2 Huge Lessons From Microsoft and IBM That Every Investor Should Know

In a way, Microsoft (Nasdaq: MSFT  ) and IBM (NYSE: IBM  ) couldn't be more different. Microsoft has lost a third of its value over the past decade; IBM has gained 50%. IBM recently surpassed Microsoft in market capitalization for the first time since 1996.

In other ways, they're a lot alike. Microsoft has grown earnings per share by 10.9% annually for the past decade. IBM's growth over the same period? 10.2%. Analyst estimates for Microsoft's five-year projected growth rate is 10.3% -- IBM's, 11.2%.                   

These are different companies with different products in different industries, yet both past and projected growth are about equal. Shareholder returns, however, couldn't be more night and day.

Why?

I think you can break this conundrum down into two parts. Both are huge lessons every investor should be aware of.

1) The most important lesson in investing 
The most important lesson in investing is simple: Starting price determines future returns.

A parade of analysts and investors chide Microsoft for its abysmal shareholder returns over the past decade. In reality, Microsoft the company has done terrific. How many large companies grew earnings at 10% annually during one the worst economic decades on record? (11, if you're wondering). Nearly all of the misery Microsoft investors experienced over the past 10 years can be explained by starting valuation. Shares traded at 60 times earnings at the start of the last decade. Shareholders' fate was already sealed at that point. There was no realistic outcome that could have left them with anything other than tears today.

IBM was a different story. While it, too, was caught up in the dot-com bubble, it never got outrageously out of whack. Ten years ago, IBM shares traded at roughly 25 times earnings. That created a high hurdle but not an insurmountable one. The compression in IBM's earnings multiple over the past 10 years hasn't been drastic, letting shareholders enjoy at least some of the company's earnings growth. Microsoft's earnings multiple compression has been astronomical, causing shares to crumble even while the company grew briskly. The same story of flatlining returns amid strong earnings growth has happened to Wal-Mart (NYSE: WMT  ) , Google (Nasdaq: GOOG  ) , and Johnson & Johnson (NYSE: JNJ  ) . Each case can be explained simply: Starting valuation determines future returns.

2) It's now just how much cash you earn. It's what you do with that cash. 
"IBM has an absolutely unequal record in capital allocation" said value investor Bill Miller last year. Microsoft's record is decent, but it's easily below IBM's.

One more statistic to toss in front of you: Cash as a percentage of IBM's market cap is about 6%. Microsoft's is a staggering 25%.                               

Both Microsoft and IBM churn out tons of cash. Both give lots back to shareholders with dividends and buybacks. But IBM takes the cake by keeping its balance sheet well-padded yet fairly lean. On the contrary, with some $50 billion lying around, Microsoft can nearly be described as a bank account with a software division attached to it.

You don't have to look far to see why investors punish a company for hoarding so much cash. Take Microsoft's recent $8.5 billion purchase of Skype, a deal done at a valuation universally panned as outrageous, irrational, and a sign of desperation. Deals like this combined with Microsoft's enormous and ever-growing pile of cash give investors an excuse to discount both the current cash hoard and future earnings. It creates uncertainty. What will the company do? More acquisitions? Raise the dividend? Repurchase shares? Many potential investors' reaction is let's wait and see, lest the company do something stupid -- like overpay for Skype. This is something IBM investors needn't spend much time worrying over. The company doesn't keep enough readily available tinder on its balance sheet to be quickly lured into something senseless. Unless a company has an impeccable record capital allocation -- such as Berkshire Hathaway (NYSE: BRK-B  ) -- investors discount large cash balances below par, keeping shareholder returns below what they could be. I've suggested Microsoft could end this problem by dramatically raising its dividend.

How much a company earns is just half the battle. What it does with that money is what seals shareholder returns.

