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 (opens in new tab)) in mid 2000, you would have lost 73% 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 14 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 but goes nowhere or declines as the business fades (think newspaper publishers and check printers).
New thinking. 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: "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%."
The relative merits of Apple (AAPL (opens in new tab)) and Microsoft (MSFT (opens in new tab)) provide one example of this price-versus-growth dilemma (and illustrate an investment call we've gotten 100% wrong). 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 at 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 $357 (all share prices and related data are through February 11).
Microsoft, on the other hand, has been more of a value trap. Earnings have grown a respectable 9% annually over the past five years, but the stock, at $27, 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 stock do we favor today? While hardly the popular pick, we're sticking with Microsoft, in large part because of the 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 2010. 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% 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 P/E. So while Apple shares are not expensive, they're not cheap, either (for another take, see Apple: A Slice 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.
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