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I'm Not Buying Microsoft or Apple

http://www.fool.com/investing/value/2010/12/13/im-not-buying-microsoft-or-apple.aspx

Jim Mueller
December 13, 2010

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