December 27, 2011
You are saying that unusually high profit margins are holding up valuations right now, and that eventually there will be a reversion to the mean. But can't profit margins stay at a high level for a long period of time, just as you said that P/E multiples can remain in a low range for a long period of time? Can't this reversion to the mean occur over a protracted period?
Profit margins usually can’t hang in there as long as P/Es – just a few years. Because when one company starts making abnormal profits, competition comes in and erodes those profits.
Let me give you this example. Apple made terrific iPhone and iPads. Several years later, there is now a lot of new competition that has introduced products that are almost as good, or products that are not as good but are much lower-priced (such as Kindle Fire). And guess what? At some point, Apple, to be competitive, is going to have to lower its prices; and therefore its profit margins, which are at their highest level ever, will have to decline.
The same thing applies for the economy as a whole, with some exceptions. There are some industries that can maintain high margins for a long period of time. But for the economy overall, competition either forces lower prices or offers products or services that have more features for the same price, and in the end profit margins decline.
Why don't we turn to one of your stock selections. I saw you wrote recently that Microsoft is a company you like. It is also one of Seth Klarman’s holdings. How can it be that a stock as prominent as that, which is followed by as many analysts as it is, can offer the margin of safety that a value investor like you would require?
That’s what is interesting. If I gave you Microsoft’s financial statements and I didn't tell you what company it was, you would say it was an incredible business. The company has more than doubled its earnings over the last five years and has a huge, cash-rich balance sheet, an enormous return-on-capital of nearly 40%, enormous cash-flow generation, and a near-monopoly in a lot of businesses where it operates.
Then you look at the stock price and you say, “Huh, this company hasn't gone anywhere for the last 12 years.” Microsoft, to some degree, is a very typical sideways-market stock. Its P/E was extremely high and its earnings were very high at the end of the last bull market, and its P/E collapsed. Its P/E was 50; and now, if you take out cash, it is at about 6.5 to 7 times earnings. There is a psychological element, where people look at the stock price and are fatigued by the nonperformance of the stock.
But there is another element that is very specific to Microsoft. Even if you take the sideways market psychology into consideration, this company should not be trading at this valuation. Wall Street lost confidence in the company's management. Microsoft’s business was so good that it was able to grow earnings on autopilot.
There is a lot more competition now, like Google and Apple. They are very strong financially. They're dominating their main markets.
The market is saying Microsoft is going to become a dinosaur. It's going to decline into obsolescence. This is where Klarman and I disagree with the consensus.
Look at Windows Vista; it was a horrible product. But it was still a financial success, because Microsoft had a monopoly. Then Windows 7 took over from Windows Vista and fixed it. Windows 7 was not an innovative product, but it was a good solid product.
Then, a few months ago, Microsoft showed Windows 8, which is going to come out next year. This was the first time I looked at a Microsoft product and said “Wow!” It was created by a company that is paranoid about competition, not something that Microsoft ever was before. It is a very good product that is going to work not only on PCs and laptops but also on tablets, which is very important, because tablets are the piece that Microsoft was missing.
Apple and Google were attacking Microsoft on the tablet front, and Microsoft did not have a product. Microsoft used to sell Windows for Netbooks, which were underpowered laptops. That category of products is gone. Microsoft is going to have a very solid product with which to compete against Apple and Google next year.
What are your thoughts on the new partnership between Microsoft and Nokia?
What I really like is that Microsoft did something uncharacteristic of itself. It did not go out and buy a company, but created an alliance with a company that was extremely desperate for an alliance – Nokia. Nokia was always great at making cell phones and hardware. But when the smart phones came around, Nokia could not come up with good operating-system software.
Then Nokia’s new CEO, who came from Microsoft, struck a deal by which Nokia is going to bet its future on Microsoft software. All the smart phones that Nokia is going to make in the future will be based on Microsoft Windows. Nokia came out with its first smart phone a few months ago in Europe, and it has received great reviews.
What is important about Nokia and Microsoft together is that to be successful in this market you have to have the marriage of hardware and software. That's why the companies are working together on developing software.
Microsoft says its Nokia alliance is going to be an accelerator. It is going to allow them to bring cellphones to the market very quickly. Nokia still has a very good brand name in Europe, and it has a tremendous distribution network.
Finally, you have a new trend that the media will be making a huge deal over the next three to six month: ultrabooks. They are thin, beautiful, powerful laptops. Basically, Intel did something brilliant; it trademarked the term ultrabook. They are going to spend a couple hundred million dollars promoting the brand. If you are a PC-maker, and you want to make an ultrabook, it will have to meet very specific criteria that Intel has spelled out: It has to be light, have a solid-state drive, a fast boot time, and a long battery life.
You are already seeing these ultrabooks hitting the stores, and we are going to see a lot more of them. Right now they are expensive, but the price will come down soon. They are going to make Windows products sexy again.
Now you have a company – Microsoft – that's actually doing smart things, and its stock price is incredibly cheap. It has a terrific balance sheet that is still based on a monopoly, for the most part. And you can buy it at one-third the multiple of the market. It’s a no-brainer.
That's why Seth Klarman owns it, and we own it, too.
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