eward with very reasonable risk.

Microsoft was the bright light in the tech firmament in the 1980s and ’90s. Then it got too successful, overconfident, lazy and uncreative, and started making bad products and wasteful acquisitions. Worthy competition eventually emerged from the likes of Apple and Google, and Microsoft had to fight for its existence and relevance.

Despite doubling its earnings in the past five years, Microsoft has seen its stock go sideways as the market has viewed it for what it is: a sleepy, often arrogant monopolist that is being beaten up by the agile, paranoid and equally financially well-off competition. Microsoft’s price-earnings ratio—which ended the ’90s at a bubbly valuation of 50—has fallen to a level most of us never thought we’d see, recently trading at less than 7 times earnings if you take out the $6 a share in cash on the company’s balance sheet.

Apple (and more recently Google with its Android operating system) has attacked Microsoft on the Windows front. The iPhone and iPad showed everyone what cell phones and tablets should look like. The iPhone killed Windows phones, while the iPad killed netbooks (low-powered, cheap laptops) as a product category and caused a first-time-ever decline in the sales of Windows.

Even a company with Microsoft’s thick skin can take only so much before it starts to fight back. The upcoming launch of Windows 8 indicates that the software giant is waking up. Windows Vista was a horrible product made by a lazy monopoly. Windows 7 was really just the Vista-fixed edition. But when I watched the demo for Windows 8 a couple of months ago, I caught myself saying, “Wow!” Windows 8 is an uncharacteristically innovative operating system made for PCs and tablets. (Microsoft is making a separate version for phones.)

But an exciting operating system needs to be married to great hardware. Apart from the Xbox, Microsoft has never made hardware; its partners have. In the world of PCs and laptops, that setup did not hinder Microsoft, but it does now.

This brings us to Nokia Corp. The Finnish company used to own the cell phone market, but it too got fat and lazy. In contrast to Microsoft, Nokia was great at hardware but not at software.

In September 2010, Nokia hired a new CEO, Stephen Elop, who joined from Microsoft. Elop killed Nokia’s effort to develop its own operating system and signed a deal with Microsoft in which Nokia committed to make phones that would run exclusively on Windows. Like conquistador Hernán Cortés, who in 1519 ordered his troops to burn all their ships when they invaded Mexico to ensure that they had to conquer the Aztecs to capture their boats and get back to Spain, Nokia has burned all its boats.

Microsoft could have done something stupid and tried to buy Nokia. Taking the Cortés analogy further, instead of burning their boats, Nokia employees would have felt that if they failed, there would be a huge cruise ship with an all-you-can-eat buffet waiting for them (a fat severance package backed by $60 billion in Microsoft cash).

The Nokia-Microsoft alliance will extend beyond cell phones to tablets; after all, as Apple taught us, a tablet is a big cell phone, not a small laptop. Despite dropping the ball on the operating system front, Nokia is the king of cell phone hardware. Working very closely with Nokia will provide Microsoft with a more holistic software-hardware design platform and give it a fair chance of creating an iPad-quality tablet. In addition, Microsoft will benefit from Nokia’s still-strong brand name and tremendous global distribution network.

Before Windows 8 hits the market in 2012, Microsoft will benefit from ultrabooks—powerful, light and thin Windows-running laptops that were inspired by Apple’s MacBook Air and envisioned by Intel Corp. Windows’ sales will likely accelerate for another reason: Microsoft will discontinue support for Windows XP in 2014, forcing upgrades by businesses that were still using it because of their disgust with Vista.

Many Microsoft shareholders are fatigued. I am too. But despite the market’s pessimism, the company’s earnings power should rise over the next decade. Its depressed valuation offers a significant margin of safety, and P/E expansion should become a significant source of returns. Considering the high quality of its business, 40 percent return on capital and cash-rich balance sheet, Microsoft should trade at a significant premium to the market, not at a discount.