Fool contributor Morgan Housel owns shares of Microsoft and Berkshire Hathaway. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Johnson & Johnson, Google, International Business Machines, Wal-Mart Stores, Berkshire Hathaway, and Microsoft. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway, Microsoft, Google, Wal-Mart Stores, and Johnson & Johnson. Motley Fool newsletter services have recommended creating a diagonal call position in Microsoft, Wal-Mart Stores, and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On May 28, 2011, at 12:23 AM, jimmy4040 wrote:

    "Shares traded at 60 times earnings at the start of the last decade. Shareholders' fate was already sealed at that point. There was no realistic outcome that could have left them with anything other than tears today"

    A completely nonsensical statement that flies in the face of the MANY, MANY companies that have have had multiples higher than that over the last decade and made a lot of money for their shareholders.

    I don't suppose you've ever heard of Netflix for instance?

  • Report this Comment On May 28, 2011, at 12:46 AM, GregLoire wrote:

    @ jimmy4040 -- Netflix is growing much faster than Microsoft was when it had a P/E of 60. The point of the article is that a company needs phenomenal growth to justify a P/E of 60, but Microsoft's was merely strong and stable.

    When the article says "There was no realistic outcome that could have left them with anything other than tears today," it is referring to Microsoft specifically with regard to its growth rate -- the article is not making a blanket statement about every public company, some of which are indeed growing much faster than Microsoft.

  • Report this Comment On May 28, 2011, at 10:39 AM, TMFHousel wrote:

    Thanks Greg! "realistic" was they key word there.

    -Morgan

  • Report this Comment On May 28, 2011, at 1:17 PM, thomascarver wrote:

    If Microsoft is such a terrible company why is MDP recommending that we buy it?

  • Report this Comment On May 28, 2011, at 2:38 PM, TimothyVR wrote:

    Interesting and helpful analysis.

    Where is the information for the p/e ratios for companies in the past? I have seen many articles on companies that had very high p/e ratios at the peak of the last secular bull, and that does help explain why prices have remained stagnant since - at least is some cases like Microsoft, as you point out.

    But i don't know where to look for them.

  • Report this Comment On May 28, 2011, at 6:26 PM, TMFHousel wrote:

    thomascarver,

    I def. don't think it's a terrible company. It just started w/ a terrible valuation 10 years ago, and capital allocation could be more efficient.

  • Report this Comment On May 29, 2011, at 9:21 AM, jimmy4040 wrote:

    Greg:

    "The point of the article is that a company needs phenomenal growth to justify a P/E of 60, but Microsoft's was merely strong and stable."

    If Ballmer and Gates accepted what you wrote, the dividend would be twice what it is, and the share price would be 50% higher. Don't tell me, tell them!

  • Report this Comment On May 29, 2011, at 10:25 AM, David369 wrote:

    Neither one have exactly been great investments. 10 yr ago IBM was 112 and today is 167 while MSFT was 35 and today is 24. Then it gets confusing because of the dividends, IBM yields 1.79 while MSFT 2.58. Of course dividends changed for both (or didn't exist for MSFT for a while) but even so I'm glad I didn't invest in either of them as I think I would be disappointed with one and disgusted with the other. I expect a better return for 10 years.

  • Report this Comment On May 29, 2011, at 3:42 PM, jimmy4040 wrote:

    "Despite some very real concerns for Microsoft -- in particular, that consumers will shift their spending dollars to mobile devices, where the company doesn't derive much revenue -- it's a pretty good bet that most large companies will still be Windows-based in 10 years. For that reason, Microsoft is still a pretty safe -- albeit unsexy -- investment"

    Eric Bleeker 6/4/2010 $25.79 then $24.76 today.

    "Microsoft is making a lot of moves that investors should love. And the market just doesn't seem to care right now. That spells opportunity. And as soon as The Motley Fool's 10-day no-trade rule expires on my mention of Microsoft, I expect to lard up my portfolio with some Microsoft shares. How about you?

    Jim Royal 9/23/10 $24.43 then $24.76 today

    "Microsoft (Nasdaq: MSFT ) is just getting too cheap to ignore. The company has grown revenue by 9% and earnings by 13% for each of the past five years and has generated enough free cash flow to make Bill Gates blush. And even though Microsoft is “cool to hate,” it is incredibly shareholder-friendly, having returned $100 billion to shareholders over the past five years via dividends and share repurchases"

    Bryan Hinmon 8/5/10 $25.37 then $24.76 today

    "The bigger question may be what Microsoft can do for an encore as cloud computing and open-source alternatives nibble at the giant. With $39.7 billion in cash and investments in the bank, Microsoft has the time and the means to figure it out."

