Rogue Missives Monday,  March 31, 1997

If there was one company that captures the paradoxical nature of a bull market, MICROSOFT <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> would be it. No other company dominates its marketplace as Microsoft does. The Redmond, Washington-based software manufacturer supplies the operating systems for more than 90% of computers on the market today. Its word-processing and spreadsheet programs are consumer favorites. In the last year, Windows NT, the company's challenge to Novell's corporate networking software, has seized a sizable share of the market. And a year and a half ago Microsoft awoke from its slumber with regard to the Internet and made strong inroads into the navigation software market.

In 1996, the company, to put it simply, hit on all cylinders. Barring some unforeseen revolution in everyday life -- along the lines of the abolition of electricity -- it's hard to see what real obstacles Microsoft will face in the near future.

Given all of this, the precipitous rise in Microsoft's stock price over the past year -- from a split-adjusted price near $50 to over $100 as late as two weeks ago -- might seem fully justified. After all, what company has better long-term prospects than Microsoft? What company has delivered the goods in terms of earnings and revenue growth with such unnerving regularity over the last decade? What company of its size dominates a market with the growth potential that computers continue to offer?

Yet, when one considers that Microsoft's stock, even with its recent 10-point drop, some hesitation might seem to be in order. The stock trades at a price-to-earnings ratio of around 50 -- well more than twice that of INTEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %> and similar to the P/Es of growth stocks like CISCO <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %> and ASCEND <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ASND)") else Response.Write("(Nasdaq: ASND)") end if %>. Does Microsoft, a company with sales totaling less than $10 billion in 1996, deserve a market capitalization of over $100 billion? (The company's market cap routinely fluctuates $3-$4 billion in the course of a day's trading.)

When it comes to this kind of valuation, it seems clear that we're dealing with something more than just investing by the numbers. What we're dealing with might be better thought of as a cultural phenomenon. Microsoft is valued as highly as it is as much because of what it represents as because of its balance sheet. The company's market cap is a testament to people's faith in the future of the industry, and indeed of the stock market as a whole, as well as, of course, a testament to people's faith in Bill Gates.

This faith is not, of course, a perfect one. The recent flight of investors from Microsoft shows that the company cannot always win the hearts of everyone. This flight seems to have been impelled by more general concerns about overvaluation in the market, than it has by any pessimism about Microsoft itself. The only specters lurking on the Redmond giant's horizon are the ever-recurring concerns about the company's ability to deliver a crucial product on time -- in this case the sequel to Windows 95. Still, no company in this decade has offered as potent a combination of security and explosive returns. While there have certainly been sharp downturns in the stock's price, those downturns have been uniformly short-lived. Seen from a long-term perspective, in the 1990s investing in Microsoft has been almost all reward and very little risk.

Of course, not everyone has believed that buying Microsoft was a no-brainer for investors, nor has owning Microsoft necessarily made people impervious to doubt. The stock has traditionally been heavily shorted. And the recent bull market has certainly brought momentum players in who are less interested in fundamentals than others might be. Analyst Mike Wallace of UBS Securities said of this week's drop: "It's an expensive stock, and whenever you get a whiff of bad news it's going to behave like this." Friday's "Heard on the Street" column in The Wall Street Journal, meanwhile, showcased a number of analysts who think the stock is overvalued, primarily because they believe its P/E is unjustifiable given an inevitable slowing of earnings growth. The comments of David Katz, chief investment officer of a fund management firm, can be taken as emblematic: "Microsoft is a great company that dominates its industry, but at some point, they're going to slow down. It could be similar to Wal-Mart five years ago. Wal-Mart was the dominant force in the retail sector. The stock was acting as if the company were going to continue that growth ad infinitum."

One of the reasons to think about Microsoft as a cultural phenomenon as much as a straight financial investment is that the stock's performance in the 1990s reveals the arbitrariness of formulas like the simple: "A company's P/E ratio should be equal to its rate of earnings growth over the next five years." (Why not 1.2 or 1.5 or 0.8 times the rate of earnings growth?) Investors looking at Microsoft see a company that has had sterling profits year after year, that continues to grow at an impressive pace -- albeit not at a 50% clip -- and that has an unequaled aura of dominance. If everyone else is willing to give the stock's price a slight premium based on these factors, it's hard to find a compelling rationale to sell it.