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

]]> http://ContrarianEdge.com/2011/12/15/3041/feed/ 1 http://ContrarianEdge.com/2011/05/16/i-am-back/ http://ContrarianEdge.com/2011/05/16/i-am-back/#comments Mon, 16 May 2011 19:21:52 +0000 Vitaliy Katsenelson http://ContrarianEdge.com/?p=2906 I am back!  It was an amazing trip.  It started with Warren Buffett’s Omaha.  I flew into Omaha on Thursday morning, and a few hours later received a call from the CFA Society of Nebraska, asking me to give a talk to their members.  Whitney Tilson and his partner Glen were supposed to do a presentation on value investing that evening for the society’s members but were stuck in NYC – due to tornadoes many East Coast planes were grounded.  To my pleasure I was told I’d be joined on stage by Robert Hagstrom.  Robert manages Legg Mason Growth Trust mutual fund and has probably written half a dozen books.  His first book, The Warren Buffett Way, was the one that introduced me to Warren Buffett.  So this was a humbling experience.  As I arrived at the event I was told that Robert and I would be the warmup for Whitney, who, beating all the odds (and probably bribing a lot of airline clerks to boot) was able to make it to the presentation just a few minutes late.

Robert and I did a 30-minute Q&A, and then we let Whitney have the stage.  When asked what is the cheapest asset class, both Robert and I had the same answer: high-quality large-cap stocks.  Robert went further and said that owning that asset class for the last 10 years was a very painful experience, but he is not throwing in the towel on it, because these stocks have got to insanely cheap valuations (I am paraphrasing).  I wrote an article about this asset class in the latest issue of Institutional Investor magazine (I’ll send it along in a few days).

About a month ago we had a potential client stop by our office.  He brought his portfolio to take a look at.  His advisor/broker bought stocks about 12 years ago and had not sold a single stock, and so the million-dollar portfolio was now a $700k portfolio – he owned Pfizer, Medtronic, Cisco, Microsoft, Abbott Labs, J&J, etc.   Amazingly, his portfolio that was constructed a decade ago looked like the portfolios of our clients today, though we bought most of those stocks in the last few quarters, and all of them in the last few years!  In the late ’90s investors loved these high-quality companies to death – they were great American icons.  It was almost a patriotic thing to own them then (though I believe that only stocks that have a margin of safety are the patriotic ones to own).  Fast-forward 12 years, and these companies have matured, some more gracefully than others (I am thinking about Microsoft as I type this – more on it later), but their earnings have generally tripled since then, and their P/E’s have declined from absurdly high to absurdly low levels.

I have to tell you, if you are a value investor and you don’t go to Omaha for Buffett’s weekend, you are shortchanging yourself (I can write this freely: I already reserved a room for next May and am not afraid of competition for hotel rooms).  It is really not about Buffett, it is about going to idea lunches and dinners with other value investors (I have a dozen stock ideas from those, including one we may actually buy soon), making new friends (while standing in line at 6 am on Saturday to get into Qwest center for the “main event”), attending presentations and small conferences, and eating a lot of DQ ice cream (since Berkshire owns DQ, when you eat ice cream in Omaha the cholesterol and sugar you consume come with reduced guilt).

One thing that Buffett said in the Berkshire meeting stuck with me.  When he was asked what businesses do best in an inflationary environment, he answered, “The ones that have royalty on someone else’s revenue.  You don’t have to invest any more capital, no receivables, no fixed costs.  Your revenues keep growing with inflation as long as the product remains viable.”  Here are some businesses that came to mind that for the most part fit that criterion: McDonalds (they receive a percentage of franchisee sales; in fact almost any company that receives significant income from franchising fits that category), credit card companies like Amex and Discover, and payment processors like Visa and Mastercard (Amex and Discover are actually both a credit card and a payment processor), and companies that just own brands, like Iconix Brands and Cherokee, etc.

