10 Core Stocks for Your Portfolio: Microsoft

This week and next, we're presenting 10 core stock ideas -- stocks our writers believe can serve as the foundation for a long-term-focused portfolio.

Every few decades, a handful of companies make the leap from ambitious start-up, to fast-growing newcomer, to cultural icon, to established blue chip. In the past, Boeing, Ford, and McDonald's have achieved such success. In recent history, the award for this achievement belongs to Microsoft (Nasdaq: MSFT), which I'm nominating as a top 10 core stock for your portfolio.

The business
Most of us are acutely aware of Microsoft's products. Odds are 91% of you reading this are using at least one of them (that's Microsoft's share on the operating system market).

Here's a snapshot of all its business divisions:

Source: Capital IQ, a division of Standard & Poor's.

Microsoft's financial success clearly relies on Windows and Microsoft Business. The first segment, Windows, is home to the software platforms that run most of your computers. The second, Microsoft Business, is where Microsoft Office (Word, Excel, PowerPoint, etc.) call home. You probably already knew that, so let's dig deeper into the details.

Why it's a core stock
For all of Microsoft's well-know faults -- its products are buggy, they're clunky, they crash, they become virus-ridden -- it continues to thrive year after year. Why? I think the answer lies in a comment Warren Buffett made more than a decade ago:

In effect, the company has a royalty on a communication stream that can do nothing but grow. It's as if you were getting paid for every gallon of water starting in a small stream but with added amounts received as tributaries turned the stream into an Amazon. The toughest question is how hard to push prices.

He's talking about Microsoft's moat, which can't be described as anything less than spectacular.

Take Microsoft Office, the business has a narrower moat relative to Windows, but it's still extremely effective. More than 80% of Office sales are to businesses. Within businesses, the key benefit of Office is its shareability. I can create a document and email it to you. You can edit it, send it to your boss, who then sends it to clients, who can open it up on their computer, and on and on. It's wonderfully convenient. And for this process to work without any hitches, everyone has to use Office. Don't like the software? Too bad. In most fields, you have to if you want to be relevant.

This chain of mutual reliance has grown so powerful that nearly every business in the world has incorporated Office into its operations. And it's likely to remain that way. It's a very tough chain to break, and one that's given Microsoft a staggeringly powerful moat.

The rewards of this moat are, of course, extraordinary financial results. And Microsoft hasn't just become a champion of profits, but more specifically cash flow.

Source: Capital IQ, a division of Standard & Poor's.

Microsoft shells out $4.6 billion a year in dividends and consistently buys back twice that amount of its own stock. Add it up, and you get a company that returns some $14 billion to shareholders annually, with the ability to consistently and safely grow that sum year after year. For a stock with a $175 billion enterprise value, that's an incredibly lucrative arrangement.

Risks
Like any and every investment, there are risks here. Microsoft's moat is deep, but not impenetrable.

The biggest risks come from competitors Apple (Nasdaq: AAPL) and Google (Nasdaq: GOOG). Apple's threats are real, but mostly in areas where Microsoft has a small presence. Google, on the other hand, is likely the most menacing threat since its Google Docs are a direct run at Office, which is so key to Microsoft's financial success.

These threats shouldn't be pooh-poohed, but they don't keep me up at night as a Microsoft shareholder. If Google's office software does find traction, history shows it's unlikely to be apocalyptic for Microsoft. The reason, again, is that puncturing Office's moat requires swarms of users to switch at the same time. While you can save a file that's compatible with Word using Google's Docs, the key interface that users are acclimated to and works seamlessly with all features is still Office. Throw in the fact that many companies (again, 80% of Office's sales) receive volume discounts for bundling Office with other Microsoft products, and incentives for switching decline further.

The closest comparative example to this is, I think, competition between Visa (NYSE: V) and MasterCard (NYSE: MA) vs. American Express and Discover. Visa and MasterCard dominate the card industry, while AmEx and Discover fight for scraps, despite business models that are by most accounts superior (they integrate the entire card business, while Visa and MasterCard simply process transactions.)                                                                             

Why haven't AmEx and Discover been able to take sizable market share away from Visa and MasterCard? Because just like the office software business, they have to convince many different parties to switch at the same time in order to become successful. If businesses don't accept AmEx or Discover, it's useless for consumers to demand them. And if consumers don't demand them, it's useless for businesses to accept them. That type of competitive business environment makes gaining momentum against the established frontrunner -- be it Visa and MasterCard, or Microsoft -- exceedingly difficult, if not unattainable. Dominant first movers in these kinds of businesses tend to stay on top for a long, long time.

In sum
Microsoft's moat is thick. Its profits are deep. Its competitors have their work cut out for them. All told, I think it deserves a spot as a core holding in your portfolio.

Disagree? Hit back in the comment section below.