In a way, Microsoft (Nasdaq: MSFT ) and IBM (NYSE: IBM ) couldn’t be more different. Microsoft has lost a third of its value over the past decade; IBM has gained 50%. IBM recently surpassed Microsoft in market capitalization for the first time since 1996.
In other ways, they’re a lot alike. Microsoft has grown earnings per share by 10.9% annually for the past decade. IBM’s growth over the same period? 10.2%. Analyst estimates for Microsoft’s five-year projected growth rate is 10.3% — IBM’s, 11.2%.
These are different companies with different products in different industries, yet both past and projected growth are about equal. Shareholder returns, however, couldn’t be more night and day.
Why?
I think you can break this conundrum down into two parts. Both are huge lessons every investor should be aware of.
1) The most important lesson in investing
The most important lesson in investing is simple: Starting price determines future returns.
A parade of analysts and investors chide Microsoft for its abysmal shareholder returns over the past decade. In reality, Microsoft the company has done terrific. How many large companies grew earnings at 10% annually during one the worst economic decades on record? (11, if you’re wondering). Nearly all of the misery Microsoft investors experienced over the past 10 years can be explained by starting valuation. Shares traded at 60 times earnings at the start of the last decade. Shareholders’ fate was already sealed at that point. There was no realistic outcome that could have left them with anything other than tears today.
IBM was a different story. While it, too, was caught up in the dot-com bubble, it never got outrageously out of whack. Ten years ago, IBM shares traded at roughly 25 times earnings. That created a high hurdle but not an insurmountable one. The compression in IBM’s earnings multiple over the past 10 years hasn’t been drastic, letting shareholders enjoy at least some of the company’s earnings growth. Microsoft’s earnings multiple compression has been astronomical, causing shares to crumble even while the company grew briskly. The same story of flatlining returns amid strong earnings growth has happened to Wal-Mart (NYSE: WMT ) , Google (Nasdaq: GOOG ) , and Johnson & Johnson (NYSE: JNJ ) . Each case can be explained simply: Starting valuation determines future returns.
2) It’s now just how much cash you earn. It’s what you do with that cash.
"IBM has an absolutely unequal record in capital allocation" said value investor Bill Miller last year. Microsoft’s record is decent, but it’s easily below IBM’s.
One more statistic to toss in front of you: Cash as a percentage of IBM’s market cap is about 6%. Microsoft’s is a staggering 25%.
Both Microsoft and IBM churn out tons of cash. Both give lots back to shareholders with dividends and buybacks. But IBM takes the cake by keeping its balance sheet well-padded yet fairly lean. On the contrary, with some $50 billion lying around, Microsoft can nearly be described as a bank account with a software division attached to it.
You don’t have to look far to see why investors punish a company for hoarding so much cash. Take Microsoft’s recent $8.5 billion purchase of Skype, a deal done at a valuation universally panned as outrageous, irrational, and a sign of desperation. Deals like this combined with Microsoft’s enormous and ever-growing pile of cash give investors an excuse to discount both the current cash hoard and future earnings. It creates uncertainty. What will the company do? More acquisitions? Raise the dividend? Repurchase shares? Many potential investors’ reaction is let’s wait and see, lest the company do something stupid — like overpay for Skype. This is something IBM investors needn’t spend much time worrying over. The company doesn’t keep enough readily available tinder on its balance sheet to be quickly lured into something senseless. Unless a company has an impeccable record capital allocation — such as Berkshire Hathaway (NYSE: BRK-B ) — investors discount large cash balances below par, keeping shareholder returns below what they could be. I’ve suggested Microsoft could end this problem by dramatically raising its dividend.
How much a company earns is just half the battle. What it does with that money is what seals shareholder returns.
Being able to retire rich, or at least comfortable, is the goal of almost any investor. However, it’s much easier said than done. In a recent Wells Fargo survey, respondents between the ages of 50 and 59 said that they had, on average, about $29,000 saved up. With pensions all but gone, and Social Security targeted for cuts in the future, it’s hard to count on anyone but yourself. But $29,000 isn’t going to cut it for most people, so you’ve got to get involved in the stock market in order to grow that nest egg. Getting in the game is the easy part; choosing the right stocks is the hard part.
