windows 7 logoBy Ken Faulkenberry

There is a good debate occurring among value investors about whether Microsoft is a buy or not. In recent articles Jacob Wolinsky wrote “Why I Sold Microsoft”, and Ben Strubel “Why We Still Own Microsoft”. Both articles make well thought out arguments that I completely agree with.

If I were looking at Microsoft as an isolated investment I would side with Jacob’s argument because if I had to bet my retirement on one stock, I would not choose Microsoft. But fortunately that is not the right question. The real question is: should Microsoft be part of a well-diversified portfolio?

As Portfolio Manager of the Arbor Asset Allocation Model Portfolio (AAAMP) I ask the question: If I could find 20 companies such as Microsoft in different sectors and industries, would I buy them all? Yes! In my mind that would be the ultimate equity portfolio!  Company specific or unsystematic risk can be nearly eliminated by diversification. So my job as a value portfolio manager is to find companies with strong balance sheets, generating high cash flow, have reasonably good prospects of these continuing into the future, and whose stock price is low enough to provide a margin of safety.

Despite poor management and many negatives Microsoft is a cash flow money making machine with a solid balance sheet. The negatives and poor management may or may not change in the future. No one is able to predict specific risk. But if I could own 10, 20, or 30 companies with similar prospects, some of them would eliminate the negatives and the stock prices would surprise on the upside. Making positive changes would provide a bonus over and above the assumptions I use when deciding whether to buy a particular stock.

Return on Enterprise Value (ROEV) for Microsoft (MSFT)

Let’s assume Microsoft continues much as it does today, without any change in management. I believe the best stock valuation calculation to value company shares is return on enterprise value (ROEV).

Net Cash Flow   /   Enterprise Value  =  ROEV

Microsoft (MSFT)            25 B        /            164 B            =   15%

Microsoft is earning a 15% rate of return on the market value of the business.  This is the cash flow management has available to reinvest or return to shareholders. A 15% rate of return in combination with a balance sheet such as Microsoft has is very hard to find. Microsoft has a solid balance sheet, rising cash flow, reasonable prospects, and is selling at a price that produces a high rate of return for shareholders.

My argument is, at current valuations, Microsoft should be included in every well diversified portfolio.  Whether an income or growth portfolio, a value or growth investment emphasis; Microsoft is a compelling addition to any portfolio when specific risk is nearly eliminated through portfolio diversification.

(Disclosure:  The Arbor Asset Allocation Model Portfolio (AAAMP) currently holds a 2.2% position in Microsoft.)

Ken Faulkenberry is the owner of the Arbor Investment Planner and AAAMP Blog.