True Blue Value -- IBM vs. MSFT
*Graham and Doddsville Revisited* -- "The Intelligent Investor in the
21st Century" (5/12/98)
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"The underlying principles of sound investment should not alter from
decade to decade, but the application of these principles must be
adapted to significant changes in the financial mechanisms and
climate." (Benjamin Graham)
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A reader, reacting to our preference for IBM over MSFT, writes:
"Let's look at this from the other side of the fence. MSFT sinks
significant money into investments to hide cash from taxes in the
form of R&D, Marketing, Acquisitions, etc. This serves to reduce
net cash flow if the cash flows are not calculated from properly
reconciled net income.
"MSFT's investments are also several times more profitable than
IBM's. For instance, look at the investment in Win 95, Win NT, and
Office development and marketing. Compare this to IBM's investment
in Lotus Development and the consistent tax free dividends (share
buy backs). Which has produced more value? The difference is
significant. A major reason IBM purchases so many shares is
because they can not find any investments that can clear their
cost of capital requirement in order to create value. When in
doubt, you can always make an investment at or near the cost of
capital, the repurchasing of your equity and refinancing of your
debt. The problem is there is but so much capital to repurchase,
and the environment is growing like a weed. This money should go
into active investments like performed by MSFT and Dell Computer,
two direct competitors of IBM in the same industries as IBM."
and, a little later:
"... IBM is investing significant money into share buy backs in
the midst of a paradigm shift while their major competitors (and
the market in general) are reaping windfall revenue AND profit
growth during a paradigm shift/tornado. The share buy backs are a
ruse for management that cannot find anything better to do
with the money."
Our view is that the above comment confutes the meaning of the word
"ruse", which means a "trick", with that of the word "value", which
means, a "fair return".
$24 billion in share buy backs is not a"ruse". It's a way to return
their money to those shareholders who want to cash out, and at the
same timeto increase the equity stake of the remaining shareholders.
Further, IBM has paid dividends to its shareholders in every year
since 1916. In the words of Janet Lowe, "Dividends Don't Lie."
IBM is no longer the growth stock it once was. And, given its size,
it probably won't ever again grow by leaps and bounds. On the other
hand, it is, and is likely to continue to be, a reliable source of
shareholder value in an increasingly frothy Market.
Jim Griffin, investment strategist and chief economist at Aeltus
Investment Management, puts it this way: "IBM is a technology name
that isn't selling at an Internet multiple. To the contrary it's
selling near a market multiple and looks like a value stock. The
company's got great breadth in products, an excellent
computer-services business and good cost controls." (Barron's,
5/11/98, p. 38.)
In other words, IBM is a like one-company technology mutual fund,
with a lower p/e, more tax efficiency, and without a 2% annual management fee.
By contrast, MSFT has never returned a penny to it shareholders. But,
it uses half of what it reports as cash flow to enrich management
(off-income-statement), as revealed by Martin Sosnoff, chief
investment officer of Atalanta/Sosnoff Capital (see:
www4.techstocks.com, and then
engages in the ruse, of buying back shares to make it appear as
if shareholder value had not been diluted.
The London-based economic consulting firm, Smithers & Co., has
calculated that in 1996, a year in which MSFT reported a profit of
close to $3 billion, MSFT actually lost $10 billion dollars enriching
its employees. (See:
forbes.com
Readers who are wondering how this is possible can find out by reading
Wayne Crimi's excellent presentation on the subject in his General
Market View of 3/13/98 at members.aol.com.
By any calculation, MSFT's p/e is actually well over 100. There is no
company of MSFT's size for which a p/e of that magnitude can be
justified, on a value basis. Further, MSFT's p/e keeps expanding
while its growth keeps slowing, as is the case for the stock market
generally, a guaranteed formula for eventual carnage for those stocks
that cannot deliver the growth their p/e's would imply.
As for "management that cannot find anything better to do with the
money", all 4 of the Dow Value Portfolio choices (AT&T, BA, GM and
IBM), as well as many other large cap companies, learned their lesson
in the "empire building" years of the 1960's through the 1980's. AT&T
and GM tried to become computer companies, IBM tried to become a phone
company, and Boeing, at one time or another, spent shareholder money
on making hydrofoils, windmills, buses, and even home furniture.
All of them learned, at great cost, that the most economically
rational (as well as the most ethical) thing "to do with the money"
that can't be profitability employed in expanding their core
business is to return it to their shareholders.
MSFT is a Greek Tragedy in the making. It is not an exaggeration to
describe Bill Gates as a hero of this era, who took a gadget for nerds
in computer clubs, and put it on the desktop of virtually every white
collar worker in America. But, like a classical tragic hero, he has a
fatal flaw. In his case, it is a complete blind spot for political
reality.
It is one thing to stick a thumb in the eye of IBM. It is another to,
in the first instance, publicly tell Sen. Orin Hatch you are too busy
to testify before his committee. IBM lacks the power of subpoena.
Orin Hatch does not.
MSFT gained its preeminence over home and corporate desktops
through a lot of pluck, and, perhaps, a wee bit of luck. But,
there is absolutely no possibility that the government will stand
idly by and allow MSFT to use its dominance of desktops as leverage
to gain dominance over the Internet, E-commerce, HDTV, Cable TV,
etc. The pluck is now only provoking greater political opposition. And, luck has a way of abandoning those who would defy the gods of
the Capitol.
MSFT has stunned legal experts with its original public position,
somewhat tempered since, that the Federal District Court judge in its
case "doesn't get it". MSFT apparently did not get it that Federal
judges can order a marshall to arrest the President of the United
States. Prudence, and common sense, suggest that it is unwise to hold
such a person up to public ridicule, especially one who is presiding
over a case in which you are the defendant.
MSFT controls one state politically -- the state of Washington.
MSFT's competitors can deliver significant political capital in the
other 49. The 13 states attorneys general who now have MSFT in their
cross hairs are the same ones who have already scored a fresh kill
with the tobacco companies. They smell blood, and they are not going
away.
MSFT is being run as a piggy bank for its employees and a springboard
for its founder's ambitions, not as a source of Intrinsic Value for
its shareholders.
Caution: Rough Seas Ahead.
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Graham and Doddsville Revisited
Editor: Reynolds Russell, Registered Investment Advisor
web.idirect.com
Web Site Development/Design: ariana <brla@earthlink.net>
Consultants: Axel Gunderson, Wayne Crimi, Bernard F. O'Rourke,
Allen Wolovsky
In addition to editing *GADR*, Reynolds Russell offers investment
advisory services. His goal is to provide total returns in excess
of those produced by the S&P 500.
His investment strategy applies the principles of Value Investing
established by Benjamin Graham to the circumstances of today's
economy and securities markets.
For further information, reply via e-mail to: gadr@nyct.net
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"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham)
(C) Reynolds Russell 1998.
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