While diversification is a good way to limit risk in your portfolio, there's also the risk of being overly diversified, or diluting one's returns by allocating too much to your 50th-best idea and not enough to your best. Even Warren Buffett has advocated that active investors who own individual stocks might benefit from a "punch card" philosophy, in which an investor only has 20 investments to make in a lifetime, and no more.
While that may be a bit extreme, it can be helpful to ask, "If I only had to own one stock for the next 10 years, what would it be?" Consider the qualities you would look for: defensive, recession-resistant businesses; wide economic moats, a long growth runway, and excellent management, just to name a few.
If only one or a handful of names come to mind, Foolish investors might wish to concentrate more of their portfolios in those stocks, and less in more-speculative stocks or alternative assets.
And if I had to pick just one stock to recommend, especially for risk-off beginners, one company sticks out above the rest.
Redmond, Washington's finest: less risky than the U.S. government?
Among high-quality growth stocks, Microsoft (NASDAQ:MSFT) has some of the most superior defensive and offensive characteristics I've ever encountered in any stock -- and all in one company. That makes it an excellent investment today, tomorrow, and for the next decade.
In terms of Microsoft's defensive characteristics, consider this: It's one of two companies with a higher credit rating than the U.S. government! That's right, Microsoft is one of two companies with a AAA rating from S&P Global (Johnson & Johnson being the other). Meanwhile, the U.S. government was downgraded to AA+ by S&P in 2011 following the debt ceiling standoff.
Microsoft's sterling financial position is bolstered by two main characteristics: a fortress balance sheet along with several highly profitable, wide-moat, competitively advantaged businesses.
Microsoft is currently sitting on a huge $125 billion in cash, against just $58 billion in debt, and it's generating very strong cash flow every quarter. Last quarter, it added another $17 billion in free cash flow, some of which it reinvested in acquisitions, some in share repurchases, and some in paying its growing dividend.
That financial cushion gives the company ballast in case of economic downturns. In fact, if a downturn does happen, that cash can be deployed to scoop up other companies on the cheap, or to buy back more of its own stock, just as it was able to repurchase shares during the COVID-19 downturn.
Microsoft's myriad moats
Perhaps more important than the balance sheet, virtually all of Microsoft's various business lines have high competitive advantages versus competitors and are "sticky" for customers, helping to fend off competition and grow profits.
Microsoft's older products, such as the original Windows operating system and its Office software suite, are deeply embedded in the technology industry and business in general. These products therefore benefit from powerful network effects, perhaps the most powerful competitive advantage around. This happens when a product or service gets an early lead and becomes more valuable as it grows.
In other words, everyone gets trained on PowerPoint and Excel because this software is now the agreed-upon standard across the business world. Software vendors develop for the Windows operating system because it is an industry standard. There have even been open-source free alternatives to Office over the years, yet Microsoft's Office Suite continues to grow by double-digit rates.
Even its newer segments enjoy network effects as well, including LinkedIn, the leading social network for business, and its Xbox gaming platform. Like all social networks, LinkedIn benefits from them (after all, they are called network effects), and Xbox benefits as one of only three major video game platforms. Video game software developers must standardize on one or more major platforms, so there isn't room for tons of different gaming platforms.
The story gets even better with Microsoft's high-growth enterprise software and cloud infrastructure platforms, which benefit, respectively, from high switching costs and economies of scale.
Dynamics is Microsoft's hybrid enterprise resource planning (ERP) and customer relationship management (CRM) software suite. When an organization begins using a piece of software, it's a big deal to move employees off a system and onto another one, then reacquaint an entire workforce on a new system. So all subscription-based enterprise software companies benefit from high switching costs, especially ERP and CRM suites that form the backbone of how a business functions.
But perhaps the star of the show is Microsoft's Azure cloud platform. Although transformation to the cloud has been going on for some time, many think we are still in the early innings of the move, as businesses of all sizes transfer most of their storage and compute functions from their own data centers to more flexible third-party cloud data centers managed by giants like Microsoft.
While Amazon was the pioneer of enterprise cloud computing and is currently the biggest platform, Microsoft is in a very strong second place, and it's taking market share. Google is also making an effort. Yet outside of these three companies, there likely won't be any other substantial cloud infrastructure platforms outside of China. Cloud infrastructure takes a massive amount of capital and technological expertise to run, and only a handful of companies have the wherewithal to compete. Thus, all cloud infrastructure-as-a-service (IaaS) platforms benefit from economies of scale, forming an oligopoly (when an industry only has a handful of competitors).
