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Wednesday, June 22, 2011

Microsoft – Everyone loves to hate this stock (MSFT)

Back in the Halycon days of the tech bubble there were 4 Wall Street darlings that made investors a fortune. In the beginning there was Dell (NASDAQ : DELL), Cisco (NASDAQ : CSCO), Intel (NASDAQ :INTC) and Microsoft (NASDAQ : MSFT) who were commonly referred to as the “Four Horsemen”. Everyone used to love these stocks and they were found in countless portfolios that is until the “Tech Wreck” of the early 2000’s. A quote from an article I read during that period stuck in my mind, “It used to be that no one ever got fired for buying IBM (NYSE : IBM), but now no one gets fired for buying Microsoft”.

Much has changed since the early 2000’s and today it seems most people have given up on these companies and some actually hate them. The Four Horsemen have been put out to pasture and are considered “uncool” to own.

 Dell fell out of favor facing stiff completion, losing both market share and profitability. For a period of time Hewlett Packard (NYSE : HPQ) appeared to be having Dell’s lunch, but now all the PC manufacturers are facing stiff competition and a slowing of the upgrade cycle.

 Cisco lost its way and ventured off in to the wilderness with things like the “Flip” video camera and allowed their highly profitable core businesses deteriorate. Cisco still makes many of the components that allow the internet to function but their lack of focus has allowed competitors like JDS Uniphase (NASDAQ : JDSU) and Juniper Networks(NASDAQ : JNPR) to set up shop in their backyard.

Intel has mainly lost in the perception department particularly at the Goldman boys trading desk. Intel continues to perform and crush estimates but the Goldman gang has a thing for them so their ratings are consistently negative. Yes Intel was slow to get to the tablet party but their very high margin server business is more than adequate to make up for the fact that they are playing catch up in the mobile arena. After all much of what makes or brakes the viability of the tablet is the “cloud” and the internet that makes it possible, much of which is driven by Intel’s high end servers. As the tablet, mobile internet device, and general internet innovations markets grow so does the demand for Intel’s high margin chips. Of course the Goldman boys believe that lower margin tablets will make more money, well I guess that will remain to be seen. I liken it to the profit margins on LCD and Plasma TVs which were high initially but as more models and competition emerged the costs came down but so did the margins. As Warren Buffet might say Intel has a pretty wide moat in many areas and while there are skirmishes on the periphery they have the means, innovation and the war chest to maintain their edge. I have covered Intel in the past and do have a position in the company.

Today the “Four Horsemen” are very different companies from those early days and many people still try to view then from the lens of when they were high growth companies, instead of the mature companies they have grown to be. Today things are different not only for these companies but for investors themselves. The economy and market are such that we have slipped back to 1999 levels and while back then we were all partying today people are looking for some level of safety.

I like many others learned at a relatively early age about the “miracle of compounding” which is by far less sexy than cashing in on the next Google (NASDAQ :GOOG) or Apple (NASDAQ : AAPL), but also very lucrative. Compounding will not make for exciting cocktail hour chatter but it does allow one to grow their assets in a slower but generally less risky manner. Sure it is great to hit the home run and get rich quick, however, for every investor that does just that there are thousands that get nowhere.

With the choppiness of the markets and interest rates on safe debt instruments not even keeping pace with inflation, what is an investor to do? I might suggest using the compounding method as an alternative to what one might call low yielding fixed income investments. Buying a stock is essentially a bet on future cash flow and earnings, but buying a dividend paying stock gives you the benefit of getting paid to wait for the earnings to grow and provide you with capital gains as well. Many investors today look only at yield because they believe that they can get their money back or higher income quicker. In theory it sounds good to want a high rate of dividend but in the average investors lust for the cash they over look factors which make the investment more risky than they think.

When I evaluate a compounding stock I look for many factors but a super high dividend is not a driving factor for me. I look for companies that are in good financial shape in that have a commanding presence in their industry. Next I want to see that the company is not over leveraged as this can lead to many problems which are often times resolved by cutting the dividend. Additionally, if a company is borrowing to pay the dividend that is a huge negative. This type of situation is indicative of a management is currently unwilling to address problems in the business but will more than likely be forced to in the future. Once the situation is forced a decline in share price and probably a reduction of dividend will be the end result along with many distressed shareholders.

I like to look at companies whose payout ratio is less than 60% as this indicates that the company can cover the dividend and continue to invest in itself as necessary. Ideally, one should want a lower payout as 60% would be an upper range and a lower pay out just gives the company more breathing room to increase dividends and keep itself healthy or withstand market turmoil better.

It is also important to look for companies that have a long track record of paying dividends as it demonstrates management’s commitment to shareholders. I like to look for companies that have a minimum history of 10 years of payouts since that shows the company’s management was able to continue the dividend through a full circle of business cycles. As I said I like a 10 year minimum but I will make exceptions on a case by case basis as investing is as much art as science.

