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The Science of Hitting
The Science of Hitting
Articles (671) 

When Is Microsoft a Sell?

Some thoughts on when to sell a great business

February 19, 2020 | About:

This article requires a bit of background. First, I’ve owned shares of Microsoft (NASDAQ:MSFT) since 2011. And second, the stock currently accounts for more than 15% of my portfolio.

I have great respect for the company’s management team, primarily CEO Satya Nadella, and believe that the company has significant long-term growth opportunities ahead in large addressable markets (covered by the catch-all term "the cloud"), along with sustainable competitive advantages that put the firm in a position for continued success. In addition, the company generates prodigious amounts of free cash flow (more than $100 billion in cumulative free cash flow over the past three years, despite significant capital expenditures). It also maintains a fortress-like balance sheet, with more than $60 billion in net cash that provides support for capital returns and inorganic opportunities.

That’s a long way of saying that I continue to feel very confident about the company’s financial position, its management team and its long-term prospects. All is well on that front.

However, as is always the case in investing, the quality of Microsoft’s business isn’t the only consideration. Like a bettor at the race track, the question we must answer is whether the odds currently being offered are attractive. This requires a discussion on both the business prospects and the valuation. If an investment is made in this company’s shares for the next decade from today's stock price, is there reason to believe that the results will be attractive?

In an attempt to answer this question, let's take a look at forecasts from the analyst team at Goldman Sachs (NYSE:GS). As of their most recent update, they have modeled financial results for Microsoft through fiscal 2027 (eight years from now). In summary, their model assumes that revenues will increase at a roughly 10% compounded annual growth rate, that operating income will increase at a roughly 13% CAGR (with margins climbing by more than 100 basis points per year on average) and that earnings per share will increase at a roughly 14% CAGR. Here’s the EPS output.

Now, as we think about those expectations, a discussion on base rates is warranted (as well as a shout-out to Michael Mauboussin for his unparalled research on this topic). This is essentially the idea that we can look at similar situations in the past to derive some insight on reasonable expectations for the future. As Mauboussin notes, this exercise allows an investor to improve the quality of his or her forecast, as well as to provide a reality check on the claims and assumptions of others. As an example, here are the historic base rates for revenue growth delivered by companies with more than $50 billion in inflation-adjusted (starting) revenues from 1950 to 2015.

As shown above in the far right column, less than 5% of companies that have started with an inflation adjusted base of $50 billion or more in annual revenues have ultimately delivered a ten-year revenue CAGR of 10% or more. That says something about how difficult it can be to sustain outsized top-line growth for long periods of time once you’ve reached a certain scale. (Microsoft’s revenues last year were $126 billion.) Anybody that's working with Goldman’s revenue assumptions is putting more weight on Microsoft’s recent results than they are on the historic experience of companies like it (at least in terms of size, which I think you can argue offers some value as a relevant reference class). At the current valuation, Mr. Market is expecting future results that are quite a bit better than what companies of a similar magnitude, on average, have ultimately delivered over the ensuing decade in past occurrences. Only time will tell if that was an accurate belief.

But let’s assume Goldman's forecasts are reasonable. At the current price of $187 per share, Microsoft trades at 13 - 14 times the 2027 EPS estimate from Goldman’s analysts. At different terminal multiples, here’s an expected price return CAGR from owning the stock for the next eight years (the current dividend is a quarterly payout of $0.51 per share, good for a yield of 1.1%).

As you can see, a terminal price-earnings multiple in the low-to-mid 20’s will result in a mid-single digit price CAGR for the stock over the next eight years. The terminal multiple would need to be around 30 times trailing earnings for the annualized return to climb past 10% per annum.

Here’s what the math looks like if the earnings per share that Microsoft reports in the terminal period (fiscal 2027) is ultimately 25% lower or higher than what Goldman's analysts expect.

In the scenario where the results fall 25% short of Goldman’s expectations, which still implies a ten year earnings per share CAGR of roughly 12% from fiscal 2017 to fiscal 2027, you need a terminal multiple in the high-20’s (at least) to generate a decent absolute return (I define "decent" as a mid-to-high single digit price CAGR, which seems reasonable in the current interest rate environment).

