Apple is just not cheap enough for us to take the risk that its long string of successes will remain unbroken. By Whitney Tilson, Contributing Editor and John Heins, Contributing Editor February 9, 2011 Editor's note: Kiplinger.com readers are getting a sneak peek at this column, scheduled to appear in the April 2011 issue of Kiplinger's Personal Finance. One of the toughest calls we have to make as value investors is how much weight to assign a stock’s price relative to the underlying company’s growth potential. Pay too much, and even stocks of the best companies can turn out to be clunkers. If, say, you had paid $70 for a share of Cisco Systems (symbol CSCO) in mid 2000, you would have lost 70% of your money to date, even though the company’s earnings per share have quadrupled. How is that possible? Simple: In 2000, the stock traded at 194 times the previous 12 months’ earnings. Today, it sells for 16 times trailing earnings. On the other hand, an inferior business selling at a cheap price can be a value trap -- a stock that appears inexpensive year after year but goes nowhere or declines as the business fades (think newspaper publishers and check printers). Having had plenty of unfortunate experiences with value traps, we have shifted away from a price-is-all-that-matters mentality. We’ve noticed a similar evolution among many accomplished investors. For example, when we interviewed legendary hedge-fund manager Julian Robertson for our Value Investor Insight newsletter, he told us that his concept of value had changed over time. While he once focused solely on stocks with low price-earnings ratios and other traditional measures of value, he now takes a more flexible approach that balances valuation and a company’s expected growth. "Something at 30 times earnings growing at 25% per year – assuming I have confidence it will grow at that rate for some time – can be much cheaper than something at seven times earnings growing at 3%." One example of this price-versus-growth dilemma -- about which we’ve been 100% wrong -- involves the relative investment merits of Apple (AAPL) and Microsoft (MSFT). With everything it touches seemingly turning to gold, Apple has seen its revenues increase by more than 35% annually over the past five years. Meanwhile, its net income has grown an astonishing 60% per year. Investors with greater foresight than ours have been amply rewarded. Apple shares, which traded in the mid $60s five years ago, now go for $351.88 (all share prices and related data are through February 7). Advertisement Microsoft, on the other hand, has been more of a value trap. While its earnings have grown a respectable 9% annually over the past five years, its stock, at $28.20, has scarcely budged. Although Microsoft’s shares have appeared “cheaper” than Apple’s for some time based on traditional measures of value, we now know that Apple was the true bargain. So which investment do we favor today? While hardly the popular pick, we’re sticking with Microsoft, in large part because of the inherent protection we believe the stock’s rock-bottom valuation provides. The company’s enterprise value (its market capitalization plus debt outstanding, less $4.85 per share in cash and investments on the balance sheet) is just over $23 per share—or only ten times the $2.35 per share that Microsoft earned in the 2010 calendar year. That is dirt-cheap for a company that seems to be firing on all cylinders, with sales growth in the October-December quarter of 15% (from the same quarter in 2009) and earnings-per-share growth of nearly 30%. Subtracting Apple’s cash and investments of $60 billion, or about $64 a share, its stock trades at a bit more than 16 times the $17.91 per share it earned in calendar year 2010. That’s about the same as the overall stock market’s price-earnings ratio. So while Apple shares are not expensive, they’re not cheap, either. (For another take, see Apple: The Core of Every Portfolio?) It boils down to this: We hesitate to pull the trigger on Apple because it’s just not inexpensive enough to take the risk that its long string of successes will remain unbroken. Were it to disappoint, the market would likely be unsparing in its punishment. With Microsoft, expectations are so low that it’s far more likely to deliver pleasant surprises than disappointing ones, and that is something that should be of great comfort to its shareholders.