It’s happened to all of us. You fire up your computer first thing in the morning only to discover that a favourite stock has dropped by 10% or more.
Is it a sign that the company is struggling? Perhaps you should sell.
On the other hand, it’s now cheaper. So maybe you should buy more.
How are you going to decide?
It’s the most difficult question in investing. That’s partly because you now feel awful – even stupid. And there’s a real danger emotions will cloud your judgment.
But if you follow my third and final rule for successful investing, you’ll know exactly what to do. I’d like to explain that rule to you today – and tell you why Microsoft currently meets all of my ‘true value’ criteria.
Often the best time to buy is after a share has fallen
If you invest in individual shares, you need to know their ‘true value’ – what they’re really worth. Only then can you tell if a stock is a bargain. And only then will you know when to sell.
In my view, a bargain stock is one which is trading at least 30% below its true value. Why 30%? Because that gives you a healthy ‘margin of safety’ in case things go wrong.
So if your stock falls, find out why. If there’s new information which lowers the stock’s true value, you should sell. But more often than not, it’s down to mere sentiment. And the market often overreacts.
If that’s the case, then don’t sell. Instead, buy more. Why? Because your margin of safety is now higher. So the risk is lower. Many famous value investors make most of their money not on their first purchase of a stock, but on the second and third buys, after the price has fallen.
I won’t pretend that it doesn’t take time to value stocks. You do have to put the work in. But at the same time, valuation is not rocket science. Let me show you what i mean.
A stock that meets all three of my rules for successful investing
Microsoft (NASDAQ: MSFT) is certainly ugly, as per rule number one (‘buy ugly’), which I discussed here a couple of weeks ago: The worst investment mistake you can make. The stock price lost half its value in the dotcom crash of 2000-2002. And it’s gone absolutely nowhere since. So it’s been dead money for a decade.
Conventional wisdom says that Microsoft has been outsmarted by Apple and Google. It’s badly managed and it can no longer innovate. Google took away its search business. Apple and Google have prevented its smartphone operating system from getting any traction.
Meanwhile, Yahoo and Google are taking share from MSN. A range of rivals is eating away at Internet Explorer. Sony and Nintendo relegated its X-box gaming console into third place. The list of Microsoft failures is long. And now the analysts add that we’re all switching from PCs to tablet computers.
But conventional wisdom doesn’t tell the whole story. Microsoft’s consumer businesses account for just 16% of total revenues. But they get almost 100% of public attention. They are also unprofitable. So 84% of revenues and 100% of profits come from the core Windows and Office software businesses. Microsoft’s market shares in these two businesses are 91% and 95%. In other words, it has a virtual monopoly.
Nobody’s developing a new PC operating system. For one thing, it would cost tens of billions of dollars. And customers wouldn’t switch even if they had other choices. It’s just too much hassle for most of us to learn how to operate a PC all over again. For companies, it would be too costly. That’s why the free PC operating system called Linux has made no noticeable difference to Microsoft’s market share.
Next, can you really call management a failure when it’s grown earnings per share (EPS) fivefold since 2002? The share price hasn’t moved because the price/earnings (p/e) ratio in 2002 was five times today’s figure. The lower p/e ratio has cancelled out the growth in earnings. Is that really management’s fault?
What about the threat from tablet computers? Well, there’s very little evidence of it in Microsoft’s results. Last quarter, revenue, operating income and EPS were up 15%, 20% and 28% respectively since last year.
Microsoft has no debt. In fact it has net cash and investments worth nearly $5 per share. So it passes my rule number two (“don’t lose money” – which I covered here last week: The world’s third-largest bank is bust), as long as it meets two further conditions. First, you have to buy it as part of a well-diversified portfolio. And second, it has to be available at a price which gives you a minimum ‘margin of safety’ discount to true value of 30%.
What is Microsoft’s ‘true value’?
The current share price is $26. So is Microsoft worth at least 30% more? Last quarter EPS were 77 cents. That’s equivalent to about $3 per share per year. And note that Microsoft does not boost earnings by capitalising research and development (R&D) costs like some technology companies. It treats all R&D spending as costs, even though its software products take years to develop.
What is the true value of a business that earns $3 per share per year? Well, it depends on your required rate of return. The average long-run annual real return from stocks is 6.75%. Call it 8.75% before inflation. So you should be willing to pay about 11.4 times earnings (1/0.0875) even if there’s no growth left in Microsoft’s businesses. And there’s plenty of evidence that growth is not over.
Add in $5 per share of cash and investments and true value is at least $39. That’s a potential profit of 50%.
Of course, the full valuation is a bit more complicated than this. Normally you have to make a few adjustments to reported earnings. You should replace current margins and tax rates with long-term ‘through the business cycle’ averages, to smooth out fluctuations over time.
You should also replace depreciation (the amount written off fixed assets) with maintenance capital expenditure. That’s the real cost of maintaining the assets of the business. Depreciation is just an arbitrary accounting assumption.
But in the case of Microsoft, the net effect of the adjustments is small.
Now don’t get me wrong. You shouldn’t plan on holding Microsoft forever. The analysts’ criticisms are partly valid. And their impact may well grow over time, if Microsoft can’t get its act together in consumer businesses.
But, and there’s no escaping this conclusion, it’s priced way below true value today. And that’s why I recommend you buy Microsoft (MSFT) today.
In this report I highlight the two big mistakes many investors make when it comes to valuing shares… and two simple methods for making sure you are as confident as can be that you don’t overpay for any share ever again.
It’s very straightforward – the same principles can be used across the board, whether you’re buying a stock, open-ended fund or investment trust.
In the meantime, I’m preparing something else that ties all these reports together. I can’t say what it is just yet, but as a Money Morning reader you’ll be the first to find out.
So watch this space.
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