Investors Must Preserve Emotional Capital Too

I’m a buy-and-hold fundamental investor, but I follow a lot of traders on Twitter.  I do this for two reasons.  First, a lot of them are interesting and funny dudes (they’re almost all guys).  But second, I recognize that some traders do actually make money on a consistent basis, and that the reason the money-makers do so is because they follow rules, and possess wisdom.  And that’s applicable to fundamental folks like me.

Sunrise Trader had a great tweet this morning, that encapsulated what makes a good trader:  

  • Our job is to look for opportunity, manage risk, consistently take profits out of the market while preserving emotional and financial capital.

This is very applicable even to buy-and-holders like me.  I’m not taking profits out of the market often — only when I think a stock is really stretched beyond its fair value.  Instead, I’m just adding new capital every month from my earnings.  But sometimes I must take profits.  The really important thing that struck me again though is the importance of preserving emotional capital.

Notice he put that before preserving financial capital.  The first leads to the second.  For the buy-and-hold guy like me, you preserve emotional capital in three ways:  

  1. Size your positions appropriately.  That means at a level you are comfortable with.  I never hold more than 30 different companies.  But never fewer than 10.  That’s what I’m comfortable with.  You may be comfortable with a different number.  If I put all of my money in one or two names, I would not be preserving my emotional capital.  This would leave me more prone to doing something stupid like selling on a dip even when I believe in the company.  As I grow as an investor I hope to shrink the number of companies I own.  But there is no reason to force it.
  2. Invest over time.  I add money to my investments every month, incrementally.  It is much harder emotionally to invest $100,000 or $1,000,000 or $1,000,000,000 all at once than it is to invest whatever your total capital is over a period of months.  This also gives you additional time to scale up in positions as you gain comfort and additional knowledge of the companies and the industries in which they operate.
  3. Buy-and-hold.  This itself is a means of preserving emotional capital.  I am sitting on huge gains in Microsoft stock that I purchased at about $18/share during the financial crisis.  I bought Intel for the first time at around $13/share during the financial crisis.  I have held those positions.  I bought Walmart under $50/share in 2010.  I have held.  Etcetera.  This is not to say I never sell.  Stocks I have sold at advantageous times include Hewlett Packard, Transocean, Tidewater and Exelon, and less smartly, Ebay and Disney.  But if I think my qualitative thesis is blown or the stock is way overvalued, I sell.  That’s my rule.  Sometimes I win, sometimes I lose, but I follow a rule, just as traders do.  (It’s just that my rule isn’t a price point based on technicals.)  When you are a buy-and-hold investor, and you follow decent selling rules, and you sit on long-term winners in whose business models you still believe, you see a lot of green on your screen after a few years.  This gives you emotional capital.  This makes you more confident.  This makes you less likely to do stupid things, even with your newer positions.

Checking in on Microsoft

I have been a holder of Microsoft shares since the financial crisis in early 2009.  I have added to my position since then, and it is one of my four largest positions, along with ExxonMobil (holding and adding since 1998), Berkshire Hathaway (holding and adding since 2009), and Apple (holding and adding since 2011).  Unlike those three, most of my Microsoft stock purchases over the last three years have strongly underperformed the market.  

The issues are of course well-known.  First, Microsoft is the epitome of “dead money.”  The stock price has gone nowhere since July 1998, nearly fifteen years.  I was in college in 1998.  Bill Clinton was President.  AOL and Timewarner had not merged.  That is a long, long time.  Second, the Wintel monopoly on the corporate and even moreso on the consumer market is ending.  Duh.  Thematically, Microsoft doesn’t work.  It puts out crappy products like Zune, and overpriced (sorry, but it’s true) products like Surface.  

It’s CEO looks like a titanic oompa loompa.  He is anti-cool.  He is kryptonite to cool.  Worse, he does things like try to purchase Yahoo for too much money, pay tons of money for an ad company that leads Microsoft to the write-off billions of dollars.  And of course the attempt to compete with Google in search has largely been a failure.  Etc., etc.

So why do I own?  Why do I continue to own?  It’s important not to check one’s brain at the buy button.  And it’s even more important not to check one’s brain once one has hit the buy button.  Is my thesis wrong?  What is my thesis?  My thesis is fairly simple:   The company still makes a bunch of money, will continue to make a bunch of money, and even as the Wintel monopoly ends, this is not the end-of-the-line for Microsoft.  And because everyone thinks it is the end-of-the-line and Microsoft is going to go the way of Research in Motion, it’s cheap as hell.

