I'm Not Buying Microsoft or Apple

This article is part of our Rising Star Portfolios series.

Odds are good that if you're a fan of Microsoft or Apple, I've probably managed to annoy you. But if you give me a chance, I'll tell you why I'm not buying Microsoft (Nasdaq: MSFT  ) or Apple (Nasdaq: AAPL  ) for my Messed-Up Expectations (MUE) portfolio at this time.

Mr. Softy is too soft
Depending on whom you talk to, Microsoft is either washed up since everyone will move to the cloud to handle their computing, or the still-dominant player is getting some of its mojo back. I've even outlined some of the positive things going for the tech giant right now.

But today, things are priced a bit too rosily for Microsoft. At Friday's close of $27.34 per share, the market is expecting 6.5% annual growth in free cash flow for five years, 3.2% growth for the next five years, and 2.5% terminal growth (at a 15% discount rate). (For the rest of this article, I'll abbreviate that as "6.5%/3.2%/2.5%.") Over the past five years, FCF has grown by 8.4% annually, on average. There's not a lot of pessimism priced in compared to what Microsoft has done.

I know I've said before that Microsoft can be an intriguing investment, possibly doing a repeat of what Coca-Cola did starting in the mid-1980s. But on further reflection, the MUE portfolio is looking for situations where the market is really expecting next to nothing from a company, not just uninspired performance.

Cupertino is too hard
A similar story is found when I look at Apple. Today, it is the darling of the tech world, apparently incapable of doing anything wrong. It's very innovative and has had smash hits with the iPod, iPhone, and iPad. What's next from the brain of Steve Jobs and his team? No idea, but I have no doubt it will either be a wonderful success or a spectacular flop.

The trouble is, as far as deciding what's going into my portfolio is concerned, that's pretty well priced in right now. Using the same model, at Friday's price of $320.56, the market is expecting an 18.3%/9.2%/2.5% growth pattern (at a 15% discount rate). Yes, over the past five years the company has grown FCF at nearly 49% annually, but over the past five years, FCF growth actually increased only twice compared to the previous year's growth rate. In other words, that 49% rate might not be sustainable.

To reiterate, I'd much rather invest in a company where the market is expecting nothing, like when Apple was at $90 per share in early 2009.

These might be just right
Looking elsewhere, I'm digging further into these two:

Company

Recent Price

Expectation Growth Pattern*

Dr Pepper Snapple Group (NYSE: DPS  ) $37.42 (4.2%)/(2.1%)/0%
Verizon (NYSE: VZ  ) $34.04 (3.7%)/(1.8%)/0%

*FCF annual average growth rates over one to five years/six to 10 years/terminal rate, at 15% discount rate.

Dr Pepper Snapple is the third largest soft-drink maker, behind PespsiCo and Coke. Today, the market is actually expecting less than nothing -- falling FCF growth. Is that because of slowing sales? Or is it too much debt? I don't know yet, but over the past four years, it has actually grown FCF by 22% per year on average.

Verizon, the telecom giant, is another possibility. Here, too, the market is expecting falling FCF growth. In a group of comparable companies, it seems to be the most expensive when looking at price-to-earnings ratios, but it is supposed to be getting the iPhone next year and it does have a nice dividend yield (too nice?). There's some disconnect here because over the past five years, it's grown FCF at 23% per year on average. More digging will be required.

It's a matter of process
If you're a fan of Apple or Microsoft, you're probably saying I'm blind for not investing in great opportunities. And I expect to hear that a lot if Microsoft doubles from here or Apple continues its meteoric rise. But using the result to judge the decision, rather than judging the decision by the process, is the wrong way to go about it. Saying, "Your decision is wrong because Apple and Microsoft rose" is just like saying not hitting a hard 17 in blackjack is wrong because the next card turns out to be a four instead of a five or higher, which is much more likely.

To judge the value of the MUE process, we have to look at how each decision is made at the time and only use the outcome to modify the process that leads to those decisions. If the process is sound, happy results will occur more often than not from a right decision -- don't hit with a hard 17. If the process is flawed, then the opposite will happen and we should modify it.

So far, sticking to my process -- invest only in companies where the expectations are very dim -- has been quite successful, with all five purchases in the green. I've only been going for six weeks, so as we continue, we'll see by the results if this process is really sound or not.

Come check out the MUE portfolio holdings and then drop by the discussion board to read more about these decisions.

Microsoft is a Motley Fool Inside Value recommendation. Apple is a Stock Advisor selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Apple and 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.

Fool analyst Jim Mueller is a beneficial owner of Microsoft shares, but has no position in any other company mentioned. He works for the Stock Advisor newsletter service. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 13, 2010, at 3:26 PM, techy46 wrote:

    Buy INTEL - NFS nPad launched - This tablet will be launched after considering the drawback of the 1.6 pound Apple iPad that is a bit too heavy to hold in one hand and this Intel showed off a new tablet based on the upcoming Intel Atom Z6xx series Moorestown chipset with GMA 600 graphics last week, and Chippy from UMPC Portal reports that it weighs just 0.9 pounds or just over half as much as the iPad.

    Goldman doesn’t know squat about technology - where were they 6 months ago?

    .

  • Report this Comment On December 13, 2010, at 4:51 PM, iamtellingu wrote:

    "I rather invest Apple when it's $90..." Yes, who wouldn't? But, dream on.....It's going to $400 and I guarantee you that!

  • Report this Comment On December 13, 2010, at 4:55 PM, SpeechRec wrote:

    Nice article and methodical approach to stock-picking . I enjoy comparisons between investing & gambling because there is a chance involved in both but a professional can achieve positive expectation against the house.

  • Report this Comment On December 13, 2010, at 4:56 PM, SpeechRec wrote:

    By the way, I am happily long both msft and aapl...

  • Report this Comment On December 13, 2010, at 5:25 PM, misskimberly1 wrote:

    in agreement with iamtellingyou. I was lucky enough to buy apple when it was $90 but i ended up selling it soon after. Now i too agree it will have no problem topping $400. I've bought into this stock now and ready for a great ending year.

    Kimberly

    http://canadianprofiteer.com/

  • Report this Comment On December 13, 2010, at 11:09 PM, calies wrote:

    Likes VZ because of the iphone. Hmmm just another way of saying admit it your impressed with aapl and are afraid its too late. well it is NOT too late.

  • Report this Comment On December 15, 2010, at 1:44 PM, JustEconist wrote:

    " Microsoft as we know it might not exist in two years."

    Paul McDougall , InformationWeek

    Please read:

    http://www.informationweek.com/news/global-cio/trends/showAr...

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