Even if we accept that some version of the P/E to earnings growth ratio is appropriate, it's far from clear that the bears are on the right side of the numbers. The history of Microsoft in the 1990s, after all, is one of predictions of slower growth. As early as 1991, Newsweek suggested: "Gates may be the old cliche: a victim of his own success." In December 1992, Fortune confidently predicted: "[T]he company's sales and profits won't continue to rise at such a consistently explosive pace." And in 1993, Bill Gates himself insisted: "I've always said our profit margins will be going down to more normal levels soon."

The logic behind these predictions argues that the larger a company grows, the harder it is for it to grow faster. While the mainstream press often describes this as the law of diminishing returns, it's more accurately described as the law of deepening capital. In other words, as a company becomes bigger, it takes proportionately more investment to increase sales. Profits can rise, but at a significantly slower rate. So, in 1995, Net guru John Perry Barlow, in typically purple language, argued: "Microsoft is about to become a climax ecosystem. Neither the company nor its software can grow any larger without collapse." U.S. News and World Report made the same point a bit more clinically: "[B]oth revenues and the bottom line have gotten so huge... that even 20% annual gains will be hard to come by."

What's striking about Microsoft's performance is that while earnings growth did slow substantially between 1992 (when profits rose at a 42% clip) and 1994 (when they rose just 23%), over the last two years MSFT has actually grown faster than it had in the previous two. In 1995 earnings were up 30%, and in 1996 they rose at a remarkable 45% clip. Obviously, the key variables were the introduction of Windows 95 and the emergence of Windows NT as a key player in the networking field. As it has grown bigger, in other words, Microsoft has grown faster.

As a comparison, consider IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %>, which in many ways Microsoft has replaced as the bellwether of the computer industry. Over the last decade, as it has tried to reinvent itself, IBM's revenues have risen 40%. Its profits, though, have risen just 3.2%. This happened even as IBM has been shedding jobs like a dog in the summer time. Apocalyptic predictions of Microsoft's eventual demise always include a phrase like: "Remember what happened to IBM." But while Big Blue illustrates just how the deepening of capital works, Microsoft seems to be operating on a different playing field.

Some have argued, in fact, that Microsoft is an object lesson in what economist W. Brian Arthur of Stanford University calls the law of increasing returns. Arthur is interested in the way certain technologies -- the best example being the QWERTY keyboard -- become marketplace titans even though they have no obvious qualitative advantage that would impede competitors. For Arthur, there's a kind of tipping point after which it becomes next to impossible to dislodge the industry standard. Once enough people bought Windows 3.0, then, IBM's OS/2 was doomed. And Windows 95 -- and Memphis, the next version -- were guaranteed a sizable market share. As Arthur puts it, in what seems like a very simple formulation but is actually quite profound in its implications for competitive theory, "The more people use your product, the more advantage you have..."

So, when people suggest that Microsoft's future depends upon people continually upgrading their software, this should hardly be taken as a problem. (Gates himself, in fact, speaks in similar terms about the company.) If Arthur is right, then Microsoft has an almost insuperable advantage in competing for that upgrade market. In fact, Microsoft probably even has a competitive advantage in competing for upgrades for people currently using non-MSFT software. Eventually, one might say, we'll all be using Windows and Word.

Microsoft has also been able to evade the impact of capital deepening because, to put it crudely, it doesn't have to invest that much capital to increase revenues. One of the striking things about the company's performance throughout the decade has been that its profit margins have stayed remarkably constant. It's not, in other words, as if Microsoft is spending a lot more to make just a little more. The difference between IBM and Microsoft, after all, is the difference between a hardware company and a software company. Once Windows 95 is developed, it costs Microsoft essentially nothing to produce it. Every additional copy it sells is almost pure profit. The more you sell, the better your profit margins. There aren't many businesses like that in the world.

