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The Science of Hitting
The Science of Hitting
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Microsoft - Three Simple Questions

October 24, 2012 | About:
You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

- Benjamin Graham

Being contrarian isn’t easy. When the markets and the media are telling you that you are wrong time and time again, the color red and the cries of the crowd can cause your stomach to turn while emotions and fear counterbalance your analysis; in these trying times, the value investor, through a firm balance of humility and conviction, must remember that in the long run, the underlying value of a business will be reflected by a company’s stock price.

In his 1992 letter to shareholders, Warren Buffett (NYSE:BRK.B)(BRK.B) provided a solid mental framework for investors when he said the following about accounting for stock options:

“The most egregious case of let's-not-face-up-to-reality behavior by executives and accountants has occurred in the world of stock options. In Berkshire's 1985 annual report, I laid out my opinions about the use and misuse of options. But even when options are structured properly, they are accounted for in ways that make no sense. The lack of logic is not accidental: For decades, much of the business world has waged war against accounting rule makers, trying to keep the costs of stock options from being reflected in the profits of the corporations that issue them.

Typically, executives have argued that options are hard to value and that therefore their costs should be ignored. At other times managers have said that assigning a cost to options would injure small start-up businesses. Sometimes they have even solemnly declared that "out-of-the-money" options (those with an exercise price equal to or above the current market price) have no value when they are issued…

It seems to me that the realities of stock options can be summarized quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?”

There’s beauty in such simple (and flawless) logic. As Buffett noted in the 1998 letter, “A few years ago we asked three questions in these pages to which we have not yet received an answer.”


Microsoft (MSFT) has been in the cross-fire as of late, and the main talking point is “The Death of the PC.” While this conclusion spits in the face of estimates from firms like Gartner and IDC (which predict global PC shipments will cross 500 million per annum in a few years, from roughly 350 million today), it’s interesting to look at this proclamation in addition to other talking points.

In a recent article, I discussed what I view as the goal for Windows 8, saying the following: “I think the rationale is clear as day – for all intents and purposes, Microsoft doesn’t need to worry about the PC market: Windows 8 will sell on computers and in a big way, regardless of its perception among techies (when I say big, I mean in comparison to any non-MSFT alternative). Microsoft is pushing this OS on consumers in the hope that the lure of familiarity (over time) and connectivity among devices will be enough to lure their faithful desktop base of more than 1 billion people into the world of smartphones and tablets (where the OS has received accolades) – and in my mind, this is all that matters.”

What amazes me is that when I read about Windows 8 from the same crowd predicting the death of the PC, they generally conclude the following: Windows 8 will be an attractive operating system on things like smartphones and tablets, but will be an utter failure on desktops (PCs). I’ve read these articles for weeks on end, and still can’t circle the square. As a result, I have three simple questions that I would like to have answered by anyone who can understand such rationale:

1. Is the PC dead? If you believe yes, please define what dead means in terms of PC shipments in the next couple of years (do they mean flat lined, or disappearing completely)?

2. If it is dead, what would be the smartest thing for Microsoft to do in their attempt to transfer their PC base of more than 1 billion PCs to the world of tablets and smartphones, where they have failed to gain traction?

3. If the PC will in fact remain relevant (which it would need to be for the Win8 desktop launch to even matter), and consumers wholly reject the Windows 8 operating system on the desktop, which OS will the vast majority of consumers and enterprises revert to? A look at Microsoft’s operating results during the launch of Vista may be instructive when answering this question.

I would happily change my investment thesis on Microsoft if there were answers to these questions (as a whole) that suggested something contrary to what I put forward in my recent value contest submission; yet in dozens of articles about this product launch and the future of Windows, I’ve yet to hear these seemingly apparent questions discussed a single time.

I think the crowd that is simultaneously calling for the death of the PC and the failure of Windows 8 should spend a few minutes thinking about what this would mean – if they did, I think they might have a bit clearer view on the strategy currently being pursued by the boys in Redmond.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.0/5 (25 votes)


Crafool premium member - 5 years ago
Good article. Full disclosure is that I am Long MSFT.

I think part of the problem is people making bold/broad claims is just part of the media today. Reporters don't feel the need for accuracy but rather eye balls. The old expression of "Get it first then get it right" is what matters most with today's 24/7 media cycle.

As far as "Death of PC", I can only speak from personal experience. I am a businessman and I meet with clients daily. I have to stay informed to do my job well. So technology is very important. I personally have a lap top with docking station along with twin monitors at the office, an iPad, an iPhone and a lap top at home for personal use (FYI, I am using it to write this post). Why some many products? Well, I have yet to experience one that can do all that I need and I have acquired these items as they have become available. I beleive there is a turning point, but not what I hear from the mainstream media.

