big redemptions.

Thus, projections about the future are generally rosy, so long as you "invest for the long term" and park your cash with that expensive manager.

The Outlook for Equity Prices: It’s probably worse than you think

With recent tremors in global markets queued up by concerns about oil supplies, sovereign debt levels, government deficits and the tax increases and spending cuts required to get them under control, I think it is about time to look at Equity Prices in a more holistic – and to my mind, clearer - way. To strip away the noise, and think about what truly long term returns are likely to be.

The proximate cause of this exercise was an interview given by James Glassman, contributing editor to Kiplinger’s Personal Finance and author of the notoriously badly timed “Dow 36,000”, to Henry Blodgett of Tech Ticker. Glassman, it should be noted, is now peddling a new book – encouraging investors (individual investors) to reduce their overall stock exposure and instead to hedge against loss. This only took 10 years of dismal equity returns for him to acknowledge that markets sometimes go down and for long periods. I admit that I have not read either book, though I have read many of his columns over the years.

Blodgett and Glassman discussed the effect of a lower volatility portfolio on long term returns. Both used a 10% number as the long term compounded (geometric) average return to investors from equities. Glassman’s argument was that in saving for retirement, you should sacrifice some upside to ensure that you don’t experience a big, catastrophic drop – in his words “once of the worst things you can do is reach for extra return”. (I agree with this view. Warren Buffett also had some choice words on this in his annual letter). Blodgett countered – but what of the people who *need* 10% to make “the number” they need to retire? Glassman essentially said, you should settle for a lower return, which he estimated at around 8%. When challenged by Blodgett that this might also be optimistic, he conceded that 5-6% returns might be possible if things were “really bad”. Unsaid by both was that with lower investment return expectations, that investors must instead adjust either saving rates (up), working life (longer with a shorter retirement), or their accept a lower standard of living in retirement.

Glassman and Blodgett were talking about a version of this chart, which I confess had a huge impact on me as an undergraduate in the 1990s, and got me focused on saving and investing. But consider how different the chart looks if returns are much lower than 10%, or even Glassman’s 8%. The difference between 8% and 10% is 60% of the total account value for our “young and done” investor, and *only*45% of the account value for our later diligent. What if returns fall to 6%? That $1 million portfolio might now buy our “young and done” investor a small condo in Miami (at post bubble prices). Even our diligent saver has lost 67% of his projected nest egg.

Given the impact that different rates of return have on expected retirement assets and living standards, it makes sense to have a basis for expectation. All of the numbers I see are “rear view” projections. They make assumptions that the future will be like the past.

Instead, I would like to suggest that we face forward, and think about what is probable – not in the near term, but over the long term. The short answer is – we aren’t going to get historical returns.
Let’s start by unpacking the components of equity prices. Stock prices have two drivers – earnings (dividends, or free cash flows, technically, but over an infinite time horizon these converge), and investors’ appetite for earnings (that is the price investors are willing to pay for those earnings).
Earnings have two components, the current rate, and the rate of earnings growth over an infinite time horizon. This is what one might call “fundamental” or “intrinsic” value – the actual money the business would throw off.

Investor’s appetites (valuation) have three components - interest rates, volatility (risk) and expectations of earnings growth.
I want to begin our investigation by thinking earnings and – more importantly earnings growth. I start with a statement – over the long term, earnings cannot grow materially faster than GDP. This might shock you, but it is the GDP identity.

Without getting too technical, there are three methods of calculating GDP: the output method, the income method and the expenditure method. In theory, they should produce the same result. In actual practice, they differ slightly, but are close enough for our purposes. Since we are discussing income (earnings) we will apply the Income Method, which states:

GDP= Employee Compensation + Corporate Operating Surplus + Gross Mixed Income + Taxes – (Subsidies on production and net Imports)

This identity says that Employee net income, plus corporate net income, plus the income of unincorporated businesses, plus taxes (government income) less subsidies (which accrue to one of the other income sources) is the national income. This makes sense. From this identity it follows that for corporate profits to be larger than GDP, either employee compensation, proprietor income or taxes (less subsidies and imports) would have to be negative. In practice, no one component would ever be as large as GDP, even in a socialist country, because people have to eat.

If one component in growing faster than GDP, it is gaining share of the national income. Moreover, that over very long (infinite) time horizons, no component can grow significantly faster than the whole, since it would over time gain enough share to approach 100% of GDP, and either drive up GDP growth with it, or slow to a rate approximating GDP. Over shorter than infinite time horizons, however, individual components can grow faster than the whole, and gain share of the overall pie.

I suggest to you that people who throw 8, 9, 10, 11% growth as the “long run” return of equities are projecting a future in which corporate earnings permanently grow significantly faster than the underlying economy. If you ask these same people to estimate GDP growth you will usually get a number of either 3% or 6% depending on whether you mean nominal or real GDP. (Since earnings are a nominal measure nominal GDP is what counts here). I also suggest that they are likely to be disappointed.

