Is Microsoft a Buffett Stock?

As the world's third-richest person and most-celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.

We can't know for sure whether Buffett is about to buy Microsoft (Nasdaq: MSFT  ) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us.

In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:

  1. Consistent earnings power.
  2. Good returns on equity with limited or no debt.
  3. Management in place.
  4. Simple, non-techno-mumbo-jumbo businesses.

Does Microsoft meet Buffett's standards?

1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.

Let's examine Microsoft's earnings and free cash flow history:

Source: S&P Capital IQ.

Microsoft's earnings and free cash flow have steadily grown over the past several years.

2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt-to-equity ratio, because that will skew your calculations and make the company look much more efficient than it is.

Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.

Company

Debt-to-Equity Ratio

Return on Equity

5-Year Average Return on Equity

Microsoft 20% 42% 44%
IBM (NYSE: IBM  ) 155% 73% 61%
Oracle (Nasdaq: ORCL  ) 35% 24% 24%
Red Hat 0% 11% 8%

Source: S&P Capital IQ.

Microsoft earns a truly absurd return on equity considering how little debt it relies on. Even names like IBM and Oracle -- no slouches in this department -- don't produce returns at that level. That's largely because IBM and Oracle are partly in the hardware-manufacturing business, which is naturally a bit more capital-intensive than software programming. While they may not have the same dominance Microsoft has in operating systems, word processing, and some business solutions, they are fairly powerful in their own lucrative fields. In fact, Buffett recently purchased over $10 billion in shares of IBM due to its enormous services moat.

3. Management
CEO Steve Ballmer has been at the job since 2000. He's held various management positions at Microsoft since Bill Gates hired him in 1980.

4. Business
Despite Microsoft's well-known moat in the software industry, some threats do exist, from Apple and Linux in operating systems to Google docs in word processing. (Interestingly, many years ago, Buffett turned down a friend who suggested he invest in Microsoft, probably because he didn't feel like he could predict with enough certainty how resistant to technological disruption the company was.)

The Foolish conclusion
So, is Microsoft now a Buffett stock? Perhaps. The company exhibits several of the quintessential characteristics of a Buffett investment: consistent or growing earnings, high returns on equity with limited debt, and tenured management, though Buffett might be somewhat hesitant to invest in a company whose industry is subject to such constant change. If you're interested in a stock that our top analysts and chief investment officer picked to beat the market, you can check out The Motley Fool's Top Stock for 2012. I invite you to download this special report for a limited time by clicking here – it's free.

Ilan Moscovitz owns shares of Apple and Google. The Motley Fool owns shares of Microsoft, Oracle, Apple, Google, and International Business Machines. Motley Fool newsletter services have recommended buying shares of Microsoft, Apple, and Google; creating a bull call spread position in Apple; and creating a bull call spread position in Microsoft. 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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