Even during the disastrous fiscal year that ended in June 2012, the company generated record free cash flow of $29.321 billion, and $3.44 of free cash flow per share, also a record.  And record revenue.  Against around $11 billion in long term debt, it was holding over $50 billion in cash and cash-equivalents.  

These aren’t really new facts to anyone who follows Microsoft.  More recently, earnings-per-share were down from $0.78 per diluted share in 11/2011 to $0.76 per diluted share in 12/2012.  The future is all that matters.  The trend is all that matters.  What’s the saying? — I’d rather pay up for a quality business than get a bad business for a good price.  Something like that.

Well, let’s see more concretely what this last year hath wrought.  I last checked in on Microsoft’s valuation in April 2012.  (I’m a long term kind of guy, I don’t follow the ticker every day.)  At the time, as you can see in that sheet, I assumed 4% yearly free cash flow growth for ten years and 1% thereafter.  I assumed a WACC of 9.2%, and a share count, then-existing, of 8.593 billion diluted shares.  I discounted the cash (less debt) that Microsoft was holding by 35% to assume Microsoft would eventually have to pay taxes on all of the cash it holds overseas, or else will blow some of its money on stupid acquisitions, and lose some to inflation.  That gave me a valuation of around $45/share, give or take.  (This isn’t a science, and anyone who tells you otherwise probably wants you to pay for some worthless subscription or newsletter.)

Note, by the way, that although I assumed 4% yearly free cash flow growth, in this actual first of my ten years from the above calculation free cash flow actually grew 19% from year-end 6/2011 to year-end 6/2012, from $24.639 billion, to $29.321 billion.  We can’t really expect to see that repeated this coming year-ending 6/2013, but we shall see.

Now this year, from the 6/2012 starting-point, we have only 8.444 billion diluted shares outstanding, because of share repurchases.  The WACC is still about the same.  Some sources say only 9%, but I’ll stick with 9.2%. Note that debt is now up from last year, to over $14 billion, because Microsoft has taken advantage of stupid-low interest rates.  And cash is up to $68.312 billion as of 12/2012.  I continue to just write-off 35% of Microsoft’s cash when making my analysis, for the same reasons as above.  The result I get is that Microsoft is now worth around $54.60/share, more than it was last year, and that it is nearly 50% discounted.  Even if you completely write-off all of its cash, it’s still way undervalued by this analysis.

Can this be?  Can Microsoft really be so cheap?  I think so.  That’s why it’s such a large position for me.  If you think its earnings are about to fall off a cliff, as is its cash generation, you may disagree.  But I’ve been covering Microsoft pretty extensively for four years now.  If you think that now, you have probably thought it for four years, and that time, during the advent of the iPhone and the iPad and Google Chromebooks, etc., Microsoft has grown its free cash flow from $15.9 billion at the bottom of the financial crisis, to over $29 billion, yo.

So what say you?  I still say it’s a buy.  And while I wait for the market to agree with me, and hope that my thesis is correct, I’m happy to collect the 3% dividend yield, and happy to see that so far its actual free-cash-flow generation confirms my thesis.

Yup, Intel Remains a Great Buy

In my new article I talk about why I think that Intel remains a great buy, despite its recent share-price appreciation.  As always huge risks exist, but I think the company is at the current price of around $28/share, because it is 20% or greater below my best guess as to the fair value of the company, of $35/share.  I also highlight the three best analyst questions from the recent conference call, and I express my worries about recent stock options/sales by the CEO.  For my full article, see here.

Microsoft: A Brief Checkup on My Largest Position Says It’s A-OK

For some time, Microsoft has been the largest position in my portfolio.  I first added around $19/share during the financial crisis.  That was based on more of a knee-jerk “holy crap that’s cheap and no the world is not ending” analysis.  Subsequently I did a lot more real analysis, after which I added around $24/share, and I added in late 2010 at around $28/share, in March 2011 at around $25.50/share and last Fall around $27/share.  Today the stock is still either: 1) stupid-stupid-stupid-stupid cheap (as in, undervalued by 30% or more); or 2) Windows 8 and everything else is actually going to fail and it is going to go into terminal decline.  You pick.

But first, how did we get here.  Well my original thesis went like this, written on February 20, 2010, though developed before then:

In yet another sign of the insanity of the late 90s, and the myopia of today, MSFT is selling now at about what it sold for twelve years ago! Except now it is vastly more profitable, pays a decent and growing dividend, and has diversified its business somewhat from the Windows/Office core. The dividend is nearly 2%, and growing, and the payout ratio is quite low, leaving significant room for growth. I bought in for the first time at around $19/share during the market bottom, and may add to my position on further weakness. P/E is sub-16. MSFT is the “uncool” tech company now. AAPL is a better company, but shareholders face HUGE risks b/c so much innovation comes from Jobs, who just had a liver transplant and may not be around much longer — look what happened to AAPL the last time he went away.