I took a very early flight out of Omaha to Denver, spent three hours with my kids, then grabbed my wife and we flew to Amsterdam. I’ve been to Amsterdam three times and every time I love it more.  I don’t have a particular affinity with the red-light district or the legal marijuana, which you can smell quite often as you walk the streets.  (In fact – and this is the honest truth – I have never smoked a single joint in my life!  I do have a very addictive personality: I smoked for seven years from age 14, almost two packs a day.  So knowing my limitations, I never dared to try pot.  And yes, I’ll admit the stock market is my current addiction.)  I love Amsterdam for its canals and Van Gogh Museum.  When I go to an art museum I usually rush to the Impressionist section; and if I’m lucky I’ll find a dozen paintings by other Impressionists and one or two by Van Gogh.  The Van Gogh museum in Amsterdam has the largest collection of his paintings in the world.  We spent three hours there and did not want to leave.  Also, Amsterdam must be the bicycle capital of the world.  You see people of all ages riding bikes: an eighty-year-old woman is riding a bike full of groceries with the elegance and grace of a 20-year-old; a teenager is taking his girlfriend on a date as she is sits balanced on the frame etc…

My wife and I spent two days in Amsterdam, then rented a car and. with our final destination being Frankfurt, drove through Den Haag, Bruges, Antwerp, and Brussels.   (This also gave me an opportunity to see European retailers).

Den Haag is only an hour from Amsterdam.  It has a terrific Mauritshuis museum.  My wife and I rented an audio guide, and to our surprise even the most innocent-looking, unsuspected paintings carried some kind “amorous” meaning!  Our favorite painting was by Peter Paul Rubens, “Old Woman and a Boy with Candles.”  According to the museum, the painting is about an “old woman who reflects at night on lost opportunities for love. Perhaps she is the crone portrayed here, who passes light to the boy, thus urging him to enjoy love before it is too late.”  (Here is my wife Rita looking at that picture).

When we drove into Antwerp, where we intended to spend the night, to our great surprise our hotel was in a neighborhood full of orthodox Jews – it felt like we had found a little Israel in the middle of Belgium!  As I discovered from almighty Wikipedia, after NYC, London, and Paris, Antwerp has one of the largest orthodox Jewish communities outside Israel, with a population of 15,000, and they are mostly involved in the diamond trade.  We went to a kosher restaurant and had one of the best meals of our whole trip.  After this meal, my wife (who is an incredible cook) almost apologetically told me that she’ll have to get some new recipes.

My son asked me once if I enjoy driving a car.  I had to think about it, and I replied “Sometimes.”  I have little patience for traffic and the rude behavior of other drivers (in Denver we say that they must have come from California), so in general I am an unenthusiastic driver.  However, driving in Europe, especially in Germany, was a pleasure.  The roads (especially the autobahn) are flawless, there is no speed limit to worry about, and drivers follow a strict etiquette – leaving the far left lane for very, very high-speed vehicles and passing – and to top all that, the scenery was absolutely incredible: early May is a magical time of the year, with the fields yellow with rape flower.  Our Audi A6 topped out at 109 miles an hour (I got the feeling, however, that Sixt, the car rental agency, had installed a governor to limit my enthusiasm).  I thought I was going fast, until I found myself being passed by car after car.  Unfortunately, at the beginning of our trip my Nikon camera died – the lens refused to come out – so most pictures on this trip were taken with my iPhone 4.  Here are some more pictures from Europe.

I hated Germans for a good portion of my life.  I was not alone; I shared the hate with generations of Russians after WWII.  Probably two-thirds of the movies made in Russia after WWII were about WWII.  Though hate is not an emotion that should propagated, I  completely understand its source: tens of millions of Russians were killed by Germans.  Being Jewish and knowing what was done to my ancestors only added extra hate towards Germans.  Hate was an emotion that was just dormantly there; I never acted on it, never really gave it much thought; it was just a normal part of me.