If the earnings per share figure that Microsoft delivers in 2027 is 25% higher than Goldman expects, you can generate attractive absolute returns if the terminal multiple is anywhere around 20 times earnings (in that scenario, Microsoft’s trailing 10-year EPS CAGR would be roughly 18%).

Conclusion

The question is how to determine the appropriate terminal multiple. The more I think about this topic, I feel torn between two schools of thought. The first comes from Charlie Munger (Trades, Portfolio):

“Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.”

The idea here is that the truly great businesses are worth substantially more than an average business. When you think you’ve found one, do what you can to keep it. You shouldn’t sell because the multiple went up to 25x, 30x or even 35x. At present, Microsoft certainly seems to fit that description (in my opinion, it may be the epitome of that description). It's a great business that seems to have unparalled opportunities for reinvestment and long-term growth. For that reason, do what you can to avoid getting caught up in the present valuation; just close your eyes and hold on.

The second view comes from Bill Nygren (Trades, Portfolio) of the Oakmark Funds:

“For almost all businesses, our crystal ball goes dark after seven years, so we assume all businesses trade at similar P/E’s after seven years. With an estimate of fair value seven years in the future, we can discount that back at an appropriate risk-adjusted discount rate to estimate today's value. Whether that results in a near infinite or a negative P/E on current earnings is not of concern to us.”

His perspective is that it is difficult to comment on the quality of a business seven-plus years out. I agree: the idea that you can accurately forecast where most businesses will be a decade from now seems optimistic – and Microsoft’s own history over the past twenty years bears that out. The company was seemingly on top of the world at the turn of the century, then became a “dinosaur” that many believed was in a state of terminal decline, before returning to best-in-class status today.

That evolution doesn’t strike me as particularly odd; I do not find it unusual that any company, especially in the tech industry, will experience such swings over the course of a few decades. To me, the idea that you can predict what will happen to a company five-plus years from now – let alone 20 years from now – requires some hubris.

When I discussed this Nygren quote in a previous article, I wrote:

“Personally, I’m on the fence on this one – it seems a bit draconian, but I can see the merit of the approach Nygren has adopted. When I build models, I rarely stray from a level near the historic market multiple, especially when I’m applying that against an estimate of normalized profits. As with most things in investing, this is a balancing act that seems to be more art than science.”

I still think that’s a reasonable way to think about it.

Ultimately, I think the “right” answer is a blend of Munger and Nygren.

A great business like Microsoft that appears to have substantial long-term growth prospects may deserve some premium to the average company in terms of what you’d be willing to pay for a dollar of earnings or free cash flow 5-10 years from now, but it’s tough for me to defend something meaningfully higher than average. The reason why is because it’s too hard to say that any company will maintain its greatness and its growth prospects more than a deacde or so into the future. (The opportunity to bet on a unique individual or group of people may be an exception, but that’s a topic for another day.)

So, what’s the definition of “some premium?" Well, I don’t think it’s 100% higher than the market multiple, but I don’t think it’s 10% either (again, I mean this in terms of the multiple applied to an EPS estimate ten years down the road). If you accept the estimates outlined above (which I find plausible), apply a trailing terminal multiple of 20 – 30 times in fiscal 2027 and require an 8% price CAGR over the forecast period, the output is a fair value estimate of around $150 to $225 per share.

Given those numbers, especially in consideration of the position size in my portfolio, it will be tough to sit idly by if the stock continues to run. I love to own great businesses for the long-term, but the idea that one can completely disregard the price they’re being asked to pay is a bridge too far for me. There must be some limit. For that reason, if Microsoft continues to climb towards the high end of that range in the relatively near future, it’s likely I will trim my position.