(Note that I subsequently resolved my worries about Apple, and bought in 2011, late, at $365/share for my first purchases, then again at $390ish in 2011 and again on 4/23/2012 at $570ish, and Apple is now my fourth largest position.  I got rid of the false dichotomy, too, of thinking everything had to be either Apple or Microsoft, or Google or Microsoft, etc.) 

Then on September 28, 2010 I wrote this:

I believe MSFT is, as of today, the most undervalued stock in my portfolio. DCF, assuming an 11.1% [which is too high] weighted average cost of capital, and 3% terminal growth, yields an intrinsic share value of $34. That may be a bit high, but MSFT is worth at least $28 or $28/share, as of today today.

On February 7, 2011 I wrote:

The market appears totally convinced that MSFT is on the verge of losing its Windows and/or Office moat, and/or that growth in that area will be so low that the company will not grow, and/or that MSFT’s failure thus far to get involved meaningfully in the mobile market means it cannot succeed in doing so. I have never seen so much negativity surrounding one company that had not been involved in a major oil spill (XOM shortly before I bought it), major litigation (MO, shortly before I bought it). With MSFT I am just going to have to continue to trust the numbers. Revenues are growing, free cash flow is exploding, margins remain solid, triple-A rating, issues debt at stupendously low rates….I’m going to put this another way: If you assume a discount rate of 12%, which is more conservative than either Morningstar or S&P use when evaluating MSFT, and you assume MSFT will grow free cash flow 5% for ten years (which is less than the previous 10-year average of 6.9% annually, and less than half what MSFT has managed (11+%) since 2007), with 2% perpetuity growth, then counting MSFT’s cash on hand, netting out its debt, the company is worth $34.68/share today, implying a 20% discount. Even if you change the discount rate to 14% it would be undervalued. If at a discount rate of 12% one assumes it can grow FCF simply at 6.9%, which is its average over the last ten years, and is also its recent rate of revenue growth, then the stock is worth $38.35/share, for a 29% discount. This is not rocket science. At a 12% discount rate, even assuming only 2% FCF growth from now until eternity, you would be getting more than a 5% discount by buying MSFT today. Am I smoking something? Seriously, am I just spank out of my mind? What is going on with this stock?

So where are we now?

Well, unless I have totally screwed up my free cash flow spreadsheet, which you can link to and view here (if you ask I’ll give you editing rights so you can look at my formulas and mess with things), Microsoft is still basically priced for Armageddon.  I’m still thinking and saying the same things I was saying a year ago and two years ago.  If you assume a calculated WACC of 9.2% for Microsoft, then to be fairly priced today you have to believe that Microsoft’s free cash flow will basically contract from here on out.  Seriously, play with the sheet.  The numbers are right there.  (That’s assuming free cash flow growth starting from June 2011’s annualized figure, even though June 2012’s, to which we are closer, will be significantly higher.)

If you assume Microsoft can grow its free cash flow by just 4% per year for ten years (which is one third of what it has grown it on annualized rate through the past four years — during the “iPhone Era” I might add), then Microsoft is around 28% undervalued.  (The sheet is presently set up to reflect this assumption.)  Under those assumptions, it is a buy up to about $36.20/share. 

Not only that, dear reader, but to get there there are more conservative assumptions.  In my sheet I discount the $59.3 billion in cash and equivalents on hand by 35% to account for repatriation tax, even though not all of it is held abroad, and no tax may ever be paid even on what is held abroad.  AND I only give MSFT a post-ten-year 1% perpetuity growth rate, which is a population growth rate that is below inflation.  In short, this is a conservative calculation.

What’s going on here?  I suspect people would say (note, I suspect this because they DO say it), that: a) Microsoft is going to go the way of Research in Motion and that b) relatedly, the WACC is too low, whatever the math seems to say, because it’s just not as stable as it seems, and c) Microsoft wastes its free cash flow so you can’t count all of it.

This is where you have to put on your English major and tech analyst hat.  This story doesn’t make sense, or it only makes sense in part.  Yes, there is cash flow wastage.  Bing, et al.  And attempted wastage: failed Yahoo acquisition.  Yes the PC market is mature, and being eroded by the iPad.  But there is a lot of organic growth left to be had around the world.  Microsoft has grown healthily even during the iPhone era so far.  Many businesses have not even upgraded to Windows 7 because they are happy running Windows XP (service for which will shortly be phased out) and have delayed upgrades.  So even if businesses don’t want Windows 8, they’ll be upgrading to Windows 7 for years to come.  And at least at this point Microsoft still has a chance in tablets and phones.  It has expanded its gaming business.  Office is going strong, cloud notwithstanding.  Servers and tools is now something like more than 1/4 (without rechecking) of the company, and growing.

