The dramatic recovery of the stock market over the past two years has brought the market to overvalued levels, as measured our broad market valuation indications based on the ratio of the total market cap over gross national product. This market recovery is broad across all sectors and industries. Very few companies are now traded at 52-week lows, while many companies are at 52-week highs. While investors are happy with the market returns over the past two years, many value Gurus are having a hard time finding investment ideas that can still provide reasonable returns at acceptable risks. One area where they find ideas is large cap stocks that did not go up as much as the general market. They bought into technology companies such as Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO) and Dell (DELL). Those Wall Street darlings in the go-go years of the 1990s typically do not get into the portfolios of value investors. Now they do.
Since the market bottom of March 2009, S&P500 is up 93%, and the Nasdaq index is up 118%. In the same period, Dell is up 83%, Microsoft is up 66%, Cisco is up only 20%. For the last 12 months, all of them returned negative. Dell is down 12%; Microsoft is down 18%. Cisco is down almost 40% and is making new lows every almost every day.
All of the three stocks have seen large buying interest from our Gurus. With this article we will summarize why they like them, and which might be the best pick among the three.
Microsoft is one of the most broadly owned stocks among our Gurus. Many of them have discussed their views on Microsoft. Arnold van den Berg detailed his take on Microsoft in his latest newsletter:
“We realize that many believe Microsoft has fallen behind Apple on smart phones and tablets and that there is uncertainty surrounding the impact of cloud computing on its business. We believe that smart phones and tablets address different needs and different markets than PCs, and thus expand the computing device market. PCs are primarily input and productivity devices while smart phones and tablets are primarily output and content consumption devices, though there is overlap. In other words, Apple has been extremely successful in expanding the overall market, not only for its devices, but also for computing devices such as PCs and Internet servers sold by Microsoft, Intel, and Dell, among others. Regarding cloud computing, we believe that while there is considerable excitement surrounding it (much the same way there was excitement over the Internet 10 years ago), to the degree that it is adopted, it will make PCs more valuable and drive additional demand for PCs and laptops (as well as for other computing devices). We also believe that Microsoft is extremely well positioned to be a dominant player in cloud computing. However, Wall Street has the attitude of ‘shoot first and ask questions later’, creating opportunities for patient long‐term investors.”
“We believe Microsoft is worth a premium to the average company. Our 36 years of research shows that large quality companies like Microsoft often get a 20% to 25% premium over the average stock, and rightfully so. If we were to add a 20% premium to the median P/E of the Value Line Investment Survey® (an index of 1700 stocks) over the last two years of 15.6, it would put Microsoft’s P/E at 18.7 (15.6 2‐year median P/E plus a 20% premium = 18.7 P/E). If we were to use the 5‐year median Value Line P/E of 17.1 and add a 20% premium, it would suggest a P/E of 20.5.”
“While it is quite possible that Microsoft will grow faster over the next five years, we are only assuming a 5% growth rate. Under this scenario, we believe it has future earning power of $3.95. If we apply the 18.7 and 20.5 P/Es just calculated, it suggests Microsoft could sell for $73 to $80 per share. If we present value this back into today’s dollars at 10%, it is equivalent to a current price of $45 to $50. If we take the average price of $24.5 over the past six months, this stock has the potential for a 5‐year annualized return of 24% to 26%.”
In a recent article written by Whitney Tilson and John Heins regarding to Apple (AAPL) and Microsoft (NASDAQ:MSFT), the authors wrote: “While hardly the popular pick, we’re sticking with Microsoft, in large part because of the inherent protection we believe the stock’s rock-bottom valuation provides. The company’s enterprise value (its market capitalization plus debt outstanding, less $4.85 per share in cash and investments on the balance sheet) is just over $23 per share—or only ten times the $2.35 per share that Microsoft earned in the 2010 calendar year. That is dirt-cheap for a company that seems to be firing on all cylinders, with sales growth in the October-December quarter of 15% (from the same quarter in 2009) and earnings-per-share growth of nearly 30%.”
In a recent Interview with our readers, Zeke Ashton said, “... I just think both of them (MSFT and CSCO) are very out of favor and cheap if the companies can continue to generate cash at anything close to historical levels. We hope that the next 12 months provides further evidence that we are correct in our assessments of the qualitative soundness of these two businesses.”
Cisco is the only stock Arnold van den Berg bought in the first quarter of 2011. It is also a new position of Tweedy Browne managers, a team of very conservative value managers. In their latest shareholder letter released last week, the managers wrote: “Cisco is financially strong and we think statistically cheap. It has a dominant market position and has been growing within a category that we believe still has a lot of room for future growth. Perceived competitive threats and concerns about possible slower rates of growth have put pressure on Cisco’s stock price, which has allowed us an entry point in the stock that we believe is at roughly a one third discount from a conservative estimate of the company’s intrinsic value.”
Indeed, Cisco is traded at historical low P/E, P/S, and P/B ratios. It must be a magic formula stock since it is owned by Joel Greenblatt. It is even owned by Chuck Royce although Royce Funds usually buys small cap stocks only. Other renowned hedge fund managers such as Edward Lampert and George Soros also own it.
Dell is one of the largest holdings of Mason Hawkins, the manager at Longleaf Partners Fund. It is also owned by Joel Greenblatt, George Soros and Tiger Cub hedge fund manager Lee Ainslie.
