In this crazy market, many high-quality companies are selling at relatively cheap prices. Our favorite: Microsoft. By Whitney Tilson, Contributing Editor and John Heins, Contributing Editor December 10, 2010 Despite many troubling developments around the world, the U.S. stock market has marched merrily upward. From late August through December 9, Standard & Poor’s 500-stock index advanced 18.5%. Yet interest rates have risen materially, notwithstanding the Federal Reserve’s latest round of monetary-policy easing. Since early October, yields on ten-year Treasuries have jumped 34%, to 3.2%. Higher interest rates raise the cost of borrowing, making fixed-income investments more competitive with stocks and usually slowing economic growth.There’s more. The U.S. unemployment rate has climbed to 9.8%. The housing market has worsened, with sales slowing and prices weakening. The European debt crisis has reappeared, requiring a bailout of Ireland and raising new concerns Spain, Italy and Belgium. Last but not least, North Korean military forces shelled South Korea, the world’s 15th-largest economy, raising tensions in one of the world’s most-volatile areas. Two Explanations Had you told us that all of these things would occur in recent months, we would have confidently predicted lower stock prices. So what explains the market’s glad tidings? We believe there are two answers: fundamentals and froth. Advertisement Although unemployment remains a vexing problem, corporate earnings have been strong and the overall economy is showing some signs of life. That said, the data remains mixed and we still think the most likely scenario is that the economy will muddle through for several years, with growth at a weak annual rate of 1% to 2%, a stubbornly high unemployment rate of 7% to 9%, and continued high government deficits. Based on historical precedent, the stock market under this scenario would likely return no better than 2% to 5% annually. We believe that leaves froth as the biggest driver of the market’s recent surge. By froth, we mean a burst of unfounded optimism triggered by a don’t-fight-the-Fed mentality and a frenzied enthusiasm for companies showing high growth, whose stocks have soared irrespective of valuation. Our advice: Don’t be enticed into a sucker’s game of chasing the hottest stocks, and instead invest in high-quality, blue-chip companies with global businesses, powerful brands and market positions, strong cash flows, rock-solid balance sheets and healthy dividends. Normally, you have to pay a rich price for such high-quality businesses, but today quality is on sale. We can’t explain why, but are happy to take advantage of it. As of early December, six of our nine largest positions -- all of which we’ve written about in previous columns -- fall into this category: Anheuser-Busch InBev (BUD, $57.20), Automatic Data Processing (ADP, $46.53), Berkshire Hathaway (BRK.B, $80.49), BP (BP, $42.79), Kraft Foods (KFT, $31.09) and Microsoft (MSFT, $27.08). Advertisement If we were to choose one favorite today, it would be Microsoft. The consensus among most investors is that Microsoft is a lumbering dinosaur, which like newspapers, check printers and paging companies before it, is on the wrong side of technological advances that will relegate it to the dustbin of history. The problem with this view is that there is no evidence for it. Microsoft’s market share in its various businesses is stable or rising. Driven by strong results in each of its key businesses -- the Windows operating system, Office software and the server and tools division -- revenues in the quarter that ended September 30 were up 13% from the year-earlier period, while earnings per share rose 19% (adjusted for the deferral of Windows 7 revenues in the September 2009 quarter). At its current price, Microsoft shares -- after deducting the $3.85 in net cash on the company’s balance sheet -- are available at a net cost of about $27.08. At that price, the stock trades at just 12 times the previous 12 months’ earnings of $2.32 per share. This for a dominant company with prospective percentage earnings growth in the mid teens, 31% net profit margins and one of the strongest balance sheets in the world. In a stock market that is exhibiting signs of irrational exuberance, Microsoft’s shares are insanely cheap.