However, over the last few years I’ve met Germans at different value events, and I detected an inner conflict: though I was programmed to hate them, I did not.  I could not connect the dots between Nazis and the people I met, especially since all of them were born after the war.  On this trip I saw another side of German people, which really touched me.  I was one of the speakers at the conference in Frankfurt.  The last point on the agenda of the conference was a tour.  Dr. Claudia Giani-Leber – the wife of the conference organizer, Dr. Hendrik Leber – was our tour guide.  I thought she’d be showing artwork on the Goethe-Universität campus, where the conference was held.  She did not.  As I learned, during WWII, what is the university campus was the location of an I.G. Farben chemical factory that used Jewish slave labor.  Instead of showing us artwork, Claudia led us to the memorial of Norbert Wollheim (spend some time on this site, watch the interviews) – a German who grew up in an assimilated Jewish family and played an important role in transporting Jewish children to England. He also filed a lawsuit against I.G. Farben.  Claudia spoke for half an hour, describing the suffering of the Jewish people and what the Nazis did to them.  She even read part of the testimony from the trial that described in graphic detail the living conditions and suffering inflicted on the slaves.  This tour looked like an act of self-lynching.  This group of a few dozen people (none of them alive during the war) were purposely reliving the pain and shame of acts that their ancestors had perpetrated on Jews.  They don’t hide from it.  I realized that these Germans hate Nazis as much as I do, even if many of their grandfathers were those Nazis.

We left our car in Frankfurt and took an overnight train to Prague – the most beautiful city in Europe (yes, Paris, move over).  We took a bike tour of Prague, and our guide told an interesting story.  A very old building that used to be a musical conservatory had statues of thirty European composers on its roof (here is a picture of it).  During WWII the Nazis turned it into their headquarters.  However, they discovered that one of the statues on the roof is of the Jewish composer Felix Mendelssohn.  The Nazis could not allow a statue of a Jewish composer to remain on the roof of their headquarters. But the problem was that the statues were not named – and the Czechs refused to identify Mendelssohn.  In a stroke of genius, the Nazis sent two soldiers onto the roof to find the statute with the biggest nose and knock it down.  They did.  However, it was later discovered that Mendelssohn’s statue was untouched but Richard Wagner’s statue was knocked down.  (Side note: Wagner was Hitler’s favorite composer.)

My wife and I flew to NYC on Monday, May 9th.  The next day I gave a presentation at the Hard Assets conference, on China and Japan (my updated slides can be found here), which was extremely well-received, and a few dozen people nearly mugged me with questions when I got offstage.  I was a bit surprised, as the theme of the conference was “hard assets” – the stuff I argue will come back to earth fast when the Chinese bubble bursts.

A few hours after my speech I finally got to see our kids – my brother-in-law had brought them from Denver.  For the next two and a half days my wife, kids, and I were tourists in NYC (here are some pictures).  We went to see the Statue of Liberty, Ellis Island, went on top of the Rock – an incredible view of the city! – rode bikes in Central Park, and then rented a boat – my son learned how to row.

On our last day in NYC I took my son to the Yahoo studio, where I taped a show hosted by my friend Jeff Macke and Matt Nesto (I met Matt for the first time, a very nice guy); and wonderful Aaron Task, who hosts Daily Ticker on Yahoo, joined us.  (Here is a link to the show.)  We talked about China, Microsoft, and Cisco.  Jeff, despite being my friend, did not pull any punches regarding Cisco and Microsoft – I did not expect any less of him.  Jeff even wrote “R.I.P.” on Cisco’s chart.

We own both stocks; Cisco we bought recently, Microsoft a few years back. We own Microsoft despite its management.  I strongly believe Steve Ballmer needs to be replaced, but the business is too good (it is still a monopoly) and the stock is too cheap.  But we own Cisco because of the management.  I’m in the minority, but I am a big fan of John Chambers; I believe he has done a terrific job running the company.  Since he came on as CEO in 1996, Cisco’s revenues and earnings per share are up about 10-fold.  But, as any successful company, it got too happy and too fat.  Recognizing this is half the battle, fixing it is the other half.  I encourage you to listen to Cisco’s last conference call (or at least read the transcript) – John Chambers gets it.  He said they’ll streamline operations  (cut out bureaucracy), cut $1 billion of costs, refocus the company on core business through divesting underperforming and non-core units, and continue to buy back stock (at today’s valuation they can create a tremendous value).  He admitted that at the high end their switches are not as good as competitors’ – they’ll fix that.  Switches are about 30% of sales, and sales were down 9%; but other sales of other business were very healthy.

