There is almost no business in the world that is as great as Microsoft. If presented with a scenario where I could make ten investments at fair value to hold for a lifetime, Microsoft would be one of the slots. Its software products for individuals and businesses as well as cloud data storage segments has given it 30% profit margins on business lines that grow increasingly entrenched over time while achieving double-digit sales growth.
In addition, it has one of the strongest balance sheets in the world with a net cash surplus of almost $70 billion. Monster repurchases, one-time dividends, or large acquisitions certainly await its future. The R&D budget is one of the five largest in the world, and internal product growth is almost certain to contribute new products meaningfully over time. It is exactly the kind of business you would love to own over the next couple decades.
As Microsoft’s business model has not only been able to withstand the difficulties of the present year but grow stronger, the price of the stock has likewise risen from $160 at the start of the year to $200 today.
It can be easy to think, “Microsoft is a great business, and heck, its going to grow quickly over time, so I might as well just get in and it’ll probably work out.” That type of sentiment has some merit but comes with a cost.
The merit of the investment is that investing in businesses with double-digit earnings per share growth for a multi-decade period almost always yields to a satisfactory result.
The demerit of this position is that lofty valuations always impose a cost, even if it takes years to realize. In the late 1990s, people were having similar thoughts about Microsoft. It was growing profits 15-20% every year and just about every business, whether it be small, medium, or large, was contributing to its corporate coffers and also increasing its competitive position by becoming the cultural norm for business communications.
By 2000, Microsoft stock had a P/E ratio that fluctuated between 44 and 58x earnings. It hit a high for the time period of $55 per share in January 2000. Guess what happened to shareholders? Well, from 2000 to 2010, Microsoft experienced a period of 16% annual earnings per share growth but 2010 featured a recession.
Bad things happen when you start at overvaluation and end at undervaluation. From 2000 through 2010, Microsoft shareholders experienced negative seven percent annual returns per year. So if you invested $10,000 into Microsoft stock in 2000, you would have had $4,800 in Microsoft stock ten years later. You lost over half your money owning a business that was growing at 16%. This is what paying the piper for overvaluation looks like.
I would argue that Microsoft traded at undervaluation or fair valuation during the 2010-2018 stretch. Even in 2018, when the stock traded at 20-24x earnings, which I would argue represented the fair value for the stock, investors only experienced 5% annual gains despite 14.5% annual growth over the time frame. Think about that–you would have owned a business whose earnings increased six-fold, but your $10,000 investment would have only grown to $24,500.
Today, Microsoft earns $5.50 per share. At $202 per share, it is trading at 37x earnings. Analysts are projecting 14.5% annual earnings per share growth, which is in line with Microsoft’s performance since 2000.
Valuation matters. If you are on the right side of it, you can be like the investor who bought Microsoft stock in 2010 and has achieved 23.2% annual returns since 2010 (meaning a $10,000 investment ten years ago is now worth $90,000). Or, for those who invested in 2000, the compounding rate has been 9% (meaning a $10,000 investment is now $55,000).
In old Tweedy Browne reports, it was suggested that the average valuation cycle for a firm lasted 3-5 years. When you see a great business trade at a lofty price, the lofty price could last for half a decade. That means you could encounter 1,115 trading days where the overvaluation persists. No wonder it is easy to give in to thoughts of new normals and say “Aww, to heck with it, I want in!”
When you buy an ovevalued stock, it remains true that the cost of the overvaluation will need to be paid in the form of subpar compounding. Sometimes, you even have to pay excess costs as there is no rule that an overvalued stock cannot become one day undervalued. The odds are fair that Microsoft may continue to grow profits at a rate of 14.5% over the next twenty years. But the odds are even higher that shareholders buying today will reap a compounding rate that is inferior to the rate of earnings growth, perhaps by a substantial amount.