I obviously had my laptops and PCs before my iPhone. The iPhone could never replace my PCs or Laptops, however it did replace my regular cell phone. I liked being able to get emails, web access, and other stuff from it. I got an iPad and loved how I could access the emails, web and other stuff from it, however it is only good for that and isn't real handy for my business like my laptop (i.e. it doesn't support Java or Adobe Flash and writing on it is a challenge). The iPad has done me wonders including no longer needing an iPhone, but rather having the opportunity to just go back to a regular phone with texting capability. So the iPad has really canabilized my iPhone and in the future will resurrect my cell phone when it needs to be replaced.

Am iPad replacing my work computer seems like a HUGE stretch for information related to my working includes personal information and other sensitive items that I can not see being stored in the "Cloud". As a matter of fact, we will be uograding to Windows 7 in the near future. I do like the idea of Microsofts new tablet having a key board (iPads have the ability to make typos a regular occurence that a lot of society just accepts it but it isn't professional and not business worthy) and offering Microsoft Office, Adobe and Java is very appealing. It seems like the iPad is really a media access technology and the Laptops a computer, but the new Microsoft Tablet is bring these two together. I think it might be able to canabilize my iPad and personal PC in the future, but a tablet alone will never cut it at work. It could extend but never replace.

Just some thoughts. I see work/coporations/governments remaining in the Microsoft/IBM/Inte/Dell world and the tablets playing a roll but never replacing. So I disagree with "Death of the PC", and think it is more a moment similar to Businessweek's famous cover of "The Death of Equities". I think the maximum pessimism and glamour of Apple over Microsoft is probably setting up for Microsoft/Intel/Dell to possibly make investors an awful lot of money.

The three questions I have for these stocks Microsoft, Intel and Dell is as follows:

1.) How are their balance sheets? Is their big leverage or what I like to say balance sheet risk?

No I see HUGE somes of CASH. I see current assets that are far higher than current liabilities and long term debt. So on this one I'm good.

2.) Revenue risk?

Well, I think they still have growth and disagree with the Death of PC as explained above. Even at lower levels than today most of these stocks are trading with single digit P/Es. Thus, I believe the low P/E is gives me some margin for safety that revenues might disappoint even though the new Windows, and tablets are coming out. Also, corporations and governments will one day have to replace their computers after delaying for so long. Windows 7 is no cheaper with the new software release and companies may have been waitiing for this moment to upgrade.

3.) Price risk?

The share prices keep hitting lows lately or going down. The probability of over paying is declining everytime these stocks decline in value. The valuation approach that I use is the Enterprise Value of the companies divided into the Earnings per share before tax. This gives me the earnings yield and when I get these kinds of yields relative to the 10-year Treasury Bond it is compelling and from a historical basis it holds up as well since looking at Valueline these companies have never traded at these multiples. It is like the complete mirror opposite of their year 2000 valuations.

I think these stocks now feel how Apple once felt when people thought it was going out of business, Microsoft lent it money and created some software for it, and Bill Gates spoke to the Mac conference to many in the crowd booing his appearance. Boy if you bought Apple stock aggressive at that point I think you would be a Happy Camper if you held it to today.

As always please do your own research. You should never listen to anyone but yourself like the Benjamin Graham quote avove states. Happy Investing to All!!!
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM

Fantastic comment! Thanks for taking the time to write it!
Batbeer2 premium member - 5 years ago
>> If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?”

Buffett is wrong. He is thinking as an owner. It is what he does best. As the owner of the business, options etc. reduce the value of your stake. Yes, it's an expense to the owner. It is NOT an expense to the business. There is a difference.

For example.... I own some bonds of a company. Would I want the options granted to management to show up as an expense?

NO. This would make it much harder to estimate the ability of the company to service its debt.

Next example.... Would the company not have to pay taxes if they issued a lot of options in a given year. If accounted for as an expense, this would depress earnings.

Again, NO. Transferring the ownership of the business to its managers should not have an effect on the companies tax rate.

In short, most investors want to believe GAAP is solely for the benefit of the analyst trying to figure out intrinsic value. That's a mistake. The fact that investors poor over the accounts does not mean the accountant prepared them for that purpose. The markets could close for a decade and the accounting profession wouldn't miss a beat.

Just random thoughts.
Gjraf - 5 years ago    Report SPAM

Crafool I totally agree. Your comments are right on the money.

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