In an interview with us, deep value investor Mason Hawkins thinks that the reason why the stock is cheap because most of investors have a wrong perception with Dell’s business. They said:
One misconception is that Dell is not a “high-return business,” or that ROA needs to improve. We strongly disagree with that. Those returns I just talked about are way higher than at most companies.
The other interesting thing is that you actually just called it “Dell Computers,” which highlights why it is cheap. People still view it as desktop and notebooks, even though those are dying a slow death. Those represent probably a fourth of corporate value and a third of earnings.
The good segments – storage, servers, services, and software – account for the majority of value and an overwhelming percentage of future growth. Dell has its basis in computers, because computers created the free cash, which led to the 20,000-person distribution network, which is why they can now buy a storage company, widely distribute its products, and take revenues up in multiples the way they did with EqualLogic.
Margins will drift upward just because of product mix. Think of PC margins as mid-single digits. HP does the same. In PCs you are basically a reseller for Windows and Intel. With storage, servers, and services, that is not the case. You have much, much higher gross margins. You have obviously higher SG&A. Net it all out and you have significantly higher all-in operating margins than you do in the computer business.
Dell will get a product mix benefit going forward. Rising margins will not be from heroic cost-cutting, because the company already implemented those when Michael Dell came back.
Dell has over $6.00 of net cash, including approximately $1.50 in finance receivables, and a stock price around $15. I mentioned the $4 billion of free cash flow, and it will be actually more than that. With a little under 2 billion shares outstanding, Dell will generate over $2 per share of free cash flow. You are paying approximately $9 per share ($15 price - $6 cash) for the operating business – basically a 4.5 P/E on real cash earnings, if you will, for a return-on-assets in the high teens or a return-on-tangible assets in the 20s.
That is why we are there. It is cheap because of this perception of what they do versus what they actually do.
Dell founder Michael Dell has been buying large chunk of Dell shares. He bought close to 18 million shares in open market at the cost from $13.5 to $14.4 a share.
Microsoft, Cisco and Dell all are in extremely strong financial conditions. They all hold billions in cash on their balance sheet. The summary of the financial condition is below:
|Microsft (NASDAQ:MSFT)||Cicso (NASDAQ:CSCO)||Dell (DELL)|
|Market Cap ($B)||213||94.2||29.3|
|Net Cash ($B)||32||32||9|
|Enterprise Value ($B)||181||62.2||20.3|
|Net Income ($B)||20.58||7.578||2.735|
|Cash Flow ($B)||27.749||9.223||3.543|
|Gross Margin (%)||75.8||60.2||21|
|Net Margin (%)||33.2||14.6||5.9|
For both Cisco and Dell, the net cash the companies own is at a third of their market cap. The vast holding of cash brings down their enterprise values to only 7-8 times earnings and 5-6 times cash flow. Among the three companies, Dell appears to be the cheapest.
But as just pointed by our columnist John Emerson in his article The Marriage of Growth and Value: PEG Ratios and Panera, faster growth and higher quality companies deserve higher valuation. Among the three companies, Microsoft enjoys higher profit margins, more predictable business and higher growth. The slightly higher valuation than that of Dell seems be justified.
If the business indeed develops in the way expected by Mason Hawkins and his partners, Dell’s earning may grow at a faster rate in the next five years. For the fiscal 2011 ended in January, Dell’s product revenue increased year-over-year by 14%. Total product revenue represents 70% of the business. Services revenue, including software related increased year-over-year by 25%. But the gross margin for the services business declined from 33.7% a year ago to 30%.
The recent Dell business is a turn- around story. The total revenue was flat from 2008 to 2009, and declined from 2009 to 2010. It then recovered in fiscal 2011 to 2008 levels. The latest economic recovery certainly contributed to the business recoveries. But the company still relies heavily on the sales of its computers, which tends to be cyclical and heavily depend on general economic conditions.
Dell stock may be more rewarding than that of Cisco and Microsoft if the business continues to recover. But it carries higher risk because of its thin overall profit margins.
Cisco continues to make new lows lately as the market anticipated continuous decline of Cisco’s profit margins. The stock is only 20% above its price at the market bottom of March 9, 2009.
During the most recent quarter, Cisco net sales increased 6% with net product sales increasing 3% while service revenue increased 18%. Product sales represented 79% of total revenue, a 2 percentage point decrease from the prior year period; service revenue represented 21% of total revenue, a 2 percentage point increase from the prior year period.
Cisco gross margin percentage decreased by approximately 4.3 percentage points for the last quarter. Within this total gross margin change, product gross margin declined by 5.8 percentage points while service gross margin increased by 1.1 percentage points.
Compared with Dell, even with the recent profit margin decline, the net margin is still far above Dell's. Therefore, Cisco will be more resilient in economic downturns. At their current valuation levels, Cisco seems to be less risky than Dell.
Microsoft is currently valued at similar levels to Cisco. But Microsoft has much higher profit margins and stronger moat. The business growth is also more consistent and predictable. Over the past five years the company has retired close to 15% of its shares. Microsoft’s earnings grew at about 8% a year, with the share buyback, the earnings per share grows more than 10% a year. A detailed study of Microsoft was submitted to our Value Idea Contest in March.
Compared with Cisco and Dell, Microsoft has a higher chance of maintaining its profit margins and growth during poor economic conditions. With the valuation levels close to each other, Microsoft stock is better positioned for satisfactory returns at smaller risk.
Disclosure: The author does not own any stocks mentioned in the article.