What that means, though, is that you need to develop the software as inexpensively and as quickly as possible. And what's curious about Microsoft's success is that it has always been late with its products. More than that, Microsoft has not always guessed right. In fact, what's amazing about the last five years is how often Gates was wrong about what the future would hold. In 1993, he said: "In three years or so, pen computing will become a mainstream way of putting data into a device." Later that year, he insisted that something called "the TV/PC" -- you remember, that box that was going to sit on top of your television and bring the world to you -- was the wave of the future. "The revenue that can be generated by movies, shopping, and videoconferencing justifies the big capital investment," he said. And in The Road Ahead, published in late 1995, Gates was still skeptical about the importance of the Internet, a position he has since abandoned with a vengeance.

This isn't to say that Gates was more wrong than anyone else. The history of the media's coverage of technology in the 1990s is a history of dead-ends, erroneous predictions, and heroes who never materialized. NeXt, for instance, was everyone's darling in the early part of the decade. In 1992, Fortune insisted that something called "object-oriented programming" was going to revolutionize the computer, even as it said that "interactive TV" was the big new market in electronics. A year later, the magazine suggested that "video on demand" was going to be the real moneymaker on the information superhighway. And, in 1995, Time bafflingly said that desktop computing was "running out of room for growth." At some point one might have imagined that a responsible editor would have called for a moratorium on the soothsaying. But readers' appetites for futurism is apparently unslakable.

In any case, the point is that Gates' success has not been the result of his superior forecasting skills. Rather, Microsoft has succeeded by building on its initial position in the market in a remorseless fashion and by being quick to recognize when it's made a mistake. The legendary moment when Microsoft programmers were suddenly yanked off their existing projects and put to work on Internet programming encapsulates the corporation's willingness to make the changes that have to be made. It's that sense of decisiveness, perhaps more than any other, that has given Microsoft the air of invulnerability it has.

Microsoft's valuation, then, reflects tremendous underlying strengths as well as impressive prospects for growth in the future. However, it also reflects two more intangible factors. The first is the fact that Microsoft is a stock that individual investors want to own because it's a company they know and, in best Peter Lynch fashion, can understand. This, in turn, has driven the stock up in no small part because Microsoft has, year after year, split its stock, to the point that there are now more than a billion shares out there. Remember, when we say Microsoft was as low as $50 around a year ago, that's split-adjusted, which means that the stock's low was actually around $100. By continually splitting its shares, Microsoft has made itself available to individual investors. Imagine that the stock hadn't split the last three times, and that there were one-eighth the number of Microsoft shares available. Does it really seem likely that the stock's price would be eight times what it is today? To be sure, the actual price of the stock should not matter. But with individual investors it does. And as a result Microsoft's P/E is almost certainly much higher than it would have been without all the splits.

The second, and more important, intangible has to do with Microsoft's status as a bellwether. It's hard to document exactly when the transformation of Microsoft from fast-growing challenger to world-striding behemoth occurred. Though one might argue with this assertion, it seems safe to say that around the time IBM collapsed -- between spring 1991, when its stock traded above $130, and spring 1993, when it fell to $40 -- Microsoft simply took its place. Not until 1990, after all, was Windows 3.0 introduced -- with a remarkable list price of $150 -- and not until 1992 did it become clear that a new industry standard had been created. More importantly, it took time for people to believe that there wasn't a challenger really lurking around every corner. By 1995, Microsoft was the Microsoft we recognize today.

Even so, at the beginning of that year the stock was trading at a P/E of just 30, and in September 1995 its market cap was just half what it is today. In that sense, the company has been one of the big winners in the bull market, even as it has been one of the major forces driving that bull market. In another sense, though, the doubling of Microsoft's market cap says something important about the dramatic cultural inroads made by the computer generally and the Net specfically in just the last year and a half. It may not be the brave new world that Wired keeps imagining, but it is a world in which the computer is an, perhaps even the, essential tool. And in that world, it's Microsoft that's playing the bass line to which all of the rest of us are moving.

-- Jim Surowiecki (Surowiecki)

(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.

© Copyright 1995-2000, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. The Motley Fool is a registered trademark and the "Fool" logo is a trademark of The Motley Fool, Inc. Contact Us