Making prudent decisions
Generally speaking, I look for four traits in a retirement stock:
- Valuation: Investors of all ages want to make sure they’re not overpaying for a stock, but this matters even more in retirement. Retirees don’t have the long time horizon that younger investors have, so it’s essential to make sure you don’t overpay in the short term.
- Dividends: Most retirees need a combination of both growth and income, as they’ll be depending more and more on their portfolio to help with everyday expenses. Companies that pay dividends not only offer immediate income, but they’ve also proven to outperform nonpaying dividend companies over long periods of time.
- Growth: Investors love dividends, but everyone wants to see their stocks rise over time. Growth can be as big a part of your portfolio as a steady dividend. It’s important to note that you don’t need a high-flying stock that’s going to shoot to the moon; a company that can grow and outperform the market is hard enough to find, so steady growth is highly covetable.
- Low volatility: Retirees want to invest in great growth stocks just as much as anyone else, but they also want to be able to rest well knowing that their portfolio won’t be taking them on a roller-coaster ride. At the end of the day, most retirees would rather own a sturdy company that lets them sleep at night than a company that whips up and down with the gyrations of the market.
Although some companies are definitely more geared toward retirees, which companies you choose to invest in will be dictated largely by what you already have in your portfolio. Small, mid, and large caps can all play a role in your investing strategy, so I chose to evaluate all varieties of stocks in this regular series.
So how does IBM stack up?
In order to check out the valuation of IBM (NYSE: IBM ) , we don’t want to look at only its P/E ratio of 14.3. That may seem cheap, but really we don’t know without looking at the ratio in historical context. Over the last five years, IBM’s average P/E ratio has been 14, which is just slightly less than the current ratio. This suggests that investors may be paying more than they’ve had to in the past, so it’s important to find out why the price tag might be a bit higher today.
IBM’s dividend yield is 1.8%. This might not seem like a whole lot right now, but that dividend has room to grow, so I wouldn’t discount its importance. Getting a dividend at all shows a company’s dedication to its shareholders, and that’s significant.
Next, we want to ensure that IBM’s stock has the ability to rise over the next five, 10, or 20 years. A company that’s growing its net income has the best possible chance to see its share price rise over time. Of course, we can’t predict the future, but we can look back to get an idea of how the company has performed in the past in order to try to ensure future earnings growth. Over the past five years, IBM has grown its net income by 12.9% annually. Fortunately, IBM has been able to grow its earnings over the past five years, and that’s pretty significant considering all of the market turmoil in the last few years. Of course, this doesn’t mean that growth will continue, but it’s a great sign that the company can prosper in the face of difficulty.
One of the best measures of volatility is called beta. Beta measures the impact that the movement of the stock market will have on a particular stock. For instance, a beta of 1.0 signifies that IBM will move in tandem with the market; a beta of 2.0 means that the stock will move up twice as much as the general market, and vice versa. In this particular case, IBM has a beta of 0.78, which is pretty low. Generally speaking, I like to see a beta below 1.2 for retirees. In this case, IBM fits the bill.
Let’s look at the competition
We’ve taken a look at IBM, and maybe you think it’s passed all the tests, or maybe you just don’t feel comfortable with the results. Either way, it’s beneficial to see how a company stacks up in its industry, because it’s just as important to understand a company’s competitors as it is to understand that particular company. Here are IBM’s stats when compared to three of its closest competitors:
|
Company |
Current P/E |
Dividend Yield |
5-Year Net Income CAGR |
1-Year Beta |
|---|---|---|---|---|
| IBM | 14.3 | 1.8% | 12.9% | 0.8 |
| Oracle (Nasdaq: ORCL ) | 22.5 | 0.7% | 19.9% | 1.2 |
| Apple (Nasdaq: AAPL ) | 16.2 | 0% | 62.8% | 1.4 |
| Microsoft (Nasdaq: MSFT ) | 9.8 | 2.6% | 10.1% | 1.0 |
Source: Capital IQ, a division of Standard & Poor’s.
Each company has traits to like and traits left to be desired. Either way, it’s beneficial to look at the industry picture and not just IBM in isolation.
Of course, I can’t decide for you whether this is the best stock for retirement, but it has passed three of the four tests, which shows that this stock has some promise. Depending on which traits are most important for you, you’d be wise to look further into this stock for your portfolio.
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