In the ever-present battle to beat the market, I believe a Fool's most potent weapon is a long-term (i.e., 5-10 years) investment horizon. Taking a long-term perspective sets us far apart from Wall Street, which tends to be tightly focused on operating results over the next 6-18 months. Many of the best investment opportunities can be found in companies that have long-term opportunity, but are currently out of favor due to short-term difficulties.
One company that Wall Street is sorely down on is the once-mighty Microsoft (Nasdaq: MSFT). In truth, the next year or two will probably continue to be unspectacular for the software king. The PC replacement cycle is slowing, the economy as a whole is slowing, and Microsoft has yet to set forth a strong business strategy for growth beyond its Windows franchise. Nevertheless, the current price is low enough so that there's little risk in obtaining long-term market-beating returns.
Last week, two prominent analysts lowered their estimates for Microsoft's earnings over the coming year. One of these analysts, Rick Sherlund of Goldman Sachs, appeared on CNBC Friday morning. I listened with somewhat cynical interest as Mr. Sherlund said (to paraphrase) he wouldn't be able to really get excited about the stock until Microsoft articulates a concrete strategy to profit from the Internet, whether it be through software for post-PC Internet appliances or viable new Internet-based services (i.e., services more clearly defined than the existing .Net vaporware).
This is classic Street-think. Wall Street will continue to be down on the company until Microsoft's new revenue streams beyond Windows become clearly visible. In essence, Wall Street pays a high premium for certainty.
I find Microsoft much more interesting amidst an atmosphere of uncertainty -- because of the lower price that accompanies that uncertainty. I'm willing to assume that Microsoft will eventually craft an attractive business plan for capitalizing on the Internet (and maybe even Linux, too). Unlike the analysts, I don't need to know when exactly these revenue streams will emerge, as long as they do emerge, and meaningfully so, in the next 3-5 years.
At $54.44 per share, Microsoft trades at only 23 times trailing free cash flow. (Regular readers know how we in the Rule Maker Port view free cash flow as substantially more meaningful than accounting earnings. To learn more about what free cash flow is and how to calculate it, I highly recommend this article.) By way of comparison, the S&P 500 as a whole trades at 28 times free cash flow, according to S&P/Barra. Additionally, Microsoft's free cash flow growth in the coming year and beyond is likely to at least match that of the S&P. I suspect Microsoft can grow its cash flow by ~10% in the coming year, which would trump the 7% S&P earnings growth that Goldman Sachs is forecasting.
To take this comparison one step further, Microsoft's business model is unquestionably superior to that of the average S&P 500 company. Software is the most lucrative business to ever grace the commercial world. Software development has high up-front costs, but once revenues surpass fixed development costs, future revenues are pure profit. That's why, over the past year, Microsoft has earned 56 cents of pure cash profit on each dollar of sales. If that's not the highest level of cash profitability in the world, it's awfully close. Software is simply a fantastic business (see Zeke Ashton's Rule Maker article on The Software Advantage).
Even with all those profits, Microsoft has managed to invest just shy of $10 billion into research and development over the past three years. With that level of investment in future growth, I think Microsoft's high-caliber management can be expected to find some substantial opportunities to create value with new software. Heck, we live in an increasingly digital world -- my bet is on an increasing need for software.
If you believe Microsoft will eventually come up with a business plan to maintain and grow its competitive position, then the stock looks awfully attractive. I like the odds, with management as strong as Microsoft's. Let's not forget about the enduring attributes of Microsoft's management.
The market's propensity to pay a premium for short-term operating predictability allows us to frequently buy long-term fundamental business merits -- such as sustainable strong management, competitive advantages, big-picture expanding possibilities, and superior economic models -- at a discount to their real value.
- Matt Richey, TMF Verve on the Discussion Boards