P.S. Painting “Handyman” by my father Naum Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here. .

Copyright Vitaliy N. Katsenelson 2011.  This article may  be republished only in its entirety and without modifications.

The software company will use the sales proceeds to repay short-term debt. If it was any other company I’d ignore this headline as a daily noise as this kind of things happens all the time. But Microsoft has $39 billion of cash and generates $16-$17 billion of free cash flows a year. Issuing short-term debt, for which Microsoft will surely pay higher interest than it receives on the pile of its cash makes absolutely no economic sense – zero.

Microsoft has $1 and $0.75 billion of debt that matures in 2019 and 2039, respectively. Ironically, though this debt comes with higher interest, it makes sense if the company believes that we’ll have significant inflation and it will be paying off its debt with inflated dollars.

When you are sitting on pile of cash that earns nothing, borrowing short-term (three years is short-term) makes no economic sense. It seems Microsoft finance department suffers from the same problem many investors do, it cannot sit on its hands, it has to do something even if it is losing proposition for the company and shareholders.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles by email, click here.

 I’ve received a few emails asking my thoughts on Microsoft’s (MSFT) quarter.  Here is my take: this is probably the least meaningful quarter in the company’s recent history.  MSFT is about to introduce Windows 7 (and a slew of other products.) If I were a corporate customer, I wouldn’t be buying Windows Vista now if I could buy Windows Vista FIXED (or also known as Windows 7) in four months.  

 There is also news that it is difficult to upgrade from Windows XP to 7, but this difficulty will only impact consumers and very small businesses. Corporations upgrade using a very different procedure. They create a master disk, an image that has all programs installed and preconfigured, and then rollout this image to all computers.  So in other words, corporate IT guys don’t go from one workstation to another with a Windows 7 disk and upgrade one computer at a time.

Today I’ve caught up on my last three BusinessWeek podcasts, called “Story Behind the Story.” John Burns, BW’s editor, interviews the reporter who wrote this week’s cover story. These podcasts are fantastic, because you often get a good overview of the lengthy article, but also some interesting new insights.

One talked about the Chinese shopping spree. China has found that it is hard to diversify away from the US dollar without shooting itself in the foot by driving the dollar down (thus devaluing its dollar reserves), and so it’s going on a buying spree of foreign businesses – smart! Unlike the Japanese, who in the late ’80s were buying up the world and paying market or above-market prices, the Chinese are buying things on sale – things tend to be cheaper during a recession.

Another podcast talked about Microsoft, a stock I own and have written about. Microsoft has been doing a lot more things right than wrong lately. But introducing free online Office (supported by advertising) will be a very tricky endeavor, because it has to make sure that it doesn’t cannibalize its core Office business. The upside here is that Microsoft may be able to capture a new customer – the one that used but never paid for Office (like most people I know who use Office at home) or the ones who are not using Office, or using Google’s apps.

The last podcast discussed retirement. Here is what I took out of it: stocks for the long-run, no more. The promised average 7% real (after inflation) rate of return from stocks, also called Siegel’s constant (after Jeremy Siegel, Wharton professor who wrote Stocks for the Long Run), only exists if your long run consists of decades. Here is the chart from my book that shows how the “real” rate of return came about. Range-bound markets took the above-average real (after inflation) returns of bull markets, splashed them with their below-average real rates of return, and voila, you got yourself stocks for the long-run rate.