    Rick Munnariz 4/23/10 $30.96 then $24.76 today

    "If the following on Motley Fool is any indications this must be a core holding in every average investors’ portfolio. The CAPS members vote 12,341 to 1,903 that the stock will beat the market and the All Stars agree 2,927 to 189. Fool notes that the recent articles about the company have been positive 49 to 1."

    Jim Van Meerten 10/19/2010 $25.10 $24.76 today.

    "Cisco (Nasdaq: CSCO ) fell 12% after hours yesterday, despite reporting earnings that beat expectations. Now, I don't follow the company at all -- couldn't even tell you what it really does -- but this caught my attention. How can a company beat expectations and still be an epic disappointment?

    Most who follow the company blamed a dire outlook. I'd like to believe them. But I found this line, quoted from an analyst we'll leave unnamed, both candid and amusing: "The Street was expecting a bigger beat"

    Morgan Housel 11/11/10 CSCO then $20.52 $16.46 today

    "It takes patience, sometimes years of it, but markets eventually realize the potential of mispriced companies. Microsoft will get there soon enough"

    Morgan Housel 3/16/2011 $24.79 then $24.76 today

    "If Microsoft never again grows earnings from now until the end of time, shares would still be a bargain. If it lit $10 billion of cash on fire just to watch it glow, shares would still be a bargain. If Google Docs takes off like wildfire and Office sales fall 50%, Microsoft's total net income would fall by roughly 25%, in which case shares would still roughly match the valuation of the broader market. Create your own adventure: You can torture a range of possibilities and still struggle to come up with a scenario where Microsoft's shares aren't reasonably cheap. That's when investing gets fun"

    Morgan Housel 7/16/10 $24.44 then $24.76 today.

    I could go back farther in time beyond the start of 2010, but the quotes would be MUCH more embarassing. You're right. The problem is all about what happened 10 years ago.

  • Report this Comment On May 29, 2011, at 9:21 PM, HectorLemans wrote:

    @ TimothyVR

    Have you used Google Docs? You can use the "GoogleFinance" equation in a spreadsheet to automatically grab historical stock prices. If you know the earnings per share during that date (which you can look up on Google or Yahoo Finance) you can calculate the historical PE ratio.

    Here's a sample spreadsheet with Microsoft illustrating what I'm talking about:

    https://spreadsheets.google.com/spreadsheet/ccc?key=0AptdKyI...

  • Report this Comment On May 30, 2011, at 8:25 AM, David369 wrote:

    @Jimmy4040

    Good posts. Yeah, Netflix is kind of unusual but there are a bunch of "plain" investments that are not supposedly cutting edge/leading techs that I would have rather had my money in. Even plain old CAT did better not to mention QCOM, ISRG, COST, AMZN and many others. Even AAPL went from 10 to over 300 in the last 10 yr. I know two places I'm not going to invest my money.

    Maybe that's the 2 lessons. Don't invest in IBM or MSFT.

  • Report this Comment On May 30, 2011, at 10:25 AM, jimmy4040 wrote:

    David:

    I really don't get it. Warren Buffet is the CEO of Berkshire, and his name turns up in about every third story on MF, involving companies he's never been associated with his entire career.

    Yet Ballmer is the CEO of MSFT and his name is rarely even MENTIONED in any story about the company, like this one. It's as if this was a Harry Potter story and Ballmer was "he who must not be named"!

  • Report this Comment On May 30, 2011, at 4:14 PM, TMFHousel wrote:

    I'm not sure how/why any of the above quotes should be embarrassing, or how they disprove anything written in this article. Impressive determination to dig through archives, though.

  • Report this Comment On May 30, 2011, at 7:14 PM, David369 wrote:

    Jimmy:

    You're right. Never noticed until you pointed it out. Well, it's not like Ballmer has really done anything good is it? He's using yesterday's technology today while Jobs is innovating and directing the future of technology so all others play catch up with Apple. Buffet is a good/smart stock picker and you just have to give him credit for some brains and I can see where the MF staff would like to be as skilled.