So you have a choice with Microsoft: do you think it’s going to fail?  Or do you think it’s going to be fine, and is stupid cheap?  I very well could be wrong, but I think the latter, and have thought it for two years.  Believe me, I watch the numbers carefully to see if I’m wrong.  I believe that there will be pretty clear signs that Microsoft is truly losing its Windows and Office franchises, if it happens.  But so far, in the two years I have been closely following it (including this past quarter), I have seen nothing to indicate Microsoft is going down.  And I still do not.

On a broader note, I am sick of fads masquerading as themes.  I have been around the block a couple of times by now.  In 1998 tech companies were God.  They were unassailable.  Drug companies were god.  They too were unassailable.  In 1998 Altria/Philip Morris was a turd pile (it crushed the S&P index from then until now, just crushed, including spinoffs).  In 2004-2007 houses were God.  In the 1990s the big thing was for oil companies to merge, and to “vertically integrate.”  Now COP’s split into two companies is hailed as visionary and people want Exxon to do so as well.  Waves and tides, nothing more.  Now, too, the Sophisticated Investing and Blogging Elites think tech is “inherently unstable” and a “no moat industry” and that every company no matter how big is inches away from some tiny competitor blowing them up.  The pace of change is now scary, not exciting.  Anyway, all of this is why most of the tech and drug companies were a crap place to invest in in 1998 (when I was buying Philip Morris), why houses were terrible in 2007 (when I was putting my life savings in a 5% one year FDIC-insured CD) and why, astoundingly, Google, Microsoft, and Apple are all simultaneously some of the most undervalued stocks in the market today.  We need to get rid of the fad and themes, people, and just look at the numbers.

Responding to Howard Lindzon. What will Apple do?

Howard Lindzon is obviously a whale and I’m a flea.  And he’s an intensely admirable whale, as a businessman, investor and blogger.  But Howard posted a blog last night about why Apple should buy Twitter that I think is totally wrongheaded.  The thesis is that dividends would be a horror for Apple (and Jobs, in his grave), and that Apple needs to buy Twitter in order to move “the needle.”  The catalyst for the post is Apple’s already-famous announcement that it will do a press conference tomorrow regarding what it is going to do with its cash horde.  The cash horde is presently at $97 billion-plus, about 60% of which is held overseas.  Here is the quote of Howard’s I find particularly wrong-headed:

As a shareholder I am quite happy that they have never given me the cash. How would I have done better than them to date.

Let me just say I believe the big announcement will be a special dividend, combined with some stock purchases and/or a tiny regular dividend.  But getting back to Howard’s post, I think it’s totally wrong to view the dividend money as an alternative to reinvestment in Apple’s growth at all.  Apple hasn’t grown using Howard’s theoretical dividend money!  Rather, Apple has grown using the money it actually needed to reinvest in its business, and Howard’s theoretical dividend money has been piling up in a savings account (or actually, in short term Treasuries and other cash equivalents)!  

So I think the post is just wrong.  The hatred that growth guys have of dividends simply astounds your humble Dumb Money correspondent.  Apple won’t be admitting that it can’t grow faster or continuously if it gives this money back.  Apple has already admitted that by saving the money up.  The least it can do is return something.  Because do you know what Howard, you probably could do better than Apple is doing in its savings account.

As far as buying Twitter, if Apple’s going to do a purchase, that’s not a bad idea.  But I think it’s questionable whether an investment even in Twitter is likely to generate the return on invested capital that Apple’s reinvestment in its own business does, either.

Howard’s connected, and I’m not.  So maybe he already knows that Apple will buy Twitter.  It would make sense in a way.  After all Microsoft just deployed a lot of its overseas cash horde by buying Skype.  Of course, as far as I know Twitter is actually legally domiciled in San Francisco, as well as headquartered there.  So Apple would not even be able to blow its overseas cash horde without paying full U.S. taxes on it.  Another reason Apple is in my non-expert view unlikely to buy Twitter.

Update:  I drafted this last night, and saved as a draft with the intention of posting today before “the news,” because this was my post for Monday.  And Apple went and announced its news before I could post it seems.  Nevertheless, I was essentially correct in my prediction, minus the special dividend.