—Peter Cundhill, Renowned global value investor
A little more than 25 years ago, on March 13, 1986, Microsoft became a public company. The IPO price was $21 a share and the offering was to raise $61 million. Already a powerhouse in the world of PC software, the future looked bright for the company and its 30-year-old co-founder Bill Gates.
If you’d been fortunate enough to buy 100 shares at the IPO price of $21 for a total cost of $2,100...and held them until now, after nine stock splits...you would have 28,800 shares worth more than $750,000.
Throughout its life as a public company, Microsoft has been financially sound. From the start, the company’s balance sheet has been as strong as the rock of Gibraltar. The company has been profitable each year and has returned billions of dollars to shareholders through dividends and stock buybacks. For the past 25 years, MSFT has met our first rule, which is that a company must be financially sound in order for us to invest in it.
Although the company is financially strong and has dominated its industry, there have been relatively few times in the past 25 years that we would have considered purchasing the stock. Our second rule—buy only when the stock is trading at a bargain price—was not offered to us by Mr. Market. Most of the time the stock has traded at valuations that had us sitting on our hands and waiting.
Having the proper temperament is a must when it comes to investing in stocks. In general, investors that look to the stock market for action and get a thrill from trading usually lose their money. Yes, there are exceptions and some traders that are very active consistently make money. But keep in mind that they are the exception rather than the rule.
Investors whose decision-making process is guided by the facts and their analysis rather than their emotions usually end up less stressed and much more successful than “whirling dervish” adrenaline junkies. Not having the patience to wait and buy only when the stock is attractively priced usually leads to frustration, bad decisions, and financial losses.
Let’s take a look at how an investor who did not have the patience to wait for the right time to make a purchase would have fared over the past dozen years. Assume they were able to identify that Microsoft was a financially sound business, which wasn’t very hard to do, and were itching to buy at any price…how do you think they would’ve made out?
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As a company, Microsoft’s dominance of the PC software market is uncontested. Microsoft’s market share is currently a staggering 90% and has been even higher at various times over the past 25 years. Even though over the past five years Apple has made enormous strides in capturing market share, Microsoft’s software still runs the majority of the world’s computers.
It should come as no surprise that this type of market share dominance is reflected in Microsoft’s financial statements. Over the past 10 years earnings grew at an annual rate of 11% and revenue climbed by more than 13.5%...an amazing accomplishment for a company Microsoft’s size.
If an investor had concluded at the end of 1998 that Microsoft would continue to thrive and dominate the software market, and only get financially stronger, they would’ve been right. BUT if they invested based solely on the financial worthiness of the company, they would not have made a dime on their investment. If you factor inflation into the equation, their investment would have shown a negative return.
Adjusted for dividends and stock splits, a share of Microsoft purchased at the end of November 1998, at $25.48, would have been worth $25.39 on March 31, 2011. Adjusted for inflation the current share price would be worth around $19 (1998 dollars), for a loss of more than 24%.[url=#_ftn1][/url]
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Perhaps you’re scratching your head and asking yourself, “How could it be possible that by owning shares in a financially sound business that has knocked the cover off the ball for decades and earned tens of billions of dollars for shareholders...one could end up losing money?”
The short answer is, price matters. While the investor in our example did act wisely by choosing a financially sound business, they didn’t take into account that Mr. Market had already priced in a rosy future. Purchasing a financially weak business at an attractive price can yield good returns, but purchasing a financially sound business at a high price, as we’ve seen, can yield terrible returns.
We consider a stock attractively priced if it trades at a P/E no greater than 10. Over the past 12 years Microsoft’s P/E was as high as 60 and never even came close to our target of 10. During the financial crisis of 2008 when the stock market lost 50% of its value, Microsoft’s P/E was 9.5. It had finally met both our rules: it was a financially sound business trading at an attractive price.
On January 27, 2009, we added Microsoft to IWP at a price of $17.66. Nine months later on October 15, Mr. Market rewarded us for our patience—we sold our shares at a price of $26.71, for a gain of 51.2%. In the 1.5 years since we sold Microsoft from our portfolio, the stock has traded flat to slightly lower.
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Mr. Market might be giving us a chance to buy the stock again. Microsoft continues to be a financially sound company; it is one of only five publicly traded U.S. companies that has a Standard and Poor’s credit rating of AAA.[url=#_ftn2][/url] If the stock price should fall to the mid-$24 range over the next few weeks, it will once again be attractively priced and make the cut to be considered for IWP.
It isn’t hard to find companies that are financially sound, and it isn’t hard to identify stocks that are attractively priced. The hard part is finding financially sound companies when their stocks are trading at attractive prices. That requires not only research and vigilance, but also patience. We have something that most investors lack, and that is the discipline to follow our rules. In other words, we won’t buy a stock unless it meets both conditions...it’s that simple.
To be a successful investor you need to get up to the plate, keep the bat off your shoulder, and swing at only the fat pitches. While simple in theory, it appears that many investors can’t do it in practice. As a subscriber to IWP, you’re part of a group that makes an investment only when the odds are overwhelmingly in your favor. Over time that is the secret of making money in the stock market.
2. In addition to Microsoft (MSFT), Automatic Data Processing (ADP), Exxon Mobil (XOM), Johnson & Johnson (JNJ), and Pfizer (PFE) have the coveted status of a AAA rating.