  • Report this Comment On May 30, 2011, at 10:39 PM, TimothyVR wrote:

    @ HectorLemans

    That's new to me. Thanks for the information.

  • Report this Comment On May 31, 2011, at 12:53 AM, jimmy4040 wrote:

    Housel:

    I know you don't, that's the problem. For instance while you were touting MSFT in July of last year, you missed a huge bull market, in well, you name it, almost anything else!

    I know. It's all about the valuation ten years ago that keeps the shares from moving up with nearly every other stock!

  • Report this Comment On May 31, 2011, at 10:07 AM, TMFHousel wrote:

    Jimmy,

    I don't think anyone at TMF is trying to time the market. Nor did many of us miss the bull market -- it's not like MSFT is the only company we own. We'd prefer to look at total returns over 3-5 year periods, and the returns of TMF's newsletters (even the ones that have recommended msft for years) speak for themselves.

    Also, one of the quotes you mention was: "It takes patience, sometimes years of it, but markets eventually realize the potential of mispriced companies. Microsoft will get there soon enough." I think that underlines the entire argument.

  • Report this Comment On May 31, 2011, at 10:16 AM, jimmy4040 wrote:

    The company is a a qualty company. You have to be able to separate that fact from the idea that the stock is a complete dog.

    Anybody who has owned MSFT over the last 5 years or so would have been much better to spend a few hundred or even a thousands to buy a call spread, and to invest the money into almost any other quality stock. You would have been protected against the possibility of a Ballmer resignation as a catalyst, and yet have made far more money, even after losing out on the calls.

    Nothing you write about the company, as opposed to the stock, can disguise the fact that anyone who holds the stock has LOST money versus even the most simple index like the S&P 500. The numbers are real, and you can't change them.

  • Report this Comment On May 31, 2011, at 10:28 AM, TMFHousel wrote:

    You can create a list of hypothetical "you could have bought ..." arguments all day. With that hindsight, I can just as easily ask why didn't you buy the winning lotto tickets last week, and insinuate that you're clearly unskilled for not doing so.

    Buying what you consider to be cheap stocks and holding them until they aren't cheap is, I think, indisputably the greatest investment style. After Buffett bought Washington Post, it fell 20% and stayed there for 3 years. He went on to make over 100 times his money. Again, it's not about timing; it's about patience.

  • Report this Comment On May 31, 2011, at 10:47 AM, jimmy4040 wrote:

    NIce non-sequitur bringing Buffet again into an argument about a stock he has never owned, as if somehow he would approve.

    For me, the worst part is when Ballmer finally gets kicked down the road, the stock WILL appreciate significantly, and then you will say it proves you were right, when really it proves how wrong you were.

  • Report this Comment On May 31, 2011, at 10:56 AM, TMFHousel wrote:

    The Buffett/WaPo example isn't a non-sequitur. It's a good example of why I'm not "embarrassed," as you say, to own a stock that hasn't gone anywhere in a year if I can make a sensible argument that it's cheap.

  • Report this Comment On May 31, 2011, at 2:59 PM, jimmy4040 wrote:

    Please don't misunderstand me. MSFT is cheap in relative terms, but that doesn't mean it will get better on price. I have a price target of 23.75 at which point I will either buy the stock or the calls, whichever looks better, for a trade. I would have been there by now, but Einhorn temporarily drove the price back up by telling the truth. It's an ok stock for a trade, because it has a clearly established dependable trading range.

    However to buy and simply hold for the last 5-10 years while making about 2-3% on your money has been a silly invesment.

  • Report this Comment On June 01, 2011, at 11:51 AM, uaku wrote:

    When they get rid of Steve Bummer as CEO and When they bring back stable OS like windows XP. When they stop imitating Linux and come up with original products -

    Thats the time when I will buy MSFT, until then I don't care whether its going up or down

  • Report this Comment On June 01, 2011, at 12:00 PM, mtf00l wrote:

    Good work jimmy4040.

