Microsoft (MSFT) has started 2022 on a slight down note, along with many technology stocks and Nasdaq in general. The stock is currently about 10% off its all-time high of $350 and some analysts are already pounding the table to use the defining moment. We ask, “What defining moment?” Granted, the Wedbush piece was not just focusing on Microsoft but it was the stock that got the most attention as seen on the comments stream of the linked news article. We love the stock but a 10% on the back of a 500% run since 2017 doesn’t exactly sound like a bargain, much less a defining moment.
In this article, we evaluate a few positives and negatives and offer our sweet spot and an options strategy we recommend using on stocks that you’d like to own but at a cheaper price. Let’s get going, with the negatives out of the way first.
Nay: History could repeat itself
Microsoft has been around for so long at this point that is has been called every name in the book when it comes to stock categorization. From being a start up to a company with growing pains to a monstrous growth stock to a 15-year laggard to back being a monstrous growth stock. Along the way, the company also has become a 60% dividend aristocrat as it has increased its annual dividend 15 years.
Skeptics may argue that Microsoft spent 15 years going nowhere after monstrous growth in the 1990s and there is no guarantee that history may not repeat itself after the recent growth spurt. In our view, that is unlikely as the primary reason Microsoft went into a deep slumber was the lack of a meaningful rival in the operating systems era. In the Cloud and Metaverse era, many other whales may eat Microsoft’s lunch at the slightest hint of complacency.
Nay: Eventual multiple compression
Some of the greatest stocks of the past, including the Microsoft of the old and Cisco Systems (CSCO) did have an impressive earnings growth. What made the returns (after the huge runups) anemic was “multiple compression”, where the earnings went higher but the expectations were so lofty that the market started awarding the stock a lesser multiple, resulting in stagnant or lesser share price.
Forward estimates are typically compiled based on the next FY’s earnings estimates. Mr. Market isn’t usually too patient. But given Microsoft’s recent run and its quality, let’s see what the forward multiple [PE] is based on FY 2024 earnings estimate. With an expected earnings per share of $11.93, Microsoft is trading at a multiple of nearly 27 based on FY 2024’s estimates. A lot could happen between now and 2024 and this multiple does not appear cheap. Sure, on a handpicked comparison basis this may appear cheaper but we will not be surprised with either of these two scenarios (or both): the lofty earning expectations prove too high or the market does not award high multiples, even to a recent winner like Microsoft.
(Source: Seeking Alpha)
Yes, you read that right. Microsoft is not one of the two names that comes to mind when talking about Metaverse. That distinction belongs to Meta Platforms (FB) and Nvidia (NVDA). But Microsoft’s foray into Metaverse is only logical given its presence in our day-to-day life, especially the official side of it. Microsoft’s Teams is a collaborative tool that has gotten more famous by the day since the COVID pandemic began. Microsoft is taking Teams to the next level by introducing “Mesh”, which it believes will be the gateway to Metaverse. Mesh will be introducing Avatars to make meetings more personalized and “to take their avatars into immersive spaces to experience those serendipitous encounters that spark innovation”. Click here for more information about this in Microsoft’s own words.
This article by SA author Jonathan Weber argues that Microsoft getting serious about Metaverse will add spark to its shares.
Yay: Quality wins
Whenever the tech sell off stops and the market makers decide to buy technology stocks and ETFs, Microsoft will rightly be one of the first names to get attention.
Seeking Alpha’s quant ratings offer a confirmation of the stock’s high quality in many aspects including profitability, momentum, and dividends as shown below. Understandably, the yield gets a D+ as the stock’s monstrous run up in the price has slashed the yield. But keep in mind Microsoft has been increasing its dividends every year since 2006 and the stock’s five-year dividend growth rate stands at an impressive 9.40%. In other words, the low yield is not because the company cannot or does not increase its dividends but because the stock price has outdone expectations.
Valuation grade of D- is not surprising either as the market sought high growth names the last two years. We believe the stock still has more downside here and may see high $200s (say $280 to $290) before bouncing back up.
A growth grade of D+ is a little concerning but looking into the details here, the three important metrics under growth: revenue, EPS, and Free cash flow all grade well higher than the sector. However, given the increased valuation and general optimism on earnings, a multiple compression would be natural on increasing earnings.
(Source: Seeking Alpha)
Alternates ways to buying: Consider selling puts
If you would like to acquire Microsoft but at a lower price, selling puts maybe your best ally. Options are generally viewed as risky and complicated by many long-term investors. However, once the risks are understood, options can go hand in hand with fundamental and long-term investing. Hard to believe? Even the god of “Buy and Hold” investing, Warren Buffett, has used this strategy successfully.
Consider selling puts only under these conditions (all three should be met):
The underlying stock is something you’d like to own, if assigned. The strike price is something you are comfortable with. Your puts are cash-secured, meaning you have enough cash to buy the underlying stock should your strike price be met on the expiration date.
Thanks to readers of our previous article on selling puts, please be wary of company specific known events like the ones below before selling a put:
Upcoming ex-dividend date before the put option expires, as the dividend amount getting deducted from the share price puts the stock closer to the option’s strike price. Microsoft will have two Ex-dividend events between now and the expiration date of the option chain we are explaining below. But given the small yield (62 cents on a $314 stock), the quarterly dividend being deducted from the stock should not have too much of an impact in this case. Upcoming earnings release near the option expiration date, as the volatility increases. Microsoft will report two quarterly earnings in this time frame.
Below is a put we are evaluating on Microsoft. To explain this in plain words, we need to set aside $28,000 to be able to buy 100 Microsoft shares at a strike price of $280. Mr. Market is willing to pay us a premium of $1,240 for this. That’s a 4.50% return in 6 months on the $28,000 we need to set aside for this contract. Generally, we prefer options that expire in a month or two but we strongly believe Microsoft’s rough start to the year is not over yet.
Coming back to this example,
Should Microsoft trade above $280 when the option expires on July 15th, 2022, this put will expire worthless and we retain the 4.50% premium, which is more than 5 times the stock’s current yield. Should Microsoft trade below $280 when the option expires on July 15th, 2022, we’d be obligated to buy 100 shares at $280, irrespective of the market price then. However, with the premium collected, our breakeven price for this trade is $267.60 ($28,000 minus $1,240 divided by 100 shares). There is also a third way this option chain can be closed and that’s called “Buying to close” where if we believe we’ve netted significant portion of the premium, we’d close out the position before July15th, 2022, and repeat the process at a different expiration/strike price combination.
Why we are looking at the $280 price range?
At this point, you may be wondering why we’ve used the $280 price range a few times in the article. Here you go.
$280 to $290 would be our preferred entry point from a technical stand point as that represents the stock’s 200 day moving average. $280 represents a 20% sell off from the all-time high of about $350. A 20% sell off is considered a bear market and strong stocks like Microsoft are unlikely to stay in that region for long, if at all it gets there in the first place. $280 is also more than 10% down from the current stock price, ensuring a relative margin of safety.
To repeat the cliché, price is what you pay and value is what you get. We certainly see the value in Microsoft, the company. But the price is not yet in our alley. We continue holding our existing shares (including dripping dividends) and will be adding to shares on meaningful pullbacks. Until that event, selling puts offers us the middle ground to stay in the names we like while not missing out on the game entirely.