going ex-growth

What happens when a growth stock goes ex-growth.  Nothing good.

Owners of a stock like this face two issues:

–the share is doubtless trading at a very high relative price-earnings multiple, based on Wall Street expectations that its superior track record of profit expansion will continue.  Not only that, growth stocks often experience a kind of buying frenzy at the peak of their popularity that pushes the multiple way above the level the stock would deserve, even if investor expectations could be met.

–growth investors lose interest, leaving value investors as the only possible buyers.  But, as we saw yesterday, value investors are attracted only to issues that have been all beaten up and tossed onto Wall Street’s scrap heap.  Like famous relief pitcher Sparky Lyle, former growth stocks must go “from Cy Young to sayonara” –or from living in the penthouse to sleeping in a doorway in the alley–before they attract much investor support.

This process of price earnings multiple “compression” or “derating” normally takes a very long time.  I don’t understand why.  Maybe it’s confirmation bias–that people see only what they want to see.  In any event, it happens.  The first half of the 1970s, before I entered the market, were characterized by the rise of a small number of stocks, like Xerox, Polaroid or (my favorite) National Lead, that were believed to be able to grow at high rates forever.  They were called “one decision” stocks–no need to sell ever.  Many of these issues traded at 90x-100x earnings in an overall market that was selling at around 12x.

In the case of the “Nifty Fifty”, it took from 1975 to 1984 for the excesses to be wrung out of the majority of these stocks.  Of course, we need only to look at the aftermath of the Internet bubble of a decade ago to see the same process play out again, although this time it “only” took 2 1/2 years.

INTC and MSFT–APPL, too

…which brings us to the topic of INTC and MSFT, two titans of the personal computer era, and how to evaluate them today.  I’m tossing in AAPL, as well, although that firm was doomed by a series of strategic missteps by a younger Steve Jobs, to remain a bit player in the PC world.

the performance record

All three stocks hit a peak in early 2000.  From April of that year to now, their stock performance is as follows:

S&P 500          +.5%

MSFT          -41.8%

INTC          -66.2%

AAPL          +963%

From the market bottom in early 2003:

S&P 500          +55.9%

MSFT          +23.8%

INTC          +36.6%

AAPL          +2007%

From the market bottom in March 2009:

S&P 500          +98.5%

MSFT          +68.9%

INTC          87.2%  (including a 15% rise in the past couple of weeks)

AAPL          +308%.

valuations:  2000 vs. now

At the top in 2000, the S&P 500 traded at 27x earnings of $56.18; now it is trading at 13x earnings of $100.  eps growth, 2000-2011 = 78%.

At the top in 2000, INTC traded at 36x earnings of 1.53;  now it is trading at 9x earnings of $2.50.  eps growth = 63%.

At the top in 2000, MSFT traded at 68x earnings of $.85;  now it is trading at 10x earnings of $2.50.  eps growth = 194%.

At the top in 2000, AAPL traded at 30x earnings of $.85; now it is trading at 14x earnings of $25.  eps growth = 28x.

Looking at MSFT and INTC shares:

MSFT:  the obvious factor is that the stock’s relative PE has been crushed.  During much of the 1990s, the company was growing earnings at a 50% annual clip.  During the past decade, it has barely managed to get into double digits.  That’s better than the overall US economy and the S&P did over the same period, but still represents a sharp departure from the past.  One might also argue that MSFT’s numbers are flattered by the recent launches of Windows 7 and Office 2010, which together have added about $1 a share to eps.  What comes next?

INTC:  it took INTC until 2010 to surpass its earnings peak of 2000.  Yes, the PE has been flattened and the company trades at at about 2/3 of the market multiple, but earnings growth has been sub-par until recently.  The big change for INTC, to my mind, is new management that is focused on building what customers want rather than on what its engineers can create.

which to buy?

Here’s where ideology comes in.

On a PE basis, INTC is a little cheaper.

But, to my mind, MSFT has a far superior operating model.  Relative earnings growth vs. INTC over any time period shows this.  MSFT has had a stranglehold on the personal computer operating system and productivity program businesses for over two decades.  There are few signs of this changing, since so many corporate IT systems are built on MSFT products.  Unlike INTC, MSFT has little need for capital.  And, again to my mind, because AAPL’s Office-like products are so bad, MSFT faces less competition in this arena than INTC does vs. AMD.

On the other hand, MSFT appears rudderless.  It hasn’t had a new product success in at least a decade.  And I see no signs MSFT is wiling to adapt itself to a changing environment.

INTC, in contrast, faces serious competition from ARMH.  But INTC seems to me to understand the need to recast the way it operates and is changing itself as quickly as it can.

If I could choose one of the two to own 100% of myself, there’s no question I’d pick MSFT.   So it seems to me that if I were a “no catalyst” value investor, that’s the stock I’d choose.

But, as it turns out, I’m a catalyst-for-change kind of guy.   I own INTC and not MSFT.  Why?  It isn’t the lower PE.  It’s the catalyst that I see in the current INTC management and that I don’t detect with MSFT.

a footnote on AAPL

How does AAPL fit into this discussion?  In a sense, it doesn’t, because AAPL is clearly a growth stock.  Over the past two years, however, the AAPL PE has contracted from about 30 to the current 14.  In fact, if you subtract AAPL’s $50+ billion in cash from the market capitalization, AAPL is trading at a sub-market multiple of under 12.  The stock is being priced almost as if the company had already gone ex-growth, which it clearly has not.  I can’t recall ever having seen a true growth stock act this way.