Sage Investment Club

lcva2 Return to Shareholders/Capital Allocation Capital allocation decisions by CEOs and the rest of the C-Suite executives have an enormous impact on the long-term value of the corporation. Companies can allocate capital by returning money to shareholders or using the money to grow the business. Our Risk forecast integrates dividends, share purchases, share issuance, and operations growth. However, we pay special attention to it here because Microsoft’s (NASDAQ:MSFT) recent trend of decreasing yields may be cause for concern. Microsoft’s return to shareholders has decreased from a high of almost 7% in 2008 to what is now only 1.6%. While the dividend yield of over 3% in 2014 likely attracted many dividend investors, the yield has now dropped to less than 1%. Authors Image from Financial Modeling Prep DataShould Microsoft grow operations or return value to shareholders through dividends and share repurchases? The answer to this requires an informed guess on earnings growth since earnings should only be reinvested if they can be expected to earn high returns. Microsoft’s fast growth days are not over. Unfortunately, Windows, Xbox, and Office have such massive market penetration and little room for continued growth remains in these segments. However, when we look at management’s discussion of performance on their last 10K submitted to the SEC we see four high growth segments. Microsoft Cloud, Azure, LinkedIn, and Microsoft cloud services all grew by over 30% last year. Can that continue? Aren’t Amazon Web Services (AWS), Google Cloud, and Oracle Cloud Infrastructure (OCI) fierce competition? While OCI has a niche with Exadata, we will leave that for another article. The rest are destined to become commodities with Azure a standout differentiator. Why Microsoft is the Future Now, in full disclosure I am a fan of Amazon Web Services (AWS) over Azure. Both offerings are remarkably similar in cost and services provided. AWS is just simpler to learn because it has better documentation. Ever click that Help button on an MS Office product? Did it help? Azure’s documentation is not much better. The thing is data science geeks, like me, are taking another look. Microsoft may just be the future of Artificial Intelligence (AI). If you have not heard of ChatGPT try it and ask it a question, then ask a follow up. Trust me, you will be amazed. It is an AI based on a Large Language Model that just passed a practice online bar exam, so it is smart enough to be a lawyer. Ok, before you slay me in the comments, I did not say good lawyer. Highly qualified computer programmers are even referring to it as a computer programmer. You can ask it to write code, then fix and adjust the code it previously wrote. The geniuses at OpenAI have many other groundbreaking successes as well and can be expected to continue to deliver. That’s great you say but what does it have to do with Microsoft? Microsoft is one of the largest funders of OpenAI. This undoubtedly gives Microsoft privileged access to the engineers at OpenAI enabling them to be first to market derivative products. Microsoft has already announced it is preparing to launch a version of Bing Search relying on ChatGPT. You may know about ChatGPT already, but do you know that Microsoft owns GitHub and already released GitHub Copilot in collaboration with OpenAI? When GitHub released Copilot in June of 2022 software developer threads exploded with concerns developers would lose their jobs. It is more useful as an augmentation to a current developer, but still, seriously game changing. Microsoft, through OpenAI, has changed the game again. I see a likely future where entire business systems migrate to Azure because it integrates ChatGPT based systems that can augment their staff. This goes beyond chat bots and call centers. ChatGPT can augment development teams and other professional experts like lawyers. If a business can get the performance of a junior staff member for only $10 a month, how many businesses will leave AWS for Azure? Where will that leave Amazon (AMZN)? GPT-3, Amazon Lex, and AWS chatbot appear to be competitors Amazon can leverage. They are not competitors. It is like comparing Amazon Alexa with the computer on Star Trek. These tools are not in the same league. With these long-term headwinds and Amazons current trouble with decreasing revenue and earnings forecasts I am dropping my rating of Amazon to a sell and am pushing that position into Microsoft over the next few weeks. The question remains, can Microsoft return to high growth? Growth Potential Warren Buffett uses unleveraged net tangible assets to determine what he calls the long-term economic prospects of a business. His logic is simple, increasing earnings without major capital requirements is a better business to be in. It takes money to make money, but you want it to take as little money as possible. The following chart shows Microsoft with the rest of the companies in the S&P 500 for context. The blue shaded area here shows the distribution of all other companies in the S&P 500 since 2003. Microsoft (MSFT) is way up at the top above 85th percentile. Authors Image from Financial Modeling Prep DataAt a Return on Unleveraged Net Tangible Assets of 14% Microsoft is well above the rest of the S&P 500 which averages around 6%. Great companies have extremely high Returns on Net Tangible Assets and show up above the blue region in the chart above. This group is great because they can grow fast. Microsoft is clearly in the great growth category. What is more, the company has been able to return to this category after a 7 year stay in the ‘better than most, but not great’ light blue region between 2013 and 2020. Risk Reward Forecast I always run my portfolio through a Risk Forecast to determine what the numbers say. This is not based on any settings I have made due to my clearly bullish take on Microsoft’s future. My AI generates predictions based on past data and future forecasts from analysts at major brokerage houses. The below chart is a prediction of value at risk and potential return of holding Microsoft stock. As shown by the blue intrinsic value region in the chart below, Microsoft is below any level of intrinsic value it has traded at since 2013. If 2023-2030 works out as well as 2013-2020 we will all be incredibly happy with our returns. Authors Image from Financial Modeling Prep DataMicrosoft now has a value at risk of only 15 percent based on historic short-term volatility. With a central forecast of $399.80 potential yearly returns are as high as 39%. This is a very favorable risk reward profile. In the case of Microsoft, we use historic data on earnings and revenue to train a series of machine learning algorithms to create a forecast of price risk. The blue bands represent the predicted intrinsic value of the company with the actual price data shown against the prediction. The grey forecast line shows how the price of$239.82 at the time of forecast relates to the forecasted intrinsic value of the company. The algorithms are dependable for predicting long term price movement, but price will go outside the blue bands. Those bands are only there to show you where the price should be 90% of the time. This forecast, and forecasts for other stocks as well, tend to lag price when it goes down and lead when it goes up. This makes it useful to determine risk in a stock, but it is less dependable for market timing. That said, I am unaware of any market timing schemes that stand up to robust analysis. Final Word Microsoft may be ready to grow rapidly again. Investments in Artificial Intelligence through open AI are beginning to lead to revenue growth and may be the catalyst for renewed growth. Minor decreases in earnings growth have occurred, but most mature technology companies have seen similar reductions. This decrease in growth has caused share prices to fall, and now Microsoft shares trade at value prices. All Microsoft needs to do to deliver reasonable returns is to grow revenue and earnings in line with current analyst estimates. All this results in minimal risk with the potential for high returns.

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