I read this week that McGraw-Hill is putting BusinessWeek up for sale. The magazine got a lot thinner over the years – fewer pages means fewer advertisements; I am sure it’s bleeding money. I hope McGraw-Hill finds a buyer; BusinessWeek is a terrific magazine and the best contrarian indicator, period.

MSFT did something very uncharacteristic. It did not push back the release of Windows 7, which will be released on Oct. 22.

Bing is excellent. I played with it for a couple of days, and it’s an “un-Microsoft-like” search engine. It is very good. Type for instance “flight from NYC to Denver“, and it will tell you that fares are predicted to rise in the next 30 days. Click on the green arrow and it will tell you everything you want to know about fares.

MSFT demonstrated Project Natal this week at the E3 tech expo. If the technology demonstrated is real, and it looks like it is because MSFT has released an SDK (Software Developer’s Kit), programmers can now start developing games and applications for Natal. Natal puts Wii’s wireless controller to shame. In fact I think it will change the gaming industry forever, and I’d be very worried if I owned Nintendo (NTDOY) stock. Natal is:

“A motion sensing device that allows you to control video games and Xbox 360 menus with your body instead of a peripheral controller. Natal gives you voice and full-body motion control over your on-screen avatar using an RGB camera, depth sensor, multi-array microphone, and custom processor running proprietary software,” writes PC World.

Finally, in a previous post I wrote that “it is believed by many that creativity retired with Bill Gates.” In response, I received a lot of e-mails saying that Microsoft never had any creativity because it never had an original product. It just took products created by someone else, improved them and marketed the hell out of them.

It is very true that even the original DOS — the one that MSFT sold to IBM (IBM) — was created by someone else. But copying requires creativity, too; otherwise, why would anybody buy your product instead of competition.

Think about WordPerfect, for example. It was a dominant product at the time. Microsoft created Word, basically a replica of WordPerfect — but a much superior replica.

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

When I think of Microsoft stock, images of Susan Boyle in “Britain’s Got Talent” come to mind.  The Scottish woman appeared — middle aged, awkwardly dressed, unsure of herself, unattractive by conventional (stereotypical) standards — and expectations of her singing were in line with her appearance.  As long as she did not fall off the stage, the audience would have concluded that her performance was a success. 

If Susan Boyle was a stock, I’d call her a deep value stock with very low expectations, and thus a great margin of safety, selling at a discount to its fair value. 

Then she opened her mouth, and to everyone’s shock, this duckling had a beautiful swan of a voice.  She became an overnight sensation. The video of her performance was YouTubed more than President Obama’s inauguration. 

Then here comes Microsoft (MSFT). The company’s name doesn’t have the luster it once had.  It’s seen as middle-aged, overweight and slow, and it is believed by many that creativity retired with Bill Gates.

 The sentiment is so horrible that there is almost universal expectation that it will not come up with another good product, ever.  Kodak and Polaroid are now used to describe Microsoft’s “bright” future, and Apple and Google are the ones that will retire it there. 

But the ugly duckling is about to sing, and it will be a Susan Boyle-like performance.

Vista’s flop will lead to Windows success
Microsoft is releasing Windows 7 sometime in late 2009 or early 2010 [after I wrote the article Microsoft announced release date - October 22, 2009]. It’s last operating system, Vista was a flop.  Consumers did not care for the product and corporations did not upgrade. 

Of course failure is a relative term when it comes to Microsoft. At its release, Vista sales were double that of XP, the previous version. Vista still commands almost 24% of market share, second only to XP’s 60% plus.  

Windows 7 is not just another new release. It is really Windows Vista 2.0, or Vista-fixed, if you like.  Microsoft took Vista’s kernel – the core of the operating system — fixed it, made it faster, improved the interface and added new features, Voila, you’ve got a new multibillion dollar product.

Many corporations did not upgrade to Vista: they stayed with XP. This is now eight years old, a dinosaur in software years.  Microsoft will eventually discontinue support and updates for XP.  Unless all hackers “pinky swear” (my 8-year-old son’s favorite phrase) that they’ll not try to figure out a way to hack into the 400 million computers that run XP worldwide, a computer running could be left exposed to new security attacks. 