    Speaking of Buffet, I bought BRK.B after the split a year ago mainly for the "perks". The stock has been a dog since however; I hope the company is still solid.

  • Report this Comment On June 02, 2011, at 8:25 PM, HarryCarysGhost wrote:

    Here's my two cents-

    I owned MSFT for over a year. Bought before the crash wanted something safe, a widows stock if you will. Why did I sell at a loss? Opportunity.

    Microsoft remained fairly stable thoughout that whole debacle, but there came a time where there were better places to put my money.

    So I could say that LTBH of solid companies is the way to go until I'm blue in the face, but sometimes it's best to get what Mr. Market is willing to give you.

    Unfortunetly I do not posess a money tree so that involves selling certain equties to buy others. My guess is that MSFT will remain solid but flat for quite some time. It's in practically every mutual fund so the stock price is going to be range bound.

    Cheers.

  • Report this Comment On June 02, 2011, at 9:28 PM, TheDumbMoney wrote:

    1) Harry, David Einhorn has owned MSFT stock for five years. Talk to him about opportunity. Check out Einhorn's excellent speech on MSFT at the Ira Sohn conference, a link is here: http://www.insidermonkey.com/blog/2011/06/02/transcript-of-d... Best of luck to you though!

    2) jimmy4040, do you do anything else on this website except berate anyone who says anything positive about Microsoft? Just about all of us don't like Ballmer, that's beside the point.

    3) Final thought to all: in the past five years alone, Microsoft has repurchased somewhere between 50 and 60 billion, with a 'b', net of relatively minor issuances, of its stock, with an additional 17 billion net in year-end 06/2006, and 20 billion or so more planned for the upcoming year or two. People moan about Microsoft's capital allocation. And indeed I don't yet get the 8 billion Skype purchase, and I do not know if it can ever catch up in search to justify the billions spent there. But that blown money is peanuts compared to the totals during this period of share repurchases. (And it still has like 40 billion sitting around, though admittedly it hasn't yet paid taxes on a lot of that.) If indeed MSFT is as undervalued as people like Einhorn, and much less famously Housel, and even vastly less famously me, think, then not only will we make money in the long-term, but this near 100 billion (with a b) stock repurchase program will literally, and I'm not even joking, turn out to be one of the great corporate capital allocation decisions of all time. Only time will tell. Within about two more years from now, we'll have a pretty clear idea of whether Microsoft has failed as miserably in mobile as it seems now, and more importantly whether the dip in Windows revenue represents the begining of the end (as many believe) or whether (as I believe, since Windows revenue does not break out netbook revenue from true PC revenue) it merely represents the verifiable 1st degree capital murder, by the ipad, of the netbook category, a pointless category of PC that is only a few years old, and as to which I distinctly remember telling my besotted wife in 2009 that she was an idiot if she bought one (she didn't) because they were pointless semi-PCs, and pads were on their way and who do anything that one wanted to do with a netbook.

    In the meantime, do you know what I love, love, love? -- a company that everybody is constantly coming up with reasons why it is toast, and discounting all good news about it, as it meanwhile continues to put up S&P-beating EPS growth as a 200billion plus market cap company, as it has done over the previous 5-year period.

    I for one will gladly hold it for another couple of years at least, take my dividend increase, which will probably match or exceed the last delightful 23% dividend increase, and see what happens. And in the meantime, in a time of absurd uncertainty, the downside on this one is limited, which is worth more than most poeple think.

    Ok, Final Final Thought: Why do people go so upset about possible capital misallocation when a company has lots of cash on hand? I think that this is being over-discounted, too, in all of the "value" tech stocks, like Microsoft. Believe you me, when a company wants to make a stupid, stupid capital allocation decision, it is quite capable of: 1) overpaying by using its own stock to pay shareholders of the acquired company, if its stock is undervalued; or 2) utilizing debt, often irresponsibly.

    I am pretty sure I could give multiple examples to show that is true. People should chill about the cash, particularly at Microsoft, where it basically can barely figure out to do with all the boodle it is earning, which is why it is hiking divvies at an above-average rate while buying millions of shares of its own stock.

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