<THE RULE MAKER PORTFOLIO>
Just Getting Started
By Matt Richey (TMF Verve)
ALEXANDRIA, VA (June 24, 1999) -- International Business Machines, founded in 1924 -- age 75. General Electric, founded in 1892 -- age 107. Microsoft (Nasdaq: MSFT), founded in 1975 -- age 24. Those are the top three most valuable companies, in reverse order. With a market value now approaching $500 billion, Microsoft has created a record amount of shareholder wealth in its short life as a public company.
It was only 13 short years ago, in 1986, that Microsoft finally went public after a long incubating period as a privately held entity. And, it was really only nine years ago, in 1990, that Microsoft entered the mainstream public consciousness with the introduction of Windows 3.0. Looking back, it's as if the company was only beginning to take its first wobbly steps as it entered the 1990s.
In June of 1990, Microsoft closed its fiscal year with a market capitalization of $9.1 billion on net income of $279 million, giving the company a "lofty" P/E multiple of 33x. Few, if any, investors ever would've guessed that Microsoft stock was grossly undervalued. Since then, the shares have steadily increased in value at a rate of 50% per annum versus S&P 500 annual growth of 15.7%. For Microsoft stock to have earned a market rate of return over the past nine years, the shares would've needed a P/E ratio of 357 in 1990. See why traditional valuation rules of thumb are deadly in their error?
"Okay," you say, "that's a great history lesson, but what about the future?" Fair enough. I'd be the first to agree that investing through a rear-view mirror is a route to sub-par returns. But even Warren Buffett uses historical financials as a litmus test for evaluating business and managerial quality. Buffett's simple rule, called the "one dollar rule," says that a company should return at least $1 of market value for every $1 retained by the business.
Here's an easy example. Let's say that over the past five years, Follywood Pictures (Ticker: FLOP) earned $5 per share in net income, out of which $1 per share was paid as a dividend. That leaves $4 per share that was reinvested in the business. Unfortunately, over the past five years, Follywood's stock has been dead wood, starting at $10 in 1994 and closing at a recent price of $12, thereby giving us only $2 in additional market value. So, our calculation is as follows: $2 of market value divided by $4 in retained earnings equals only 50 cents of additional market value for each dollar retained in the business. Clearly, Follywood's management was not Foolish in its reinvestment decisions. By investing retained earnings in one bad movie after the next, management destroyed shareholder value. The company would've been better off having paid out all earnings as a dividend.
Let's see how Microsoft stands up to the test. Since fiscal 1991, which began in July 1990, Microsoft has retained $20.4 billion. (Since Microsoft doesn't have a dividend, this figure is obtained by summing all net income attributable to common shareholders.) Over the same period of time, Microsoft's market value has soared from $9 billion to $466 billion -- a $457 billion increase. By taking the $457 billion increase in market value and dividing it by the $20.4 billion in retained earnings, we find that Microsoft has created $22 in market value for every $1 invested in the business. Thank goodness Microsoft has never issued a dividend!
All of this goes to prove what everyone already knows: Microsoft is a fantastic company, perhaps the best ever. But where to from here? Microsoft already owns the operating system, with greater than 90% market share. The same is true of the desktop applications market, where the Office suite dominates. How could Microsoft's business possibly get any better? Jack Welch, CEO of General Electric (NYSE: GE) offers insight on that question:
"We never have high market share in any business that we're in, because the day you have high market share is the day you're just looking too narrowly at what you're doing, and you have to look at what you're doing very broadly. Because that's the future of any business is taking a broad enough view of what customers want to do, not defining yourself narrowly by the products you have today."
Steve Ballmer, President of Microsoft, mentioned this quote in his keynote address at the June 8 PaineWebber Growth and Technology Conference, so we can be confident that this forward-looking attitude is alive and well at Microsoft. During the same address, Ballmer mentioned a number of reasons investors can look forward to a Microsoft future that's sweeter than the present location.
Microsoft was founded with the vision of a computer on every desk and in every home. Even now, that goal is far from complete. In the U.S., it is estimated that 55% of households and 85% of white-collar workers have a PC, but the percentages are lower for small business, much lower for western Europe, and much much lower for the rest of the world. Although the original vision remains incomplete, Microsoft is already transitioning to a broader vision. Within the company, Microsofties "talk now about giving people and consumers the ability and the power to do what they want, where they want."