Corporations will not likely take hacker’s “pinky swears”, they’ll have no choice but to upgrade to Windows 7.  Also, this time they won’t have to do the usual thing and wait for Service Pack 2 — the inevitable set of bug fixes to the original product.  Vista’s Service Pack 2 is already out, and in many ways Windows 7 is Service Pack 3.  Expectations created by Vista for Windows 7 are incredibly low for Microsoft, but 7’s success is likely to be very high. 

Other reasons to go Bing
There’s more:  Aside from Windows 7, there is plenty of promise in other products that are not built into Microsoft’s stock.  Bing, a new, improved search engine, is just out and the presentation I’ve seen of it is very impressive [played with it for couple of days now, looks good].  Office 2010 will bring a subscription-based office onto the Web which may fix a longstanding consumer piracy issue.  (I personally don’t know a single person who actually bought a copy of Office for home use. Maybe I need new friends, but people just don’t want to pay $300-400 for something that we consider our birthright. )

 With Office Live, Microsoft will charge an annual fee, and you’ll get a Web product that has the same look and feel of the Office you are used to using at work. 

This ugly duckling is not hanging by a thread. Microsoft still has Windows, server products and Office, holds a leading position in gaming, generates billions of dollars of free cash flow, has $23 billion of cash and its debt will likely be trading at lower yields than Treasury’s very soon.

But the best part, there is nothing positive priced into this stock, which trades at about 10 times free cash flow.  It is incredibly cheap.  Buying it now is like a talent agent signing Susan Boyle as a client the day before she went on stage.

P.S.  Though I’ve written this article last week, before Susan Boyle lost on Britain’s Got Talent, her loss did not make the point of the article any less valid. J  In fact, I spent several hours this week watching Britain’s Got Talent on YouTube with my wife and kids.  What an incredible show.  Susan Boyle did not win, but did not lose either, she’ll will likely become a big star – she has a wonderful voice.  I’d buy her CD and go to her concert in a heartbeat. 

Position in MSFT

I know it is not the name of the final product, and I am probably reading too much into it. But “Pink” doesn’t inspire employees to create a product that will challenge a market leader.

I was interviewed by Forbes in early October.  I discussed my favorite “dotcom” portfolio of stocks, here is a link to the video.

Investing vs. speculating

Let’s talk about financial stocks for a second, because I’m sure they are on investors’ minds right now. You want to be an investor rather than a speculator; at least I am talking about investing. If you own financial stocks, you want to make sure that you own the ones that you can analyze. I dare anybody to analyze Citigroup (C) or Bank of America (BAC). Those stocks could be cheap and they may end up having great returns, but most generalists, including myself, can’t analyze those companies; they are too complex.

If you are buying a company whose fair value you can determine, you can analyze and access risk and required margin of safety – you are investing.   If you’re buying a company because it’s declined a lot and has a good reputation, and you think it’s going to go up but can’t fully determine how much it’s worth (or can barely analyze it), you are speculating. I encourage to only own financial stocks that you can analyze. Take American Express (AXP)– it is  a credit card company and processing company that you can actually sit down, look through the financial statements and figure out how much it’s worth – it is analyzable.  That’s just one example of that.  

Here is a very detailed analysis of American Express I completed in April (PDF).

Profit margins, profit margins, and profit margins

Another point, and this is where I spend a lot of time right now: when you look at companies you want to make sure that you normalize their profit margins. For a lot of companies, especially “stuff” stocks that have very high margins, you have to look at where they were historically, you have to look at their business and say what would happen if the global economy slowed down. (Though I believe the slowdown is a question of when, not if.) Would they be able to maintain these high margins? If not, you have to figure out their normal margin over a long-term cycle and value them that way. This way you’re going to avoid buying a lot of companies that see their margins contract and sudden, like housing stocks, go from 10 times earnings to 50 times earnings overnight.

 On selling

Even if you don’t want to become an active value investor, you should at least become a buy and sell investor. Selling is like a four letter word in a bull market.  Investing is about buying and selling; even long-term investments are about buying and selling. You want to buy companies when they are undervalued, and when they get fairly valued you want to sell them.  If you don’t sell them, you’re just going to see their PE keep contracting and contracting. So you want to be an active investor, a buy and sell investor.  Also realize this: return for any company or any stock really comes from three sources: dividends, earnings growth and P/E contraction or expansion. If you consider a stock that you are sure will continue to pay dividends and grow earnings, ask yourself a question: is it going to see PE contraction or expansion?

If you buy a company that is undervalued and whose P/E is undervalued and you receive dividends while you hold it and you receive return from earnings growth, and P/E goes from low to relatively normalized, guess what? You’ve already captured one source of return that may not be there in the future, the P/E expansion. Initially all you’re going to get is dividends and earnings growth. The sell question remains – “Is this company’s growth rate and dividend going to be high enough to justify holding the stock?” If the answer is yes, keep holding it. If the answer is no, move on to a different stock.  Exercise “sell” discipline.  Once P/E is normalized (increased) is not your friend, not anymore – the margin of safety is gone.

A stock idea

There is this little company that nobody ever heard of, Microsoft (MSFT). I’d tell you there are so many reasons to hate Microsoft. Their Vista product is a flop (at least there is a perception that it is a flop), Google (GOOG) is coming out with a new competing browser, the company’s too big, nobody understood what their Seinfeld and Gates advertisements were about. So the stock is hated.  I used Vista and hated it, at least at first; they have improved it since. By the way, think about the kind of competitive advantage the company must have to sell 160 million copies of Vista,  a failed product. Imagine what would happen if they actually had a successful product! This company has a tremendous competitive advantage.  

Google is coming out with a new browser, and it may possibly hurt Microsoft’s search and  advertisement businesses. However, Microsoft is losing money in its advertising business, in its online business. These businesses are not priced into the stock, they actually detract from its earnings and valuation. Even if Microsoft gives up and shuts them down, it should only be a positive. My point is, Microsoft may lose the war with Google on advertising (and that’s very possible), but it’s almost irrelevant. This is a company that’s trading at about 12 times earnings. If you take out cash, which they have $20 billion of, it’s trading at 11 times earnings.

There is another argument that Microsoft cannot grow at a very fast rate. In the last quarter they grew their earnings and sales in the mid-teens. How many companies do you know that actually can trade at 11 times, 12 times earnings; have returned capital in the mid-30s; have a competitive position that no other company in the world can match; have grown earnings in mid teens; and are trading at that valuation. But it gets better. When you value Microsoft, even if you take their earnings growth rates to zero, the stock is still too cheap. If I’m wrong on the growth rate and they say they’re going to start growing at 6% to 8% a year, even at that point the company still will be too cheap. In this economic environment, where you want to own very strong companies with bulletproof balance sheets, this is a perfect stock.  And yes, I do own it – as do my clients.

Those who are looking at Home Depot’s stock performance and blaming Nardelli for it need to separate between the analysis of a company and a stock. Home Depot’s stock has gone nowhere not because the company fundamentally did not perform well – the CEO’s main responsibility - the stock has not gone anywhere because it was overpriced in late 2000. As often happens, investors got overexcited about this great company and drove HD’s valuation to a ridiculous level of 46 times earnings.

If you bought Home Depot in late 2000, blame yourself (you overpaid for the company) not the CEO. I don’t know if any other CEO would have done a better job running this giant. As I have mentioned many times before, other large growth companies such as Johnson & Johnson (JNJ), Microsoft (MSFT) and Wal-Mart (WMT) – cannot forget this one, of course - were lifted to religion stock status in the late 90s and have been coming back to earth since. Bob (Nardelli), if you are reading this, ask for another bonus, you did a terrific job.

 Positions WMT, MSFT, JNJ