Disclosure: Long MSFT

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.9/5 (8 votes)

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Comments

jtdaniel
Jtdaniel premium member - 5 months ago

Hi Science,

Many thanks for your fine updates on Microsoft. I bought my shares in 2006 in a taxable account, so any significant selling would create an unwelcome tax event. Also, Microsoft is the best business I am in, with a great runway for long term earnings growth. My thinking is to just hold and look to add shares when the bear reappears. Best, dj

The Science of Hitting
The Science of Hitting - 5 months ago    Report SPAM

dj - I certainly understand your desire to continue holding a great business and not pay (significant) capital gains taxes. But in my opinion, there must be some limit on the value of a business. Is there no price where you would trim / sell? Maybe the answer is no. For me, I think the answer is yes - especially when that position is >15% of my portfolio and subject to certain risks (to be clear, over long periods of time). But, to each his own! As always, appreciate your feedback and thoughts.

jtdaniel
Jtdaniel premium member - 5 months ago

Hi Science,

Microsoft is exactly 10% of my equity portfolio. Yes, there is a level at which I would sell and it would not have to be a Y2K Dell or Cisco valuation. MSFT is now trading around 32 to 33X trailing EPS (I paid 10X EPS in 2006) due to some mix of strong performance and market exuberance. So a reappraisal toward a more normal market P/E near 15 brings the risk of a 50% loss, however temporary. I have to weigh that risk against the certainty of a 15% capital gains tax. For now I prefer to ride MSFT.

The Science of Hitting
The Science of Hitting - 5 months ago    Report SPAM

dj - Fair enough! As usual, I think you and I are basically on the same page :) Have a great day.

snowballbuilder
Snowballbuilder - 5 months ago    Report SPAM

Hi science ,

I always apprecciate your article and the transparancy with wich your share your experience

So the follow is only a consideration not a criticism at all

I think you are probably not fit to investment the way Munger and Akre does.

And of course there is nothing wrong with that as anybody should find a stile of investing wich make him confortable and work for him. And your result and your knowledge speak for himself that your stile is working well.

But the difference is simple and crucial: neither Munger or Akre would sleep less well for the valuation of any of their great business and / or for having the position of a great business at 15% of their portfolio.

Onestly a long term focused investor like Munger would probably consider 15% not a big position at all.

"...To the surprise of many, neither valuation nor price targets play a role in our sell decisions." Akre capital

Just some thoughts

With friendship. Snow

The Science of Hitting
The Science of Hitting - 5 months ago    Report SPAM

Snowball - I think that's probably fair. In my mind, it's just logical that, AT SOME PRICE, even the best business is not an intelligent investment. You can accept lower expected returns, apply a higher terminal multiple, whatever. In the end, there's still some price. So, while I try to focus 100% of my attention on the long-term, I think what I presented in terms of base rates and MSFT's valuation is worth thinking about.

My objective is to generate attractive long-term rates of return. At some price, I doubt the 10-year forward returns for MSFT (or any company / stock) are likely to be unattractive. And, as I discussed above, I am not in a position to honestly comment on Microsoft's prospects 10+ years from now. But I see the merit in what you've said! Have a great weekend Snow.

jtdaniel
Jtdaniel premium member - 5 months ago

Hi Snow and Science,

I went back and looked at my entire equity portfolio. If I set a policy to begin liquidating a holding near Microsoft’s current level of over-pricing (my MSFT numbers are similar to Science’s), I would also need to start selling out of long-term positions in Waters, Home Depot, Hormel, and Mastercard. In truth, selling them all after a 10 year bull market could be a most prudent decision, but I am not that kind of investor outside of IRAs. I think of these as superior businesses that could hold up better than most in a down market, or at least come back stronger. It is tempting to think, “I will sell Microsoft near the top and buy it back after the crash,” but that kind of thinking discounts other less desirable but equally possible outcomes.

mchlntzn
Mchlntzn - 3 months ago    Report SPAM

Hi Science,

Great post. Thank you.

Re the CAGR calculations, maybe I've missed something but I didn't see that you took into account all the FCF that MSFT would have produced throughout the 8 years from 2020 to 2027. I think it would have increased MSFT's valuation in 2027 by quite a lot. For example, summing up the EPS from 2020 to 2027 according to GS's analysis gives an additional $62 per share to be added to MSFT's valuation in 2027. Of course it'd be better using FCF instead of EPS but it's still instructive.

Kind regards,

Michael

The Science of Hitting
The Science of Hitting - 3 months ago    Report SPAM

Michael - Thanks for the kind words, I'm glad you found value in the post. The reason I did not directly account for all of the FCF generated between 2020 - 2027 is because it's captured in the EPS growth rate (repurchases) and dividend payments (note that I specifcially discuss price CAGR's, not TSR's). Hopefully that explanation is clear!

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