Some PC naysayers have lately been talking about a post-PC era, but Ballmer insists this is nonsense. As a general computing device, Ballmer says the PC will continue to thrive, even while other intelligent devices proliferate as well. Whether the "computer" is a PC, a TV set-top box, or a handheld device, Microsoft is positioning itself to empower the individual. Going forward, the terms "product" and "service" will converge in the description of Microsoft's offerings.
To prepare for a world where software is a service, Microsoft is taking advantage of its $21 billion kitty to forge alliances with multiple partners in the telecommunications industry. In early May, the company purchased $5 billion of AT&T (NYSE: T) convertible securities as part of an agreement in which AT&T will increase its use of Microsoft's Windows-CE TV software platform. Also in May, Microsoft announced a $600 million investment in Nextel (Nasdaq: NXTL) common stock at a fixed price of $36/share, whereby the two companies will co-market the Nextel Online offering which includes e-mail, calendar functionality, address book contacts, and access to Web-based content, all via Microsoft's MSN portal site. For both of these deals, Microsoft is investing capital in order to show its commitment to a strong partnership.
Since the beginning of this year, Microsoft has made 21 such investments and acquisitions, thereby demonstrating the opportunity that comes from a strong cash position. On many occasions, David Gardner has said that money is opportunity -- opportunity to go on a trip around the world, to change careers, or to retire altogether. The same is true of a company with a large hoard of cash. As Microsoft deploys its cash for strategic investments, I think the company will play a huge and highly profitable role in providing the software that enables all of the connected intelligent devices of the future. Microsoft is already the world's most valuable company, but I think it's just getting started.
In case you missed it, the MakerPort announced on Tuesday that we'll be adding $500 each month beginning in July. Each month, your managers will debate this "$500 question." Yesterday, Phil argued for more Cisco shares. As you can see, I'm pitching my vote for Microsoft. Tomorrow night, we'll hear about Rob's pick. In the meantime, tell us what you think on the Companies board.
Have a good evening.
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Day Month Year History R-MAKER -0.89% 1.98% 6.78% 35.11% S&P: -1.30% 1.07% 7.62% 33.14% NASDAQ: -1.70% 3.38% 16.48% 54.52% Rule Maker Stocks Rec'd # Security In At Now Change 2/3/98 48 Microsoft 39.13 84.63 116.24% 6/23/98 68 Cisco Syst 29.21 60.25 106.30% 5/1/98 82.5 Gap Inc. 22.91 46.50 102.94% 2/13/98 44 Intel 42.34 55.06 30.06% 2/3/98 22 Pfizer 82.30 101.50 23.33% 2/17/99 16 Yahoo Inc. 126.31 151.00 19.55% 5/26/98 18 AmExpress 104.07 120.00 15.31% 2/6/98 56 T. Rowe Pr 33.67 35.88 6.54% 8/21/98 44 Schering-P 47.99 48.50 1.06% 2/27/98 27 Coca-Cola 69.11 62.69 -9.29% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 64.34 76.50 18.91% 3/12/98 20 Eastman Ko 63.15 69.75 10.46% 3/12/98 15 Chevron 83.34 91.63 9.94% 3/12/98 17 General Mo 72.41 63.25 -12.64% Rule Maker Stocks Rec'd # Security In At Value Change 2/3/98 48 Microsoft 1878.45 4062.00 $2183.55 6/23/98 68 Cisco Syst 1985.95 4097.00 $2111.05 5/1/98 82.5 Gap Inc. 1890.33 3836.25 $1945.92 2/13/98 44 Intel 1862.83 2422.75 $559.92 2/3/98 22 Pfizer 1810.58 2233.00 $422.42 2/17/99 16 Yahoo Inc. 2020.95 2416.00 $395.05 5/26/98 18 AmExpress 1873.20 2160.00 $286.80 2/6/98 56 T. Rowe Pr 1885.70 2009.00 $123.30 8/21/98 44 Schering-P 2111.7 2134.00 $22.30 2/27/98 27 Coca-Cola 1865.89 1692.56 -$173.33 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 1286.70 1530.00 $243.30 3/12/98 20 Eastman Ko 1262.95 1395.00 $132.05 3/12/98 15 Chevron 1250.14 1374.38 $124.24 3/12/98 17 General Mo 1230.89 1075.25 -$155.64 CASH $70.09 TOTAL $32507.28
Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.