It is true that looking backward over long time horizons, equities have earned 9-10% or so. So how has the market delivered this return “over the long term”? Well, consider two factors. First, earnings may have grown faster than GDP over measurable historical periods. Our information about markets and economics are really quite recent developments. The stock company is also a recent development. The first joint stock company was invented in 1600 when Elizabeth I chartered the East India Company. Stock exchanges are even newer, with the London Stock Exchange having its origins in 1698. Most of the “stock” traded was government paper, not equities and their profits were tiny compared with overall economic activity. Modern industrial firms were really created in the 19th century and have steadily increased their share of economic activity at the outset. Most people were unincorporated small proprietors working at subsistence farming, or small shopkeepers. Wartime cartelization and unionization meant that in the 1950s workers held a much larger share of national income So, looking BACKWARD, corporate profits have grown faster than the economy overall, and have gained share of output, but projecting that growth onto the future is asking for trouble because corporate profits are no longer working off of a low base.

Second - there is valuation: equity investors have simply been willing to pay more for earnings over time. This is particularly true in the period after 1994. A variety of factors contribute to this, including favorable macro conditions, which have driven higher all asset prices (as measured by earnings or interest yields) - and have reduced the realm of attractive alternatives, recent experience which has been for equity prices to increase much faster than overall economic activity and reduce the perceived risk of equities, wider equity ownership (with most of the growth coming from less sophisticated investors, who may be less scrutinizing of changes in underlying fundamentals), and the possibility that investors in early market stages were excessively cautious - that is, that equity prices were simply too low relative to the risks (thus some of the gains were simply a correction of undervaluation).

In short, when we look at equity returns, I believe we are taking as normative something that is in fact a historical anomaly. Like any new and successful technology or approach, corporations experienced significant growth, taking share from other market participants (otherwise, it would have died out. It is tantamount to projecting iPad sales, or Google revenue out into the future based on the first few years after introduction.

Even exceptional cases of long term performance, e.g. Berkshire Hathaway, have experienced diminished returns over time as the base on which high growth has to be earned, expands. At some point, corporation earnings will slow, because attractive investment opportunities will decline, because workers will gain more pricing power, or because governments will raise taxes, or all three. What is certain is that to earn the kind of returns investors expect, they must believe that corporate profits will come to represent 20-30% of economic activity within the course of an adult lifetime (up from 10% now). This is highly improbable, and should therefore not be used as a “conservative” or “reasonable” forecast of returns.

Moreover, the GDP range I have used above is also historic and may also be anomalous.

6% nominal growth seems high, given that inflation is running well below 3% and the primary inputs of real output – labor (in the form of hours worked) and output per hour, both look to be factors that will grow slower in the future than in the past. More people are working in the US than practically ever before. This is mostly due to demography – women’s labor force participation has increased dramatically, the dependency ratio (the number of people divided by the number who work) has hit a low and is projected to rise as Boomers retire. Labor hours worked is set to rise slowly from currently suppressed levels. Productivity growth may continue at 1.5% but with hours worked increasing only 0.5% - 1% per year, real growth will likely be closer to 2-2.5%. If inflation remains around 2%, then nominal output will grow 4-5%, not 6%, and we will see a corresponding decline in the rate of earnings growth.

Consider though that if the variation (the volatility) of the returns stays constant regardless of the mean expected return that we should expect to see many more years with negative stock returns. The standard deviation of returns is around 15%, which means that if mean returns are 11% most years will see positive stock markets. If the mean is 4%, however, there will likely be many more years where returns are negative. Worse, stock returns are heteroskedastic, which means that volatility changes with the time horizon (though I am not sure if it increases or decreases – this is important).

I think it more likely that taxes will increase as a share of the economy, and with it, subsidies. If unemployment remains high, it is possible that corporate taxes will rise, reducing corporate income (though most policy advocates on both the left and the right seem to want to reduce corporate income taxes, which would INCREASE income as a share of economic activity, all else equal). One positive factor, however, is that net imports may decline, particularly if consumption declines as well. Finally, over the next few years, unemployment is likely to improve, and with it consumer wages. Already, we see wages rising in both Eastern Europe and the Far East, places which have supplied the low cost labor that has enabled companies to keep a lid on wages and benefits and expand corporate share of income. With rising wages, overseas and slowly falling unemployment, it seems quite reasonable to believe that wages and benefits will rise, eroding corporate profitability. Thus it seems possible that corporate income could as likely fall as a share of output as rise.

With corporate profits already at high levels, and unlikely to sustain growth faster than the economy, and the economy likely to grow more slowly than in the past, the only hope we have for Glassman’s 8% returns seems to lie in higher valuations. Sadly, the news here is also rather dismal.

Stocks rocket from periods of high valuation to periods of low valuation. This table from John Mauldin, shows what happens when you invest in periods of high valuation – you tend to get returns of less than 4%. More accurately, attempting to live of 4% of your money leaves you in real risk of winding up bankrupt over 30 years.

Today, sadly, our valuation (measured over the 10 year business cycle) is high. Several factors influence this, interest rates (at which investors discount future growth) are quite low. Low rates lead to high valuation. Faced with low yields in other asset classes, such as bonds or cash, investors are turning to risk assets. Similarly, growth expectations are high, because people are still projecting the past onto the future. Further, equity valuation has been high for so long, people have come to see it as normal. Indeed, stocks may look cheap when compared to the astronomical valuations of the late 1990s.

Pity a poor Japanese who at age 50 has been working since 1985. If he has been a diligent saver, putting his money into the stock market in hope of high returns, he has watched his investments wither away as slow earnings growth and compressed valuations have left the market down 75% from its high, more than 20 years after the peak! Real estate returns are similarly bad. That is why he instead purchases assets with no risk of capital loss – government bonds – and earns essentially zero. He is just happy to know that he can get his money back someday.

What we know is that equities tend to rotate from high valuation to low valuation and back again. Despite coming down from very high levels 10 years ago, we are not near to a low valuation level. True, at market lows in 2009 we were near the normal valuation level. Beyond 2012, ten year corporate earnings will be able to escape the poor performance in the 2000-2002 period, and so be a bit higher.

But interest rates will also likely rise, and that will give competition to increasingly risk averse Boomers. Moreover, it will raise the discount rate on stocks. If valuations fall, even as earnings rise, the perception of risk in equities as a class may rise, and the return demanded from investors may rise as well. This will feed into yet lower valuations. But this is again to suggest what might happen to stocks over the next ten years.
What I am saying is that one has to be very selective in the stocks one picks – stocks as an asset class will have low returns, likely in the 4-6% range over time. This may come from a permanently 2nd gear growth rate in prices, but history suggests that stock returns are volatile, thus returns are likely to instead go through a period of negative returns. These may be sufficiently large to reduce valuation to such a point that returns from that point forward can grow faster than economic growth for an extended period. This is not the market we face.

In short, I believe we are looking at 4-6% returns for equities going forward. This result is the combination of an expectation of lower earnings growth coupled with a fall in valuation.

This will have profound impact on the level of savings required to have the standard of living in retirement that people expect. Paradoxically, if enough people attempt to save more – we will push valuations higher in the short term, but subsequent returns yet lower later, as underlying yields could fall to Japanese levels. Pity the guy who has to select from an investment universe in which all values are sky high. In the short term, of course, returns could easily exceed this level. But they could just as likely fall.

Such low rates mean that one has to question whether one is inclined to subject oneself to the volatility of stock returns. These will be negative far more often than investors have experienced over the past 30 years. I continue to recommend solid businesses that can pay steady dividends, fortified by a low payout rate. Stocks yielding 2-4% offer current yields not materially different from the expected return on the overall market with significantly less volatility that the overall market. These stocks will also hold value better during a decline, providing the investor with the option to acquire more volatile stocks at a moment when that volatility results in low valuation. In the event of inflation, they should also have pricing power and the ability to raise yields to protect investors.

Happily, many solid dividend paying stocks, such as CL, INTC, WMT, JNJ and other solid brand-name firms are relatively inexpensive. There are also a host of smaller firms which may be attractive takeover targets, particularly in a world where investors expect strong earnings growth but organic returns aren’t in the cards. Of course, once you sell, you face the same unattractive investment universe everyone else has, but at least you have some cash.

Finally, in a world of low returns, the optionality of cash should be attractive to most investors. You are unlikely to lose big sitting out (yes, I KNOW that stocks have rallied 95% since March 2009. I wish that I had bought more in the Q1 of 2009, but we are in March 2011 now, and have to look at the situation we now face). I confess that given relatively high valuations, I believe we remain in a secular bear market, and that March 2009 lows will be back, though it may be a few years yet.

Protect your downside and adjust your expectations and your plan.

Why do investors hate MSFT ?

I cannot understand the market's valuation of Microsoft (MSFT). The market has consistently treated this stock badly since the collapse of it's insane overvaluation in the dotcom bubble.

But it has languished around the mid 20's for some time, even as the rest of the market has continued to climb. Management has continued a series of very shareholder friendly activities: ending equity derivative compensation, buying back large amounts of stock and raising the quarterly dividend, doing so again recently, from 13 to 16 cents. A substantial increase.

As a result, the stock yields an attractive 2.4%, with seemingly large amounts of upside potential.

I just ran the stock through my DCF model and had difficulty engineering a price below $30. Based on my forecasts for modest sales growth and continued solid margins (I find a price of $34 quite reasonable). In fact, using my operating assumptions, the discount rate required to reach the market's price is 14%, and that is too high for a business with a tremendous franchise, strong cash flows and a dividend.

I tried so assume that competition going forward would erode margins, and that tax policy would mean higher rates, but it is still hard to see how the stock does this badly, unless you assume no growth. MSFT should be able to lift volumes in it's most importnat segments in line with overall PC shipments, growing around 3% per year, and grow much faster in it's less mature product lines.

One cause for concern, though is the fact that R&D spending is currently less than depreciation, suggesting that the company may be underinvesting - in technology this means death (though software assets can be sweated more than hardware). Even so, I raised R&D spending above traditional rates of depreciation, assuming that to grow, the business will have to be a net acquirer of fixed assets. The $34 I derive already accounts for this.

So, what am I missing (other than an online order at my broker?)