In addition to the track record I want to see a company raise the dividend by a fair percentage on a regular basis for a couple reasons. First, if a company is growing and performing they should give back to the share holders. Moreover, if the company is increasing dividend payments, not form debt financing, it clearly demonstrates that the company is executing well as dividends don’t lie. While earnings can be manipulated the company either has the cash for the dividend or they don’t it is that simple period. Secondly, I want to see the company raise dividends as it is a form of compensation for risk of holding equities in general and as the dividend is raised you either get more out in the form of cash per share or increase your position by larger increments through dividend reinvestment. When a company is continually increasing dividends and you choose the reinvestment method the compounding is doubled as the number of shares you own grows as well as the amount that the shares pay to be reinvested grows. Once again it is not as cool as bragging to everyone that you own a piece of Facebook, and you may not grow rich overnight on Mr. Zuckerberg’s coat tails but you can grow your wealth over time.

You must also remember that time is your friend in the increasing dividend scenario. If you invest in a company that currently has a reasonable dividend in the 3% area at say $10 a share your payout is .30 per share. If the same company grows earnings and raises the dividend but now it has a price of $20 per share and the dividend is still 3% then you have both a capital gain but your yield is 6% or .60 per share since your cost basis is $10. You can clearly see from this example why it is important to find companies that increase their dividends. One should acquire shares and hold since in time when you are ready for the income stream your yield will be far greater and as long as the dividends are still increasing incrementally so will your income.

The last of the Four Horsemen Microsoft is one of the larger cap stocks on the market and has an equally large band of detractors. Mr. Softie as some people call it is one of the most unliked and unappreciated stocks out there. Since Bill Gates left the helm to Steven Ballmer it seems that Microsoft has fallen in to the negative press hell no matter how much cash the company throws off. Wall Street analysts generally tend to shun Microsoft as I believe they dislike Ballmer and find him to be uncharismatic. In many respects Ballmer is an albatross around Microsoft’s neck. I believe that the perception about Mr. Ballmer is suppressing the price of Microsoft and creating great value for long term dividend appreciating investors.

In the past it was threat of litigation whether from the US Justice Department or the EU that hung like the Sword of Damocles restraining Microsoft’s share price. It looks today as if those things are a thing of the past at least for now, since the EU seems to be targeting Google with various issues like street view and other government entities appear to have jumped off the Microsoft bus on to the Google bus.

Microsoft is a strong large cap with a household name and while there is tremendous completion in the software segment the company is still doing very well depite the fact that much trash is talked about it. The company trades at a PE below 10 which is cheap for it on a historical basis. Additionally, Microsoft has strong margins on its products although they did contract by 1% but considering they are still over 40% this does not seem like a pressing issue. Even with the slight decline in margins the company was able to grow earnings just over 22%.

Microsft has year over year sales growth of roughly 7% and over 5 years of 10%.  The company also has diversified out of just the operating system and office niche in to cell phones and game consoles. In fact Microsoft dislodged Sony (NYSE :SNE) from the top spot of console makers. Additionally, there was much made about the threat from open source operating systems to Microsoft’s dominance. While Open source has gained in popularity with the techno crowd its wide open architecture and lack of consistent flavor has made it not quite as palatable to the mass computer using public and Microsoft appears to have fended off that threat. The argument for open source software dominating the market reminds me of those who argue for Lacrosse. I have had people tell me that lacrosse is getting so popular that it was going to replace baseball as the US’s national pastime to which I would respond “uh huh ok”.

Microsoft does pay a dividend and currently yields 2.6% which is not bad, but they have paid the dividend consistently since Q4 2004. Microsoft doesn’t meet the 10 year payment criteria but based on its strong balance sheet I am willing to look beyond that metric. Management appears to me to be committed to the dividend as they have increased it 17% last year and 12.5% over 5 years. Moreover, Microsoft sports a low 23% payout ratio which leaves more than ample room for dividend growth as well as reinvesting in the company or further accretive acquisitions. I am aware that Microsoft spent $8.5 billion on Skype and there are questions as to how the acquisition will benefit or fit within their product mix, but even if it was a mistake based upon the amount Microsoft earns it could be made up for in short order and their cash available is north of $40 billion so there is plenty cushion there as well.

It is my belief that Microsoft will continue to meet the challenges it faces and have strong earnings for many years to come as they branch further in to other related areas of their business. I also believe that the current dislike of such a strong company is unwarranted but gives investors with a longer time horizon the ability to pick up a world class company with a dividend and strong balance sheet for a very good price. Moreover, as the company grows that 2.6% dividend your yield will grow as you wait for Mr. Market to recognize the value of Microsoft. Additionally, I feel that if one is patient you will be able to pick up shares somewhere in the low 20’s not because there is a problem with the company, but instead because I believe there will be a short lived market pullback after June 30 when QE2 ceases. I believe that Microsoft will continue to do well proving the naysayers wrong and eventually once the stock breaks the downtrend by moving past $25.50 on strong volume a move to the $36 area would not be unexpected. Remember as Warren Buffet has said “you want to buy when others are fearful and sell when others are greedy.” You always stand the best chance to make money by buying assets that others hate since if everyone hates it, who is left to sell(assuming you have done your homework)? If there is no one left to sell then the path of least resistance is up.

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