When you look at Microsoft's diversified business lines, basically all have deep competitive advantages, either from network effects, high switching costs, or economies of scale -- or a combination thereof. It's an extremely formidable set of assets.
Protected -- and growing at high rates
Not only does Microsoft have highly defensible positions in each of its end-markets, but those markets themselves also are growing rapidly. Under Satya Nadella, who took over as CEO in 2014, Microsoft is taking market share from competitors on top of these strong industry tailwinds. This combination should fuel strong growth.
This can be seen especially in Azure cloud and Dynamics 365. In 2020, the IaaS market grew 33.9%, but Microsoft Azure is taking market share and growing at higher rates; last quarter, Azure grew a whopping 50%. It also won the $10 billion JEDI contract from the Department of Defense two years ago against stiff competition from Amazon (though Amazon is challenging the contract, alleging political interference). Tech research firm Gartner projects the good times to continue with IaaS market growth of 38.5% in 2021 and 26% in 2022, with strength through the rest of the decade.
Not to be outdone, Dynamics 365 surged 45% last quarter, in what Nadella called a breakthrough quarter for that product. Apparently, Dynamic's unified, integrated ERP/CRM service is catching on with businesses, likely due to its full-stack integrations with big data and intelligence offerings, like the Cosmos database, Azure Synapse data warehouse, and Microsoft's Power BI data analytics platform. Dynamics 365's ability to integrate all of these systems in a way that allows businesses to make sense of all their data and automate these back-end processes is proving valuable, and legacy vendors in ERP or CRM might struggle to match it.
This is so exciting because Microsoft only has a single-digit market share in the highly fragmented CRM market and a low double-digit share of the similarly fragmented ERP market, so the growth runway for Dynamics could be as big as it is for Azure.
Then there's Teams, Microsoft's unified platform for employee chat and video. This has been a massive success, and on the recent conference call, Nadella noted there are now 145 million Teams users, up about 100% relative to pre-pandemic levels.
Microsoft is now combining Teams, Dynamics, and Azure into what it calls its Power Platform, which integrates and automates virtually all business processes through the various combinations of Microsoft tools. Customers seem to love the new capabilities: In the most recently reported quarter, Power Platform users were up 97% to 16 million.
This next-gen cloud-based enterprise intelligence and automation platform should be the star of the show, but even older Microsoft products should grow this decade. The Office suite is still growing by double digits, Windows-based laptops and Surface PCs/tablets should benefit from work-from-home trends, and the video game market is growing faster than GDP at a projected 7.2% compound annual rate from 2019 to 2023, according to game and esports data firm Newzoo.
Management and M&A add even more reasons for optimism
Under Nadella, Microsoft has not only organically grown this next-gen business intelligence platform, but has also made a number of consequential acquisitions, including Minecraft in 2014, LinkedIn in 2016, code depository GitHub in 2018, video game studio ZeniMax Media in 2020, and artificial-intelligence-based healthcare company Nuance Communications (NASDAQ: NUAN) this year.
When you consider that Microsoft has been allowed to make all these acquisitions, it's a huge advantage over its FAANG rivals, all of which are now under the spotlight of antitrust regulators. Microsoft has already been through its big antitrust suit 20 years ago, and is perhaps the only large U.S.-based internet giant with the ability to make consequential acquisitions today without much interference.
And still a reasonable valuation
Today, Microsoft trades at roughly a 30 forward P/E ratio, or a 3.3% earnings yield, and pays a 0.9% dividend yield, which should grow by double digits. That might not seem cheap at first glance, but consider this: That earnings yield is more than double that of the 10-year Treasury bond -- and Microsoft has an even higher credit rating than the U.S. government!
That earnings yield alone should make Microsoft more attractive than so-called "risk-free" assets, but those earnings should also grow by leaps and bounds over the next decade. Last quarter, revenue surged 19% and margins expanded, leading to operating income growth of 31% and EPS growth of 45%.
EPS was helped by a one-time tax benefit, but even taking the operating income as a cue, Microsoft's PEG ratio (price-to-earnings-growth ratio), one of Peter Lynch's favorite ways to value growth stocks, is under 1, which is actually considered quite cheap. And as Azure, Dynamics, LinkedIn, and its other high-growth businesses make up a greater and greater portion of the company over the next decade, I think Microsoft can maintain or possibly even accelerate these growth rates and margins as these businesses scale further.
When you consider Microsoft's best-in-class defensive and offensive characteristics, there is perhaps more risk in not owning this all-star stock over the next decade than in owning it. That's why it's the first core holding I'd recommend for new investors.