Friday, February 20, 1998
by Al Levit (email@example.com)
Glendale, CA (Feb. 20, 1998) -- Its Friday, time for our financial lesson of the week!
In my first turn at this plate, Ill take on whats probably the single most controversial tenet of our Cash-King philosophy. It makes for a perfect fit on the day that we announce the purchase of Coca-Cola shares in our portfolio, shares that are trading at 42x the company's trailing earnings per share! (Click here to read our Coca-Cola Buy Announcement). So, what is this controversial Cash-King tenet? That, when investing for the long haul, the quality of a business can be up to 1,000 times more important than the present valuation of the stock.
"Thats nuts!" some Fools cry. "You can overpay for anything -- from the best car on the lot to the best home in the neighborhood!" Hey, we don't disagree that it's better to get a great product or property on the cheap than to have to pay through nose for it. Unfortunately, thats usually not the choice that Mr. Market gives us. On the stock market, we tend to find a bunch of superior companies that are very dearly priced by traditional standards.
We believe, however, that through improved valuation methodology -- and via an approach that accounts for our time horizon as well -- the companies we're buying are actually inexpensive relative to the broader market. How can that be? Coca-Cola is trading at 42x earnings while the Standard & Poor's Index of 500 companies is trading at 22x earnings. How could Coca-Cola possibly be considered "less dearly priced" than the general market?
Since my charge in CK-ville was to be answerable to questions on our technology holdings, I'm actually going to skip past Coca-Cola for now and turn to Microsoft to see how we've drawn that conclusion with MSFT.
We bought Mr. Softy on February 3, 1998 at about $156 1/2 per share. The company's trailing earnings are $3.16 per share, giving this stock a P/E of just under 50. Many investors think that sounds steep for a company projected to grow earnings at 24% annually over the next 5 years. Of course, numerous other investors don't. Today we'll briefly explore whether we need to have our heads examined for paying so much. To be as scientific as possible, we need to include that investigations into whether or not we need our heads examined for some other reason will not be run in today's column.
As we look into the future over our standard ten-year horizon, we note that the stock's performance will depend upon the company's earnings over that time, combined with the multiple investors are then willing to pay. Now one of the things we like about our Cash-King giants is that they are widely covered by Wall Streets analysts. The growth estimates published by First Call and Zacks reflect exhaustive research at a number of firms in consensus form.
Of equal importance, most Cash-Kings devote a lot of effort to "managing" expectations lower -- in a world where so many other companies try to talk their prospects up to America. Very little helps the short-term performance of a stock than an estimate-beating quarter but, more important to us, nothing reassures the investment community more than a company with an aggressive but guarded assessment of its future prospects.
But what about that multiple -- 50x earnings?!?
The common theory (at least everywhere but here in the Cash-King Portfolio) is that Mr. Softy's multiple will come down fairly dramatically in the years ahead, as the business ricochets off the "necessary limitations on its growth" and as investors conclude that the stock was drastically overpriced. For the fun of it, we'll even concede that point -- though we do think Microsoft's business is limited only by their and our imagination. Is there a physical limit on software applications and Internet services going forward? Present price is the only limit, and mass involvement will naturally bring down that barrier.
BUT... we conceded the point; for the sake of argument, we'll agree that the price-to-earnings multiple will drop over the next decade. If its coming down, though, where will it land? My favorite place to look is over recent history. Over the past five years, Microsoft's trailing P/E has ranged from a low of 16x to a high of 60x earnings, with an average of 37.8x earnings. During this entire period, Mr. Softy has had a stranglehold on computer operating systems, while also producing and selling the dominant spreadsheet and word-processing applications on the market. For Microsoft (and many other public companies), we do believe that past performance is some real indicator (not direct correlation) of future results. So, historically, a conservative multiple for Mr. Softy would be 30x earnings, and a very conservative multiple would be the consensus growth rate of 24%, or 24x earnings.
Now let's address the question of risk. Microsoft's earnings of $3.16 per share compounded at 24% for the next 10 years would make for growth, in toto, of about 860% (now you know why Cash-King investing favors stocks with high and believable estimated growth rates). This gives the stock projected earnings of $27.16 per share in the tenth year. Off the conservative multiple of 30x earnings, that places the stock price at $815. Off what we consider a very conservative multiple of 24x earnings, the stock is priced at $652. The returns from here to there would make for about 18.0% per year on the conservative basis and about 15.5% on the very conservative basis.
So, the questions are -- 1) Can Microsoft grow at that annual rate for ten years? 2) Will the market tab Microsoft in the middle of today's historical price-to-earnings multiples?
Our tendency is to believe that both are highly-possible, given the direction of the company, the force of solid management, and the direction of our world. We believe that software will prove to be the ultimate consumer non-durable of the 21st century. We also believe Microsoft is positioned to rule that universe for many years to come, in no small part because of its superior financial management.
Check out the performance of America's greatest consumer non-durable companies in the 20th century (from Gillette to Johnson & Johnson to Gap to Coca-Cola to Hershey's). Then remind yourself that most of Wall Street is engaged in a series of short-term battles (sell tomorrow, buy today... here tomorrow, gone today) over stocks. As an individual investor, you hold a distinct advantage since you can focus on the long-term performance of businesses, without getting fired by a Hermes tie in a Brooks-Brothers suit (that's today's description of a Wall-Street executive!).
We aren't buying Microsoft for the six-month performance of its stock. For that reason, we've restrained ourselves from using "traditional" valuation theories. In fact, because our time horizon extends ten years out, or twenty (or more), present valuation isn't overly-large in our eyes. The strength of the business and the direction of the planet is.
Foolish Aside: One final note about Mr. Softy. Dont panic if you check the price on Monday (note that for Cash-King investors, the word is "if," not "when"). The high multiple has not come home to roost. The stock begins trading at its split-adjusted price after the weekend.
Next week, youll meet yet one more Fool from our Cash-King team. Rob Landley, whom many of you know as "Oak" from the Cash-King message board, will be assuming the role of scripter. Youre in for a real treat. Ill be back three weeks from Monday.
Don't just seize the day, Fools. Seize the month and the year,
Al Levit (firstname.lastname@example.org)
Stock Change Bid ---------------- INTC +1 3/16 91.75 MSFT + 1/4 155.06 PFE +1 1/4 87.31 TROW - 1/2 68.13
Day Month Year History C-K +0.21% 1.35% 1.35% 1.35% S&P: +0.58% 3.29% 3.29% 3.29% NASDAQ: +0.06% 4.55% 4.55% 4.55% Rec'd # Security In At Now Change 2/3/98 22 Intel 84.67 91.75 8.36% 2/3/98 22 Pfizer 82.30 87.31 6.09% 2/6/98 28 T. Rowe Pr 67.35 68.13 1.16% 2/3/98 12 Microsoft 156.54 155.06 -0.94% Rec'd # Security In At Value Change 2/13/98 22 Intel 1862.83 2018.50 $155.67 2/3/98 22 Pfizer 1810.58 1920.88 $110.30 2/6/98 28 T. Rowe Pr 1885.70 1907.50 $21.80 2/3/98 12 Microsoft 1878.45 1860.75 -$17.70 CASH $12562.83 TOTAL $20270.46 *The year for the S&P and Nasdaq will be as of 02/03/98