The Investable Beauty of Low Expectations

Back in December, when Microsoft (NASDAQ: MSFT  ) became a selection for the real-money Inflation-Protected Income Growth portfolio, its stock looked to be bargain-priced. How cheap was it? Well, to quote its selection article: "By a discounted cash flow analysis that assumes no growth ever again, the company looks to be worth around $234.5 billion, making its recent market price of $229.9 billion look reasonable."

Microsoft's stock had such low expectations priced into it that it still looked reasonably priced if you assumed it never grew again -- ever. That's low expectations, all right. For the most part, about the only time a company's expectations are lower are if it's actively collapsing or if it's facing down some make-or-break scandal with a high chance of sinking the business.

So what?
In yesteday's trading session, Microsoft's stock dropped an astounding 4.44%, on news that personal computer sales were far lower than expected. Predictably, PC maker Hewlett-Packard (NYSE: HPQ  ) saw its shares plummet as well, down an astonishing 6.45%, as its shipments were particularly hard-hit. HP's PC shipments dropped by nearly a quarter versus year-ago levels -- far worse than the industrywide 14% drop.

Yet in spite of that plummet, as of yesterday's market close, the iPIG portfolio is still showing a net gain on the Microsoft shares it owns. On top of that gain, the portfolio has already picked up a reasonable dividend payment from Microsoft, increasing its overall returns.

The secret of the iPIG portfolio's investing success with Microsoft? Low expectations. All stocks are priced based on what the market expects from them in the future. The market had already largely priced in a Microsoft flop. When the company delivered on that flop, investors -- like the iPIG portfolio -- who had bought in only because the company had been valued on those low expectations still came out OK.

Going from atrocious to merely very bad
In many respects, Microsoft's story of investing success in spite of bad news could be repeated for Hewlett-Packard. In fact, it was, late last year, on Dec. 21, 2012:

One of the easiest ways to have a better next year is to royally mess up this year. With that in mind, few screwups in 2012 rate worse than Hewlett-Packard's Autonomy acquisition fiasco. Earlier this year, Hewlett-Packard wrote down a whopping $8.8 billion of the $11 billion price tag it paid for the acquisition just last year.

That $8.8 billion shows up as a charge against its fourth-quarter earnings for fiscal year 2012. Hewlett-Packard alleges that the writedown was driven by improperly recognized revenue prior to the acquisition -- essentially, accounting fraud on Autonomy's part. While many wonder whether the magnitude of the alleged fraud was big enough to justify that large a writedown, the one thing that's clear is that it sets an incredibly low bar for the company to clear in 2013.

On the day that piece was published, HP's shares closed at $14.34. Yesterday, after the release of that disastrous PC shipment data, HP's shares closed at $20.88. That's an astounding 45% gain in just under four months, from a company for which the news simply "improved" from being absolutely atrocious to being merely very bad.

Returns like that are nowhere near typical, of course, but they do showcase why it often pays quite well to invest where the market expects the least.

To follow the iPIG portfolio as buy and sell decisions are made, watch Chuck's article feed by clicking here. To join The Motley Fool's discussion board dedicated to the iPIG portfolio, simply click here. Both the discussion board and the article feed are free.

What's next for Microsoft?
It's been a frustrating path for Microsoft investors, who've watched the company fail to capitalize on the incredible growth in mobile over the past decade. However, with the release of its own tablet, along with the widely anticipated Windows 8 operating system, the company is looking to make a splash in this booming market. In this special premium report on Microsoft, our analyst explains that while the opportunity is huge, the challenges are many. He's also providing regular updates as key events occur, so make sure to claim a copy of this report now by clicking here.


Read/Post Comments (2) | Recommend This Article (4)

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 May 08, 2013, at 11:02 PM, banmate7 wrote:

    I don't get the negative sentiment on Microsoft? That's why it is refreshing to read value investing oriented articles like this one. Value tends to win over the long term, as long as we're talking about a quality company.

    Microsoft is quality. It has a true business moat in the Office franchise, which is going into the cloud. The company has 1st class R&D. Deep pockets. Great margins.

    On 05/08/2006, it would have cost $11,831.95 to buy 500 shares at $23.66 a share.

    With reinvested dividends, on 05/05/2013 you would have 578.187 shares worth $19,363.48 at $33.49 a share. That's a 62% total return.

    Not bad for a boring has been, especially considering the crash of 2008.

  • Report this Comment On August 07, 2013, at 9:14 AM, cledrag wrote:

    Just a reminder, althought John Burr Williams talked about estimating dividends of the stock and discounting that to find the value of the security, that has been debunked. To value the security, value the entire business first. We should first find out and then estimate conservatively the future free cash generated by the whole business, value it, and then see if we are paying a reasonable price relative to value.

    Mr Charlie Munger once mentioned in an annual meeting that Buffett does not use the discounted cash flows approach either. According to Whitney Tilson's website which I highly recommend for your readings on Buffett and Munger:

    "If the future were predictable with any degree of precision, then valuation would be easy. But the future is inherently unpredictable, so valuation is hard -- and it's ambiguous. Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It's neither art nor science -- it's roughly equal amounts of both.The lack of precision around valuation makes a lot of people uncomfortable. To deal with this discomfort, some people wrap themselves in the security blanket of complex discounted cash flow analyses. My view of these things is best summarized by this brief exchange at the 1996 Berkshire Hathaway annual meeting:

    Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one."

    "It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close."

    Marty Whitman, Mr Fan Jiang and Mr Seth Klarman approach valuation from the book value. Mr Bill Nygren approaches valuation from a more P/E approach. Mr Warren Buffett also, from the articles I have read and the feel I get from his letter to shareholders has an earnings approach as well. However, everyone has different methods. What is important is the margin of safety - which to me means, don't pay a price that requires everything to go right before the price paid is justified.

    e.g. If you project a revenue growth rate for the next 5 years of a company that ran into some earnings trouble in the short term at say 25%, which is very aggressive, and the value you calculated is about market price, I'll say there is no margin of safety because the probability of that happening is not very high and if it does not materialize, you didn't make a value buy.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2360620, ~/Articles/ArticleHandler.aspx, 9/18/2014 8:11:04 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement