Microsoft’s 2004 Special Dividend And Growth Investing

I was reading a forum post at Money Crashers where Hank Coleman wrote an article four years ago concerning the effectiveness of one-time dividends, with Microsoft’s $32 billion special dividend in 2004 being the most famous example in the past generation.

Hank said:

The problem with Microsoft is that it is a cash cow like Frontier, but Microsoft cannot come up with much else to do with their free cash flow. They could be expanding, buying companies, coming up with new product lines, etc. But, no…they are just handing their profits back to their stock holders, and I think that is why stock holders have seen the company’s share price go nowhere for years now. In fact, shares of Microsoft are the same price and even a dollar less now than when it began issuing dividends in 2004.

The entire post seemed reasonable until the conclusion “and I think that is why stockholders have seen the company’s share price go nowhere for years now.” It’s the perfect of someone using correct data points and then drawing a conclusion that sounds reasonable to the ear, but is ultimately incorrect. It’s one of the most unrecognized lessons in investing, even though a lot of investors do recognize it at a superficial level: a company’s business can grow at a healthy clip for an extended period of time but actually make a bad investment because the company simultaneously shifts from being pricey to being fairly valued.

With tech companies approaching maturity, there is this tendency for companies like Apple and IBM to have a wide range of 10-15x earnings that constitutes fair value. The reason this is cheaper than the 20x earnings indicator of fair value that you’d see from the likes of Kraft, General Mills, and PepsiCo is that cereal and snack profits are much easier to forecast five and ten years from now, and this increased certainty leads to a higher price that investors are willing to pay for each dollar of current profits.

Back in the early 2000s, Microsoft had not yet participated in this shift—its valuation smacked of the old days when growth assumptions of over 20% annually guided investor sentiment. In 1998 and 1999, Microsoft traded at 50x earnings. From 2000 through 2004, it typically traded between 25x and 35x profits. The reason why Microsoft was such a disappointing investment during the 2000s was because the valuation shifted from 50x earnings, to 35x earnings, to 25x earnings, and eventually settling in around 15x earnings.

Microsoft has increased its profits 2.5x times in the past decade (from $1.04 in 2004 to $2.63 in 2014). And the dividend has become a substantial part of its story. It’s an important thing to understand—the reason Microsoft may have disappointed investor expectations during the 2000s has nothing to do with vague notions of lacking new ideas or handing cash back to stockholders, but rather, the price of the stock at the start of the decade was way above the fair value levels for tech companies worth $200-$400 billion that project to grow at 8-12% annually for the long haul.

This insight plays an important role in many of the articles I write here and share with you—the only company that I’ve ever written about on this site that could be fairly classified as a growth stock is Visa. That’s because the valuation isn’t outrageous (it’s in the 25x earnings ballpark) and the high probability of future growth in the 15% range seems very plausible considering Visa is replicating its U.S. strategy across the globe and seems to have many years of growth in the 10-15% range ahead. I can find other companies out there with Visa’s growth rate; the problem is, they often trade at 50x, 100x, or even 150x profits, so that getting the company’s growth story right doesn’t lead to successful investing because you get whacked by the transition to 15-20x profits or whatever the matured valuation happens to be.

Life is a lot simpler when you spend your time loading up on Exxon month after month, year after year. The valuation wiggles between 7x and 10x profits throughout most years, the profits march upwards due to 5% natural growth plus a 4-5% buyback, mixed in with a 2-3% dividend depending on your starting point, and seems to be an automatic way to (1) tap into an annually growing dividend that (2) grows 8-12% in most years without (3) worrying that you’re overpaying. The simplicity of that, plus the small dividend checks in the beginning, probably have a deterrent effect, but once an Exxon shareholder has been at it for ten years or so, the regrets about loading up on the oil giant tend to dissipate. Why do you think that is?