The New Generals: AAPL and MSFT (G vs. V)

Thursday, June 3, 2010 at 12pm
By John Friedman

Much has been written in the past week about the value of Apple, as a company, now exceeding the value of Microsoft as a company. The more jargony way of saying this is that that AAPL’s market capitalization (often trun cated down tomarket cap) exceeds MSFT’s market capitalization.

In fact, last I checked, if you were buying Apple the company, lock-stock-and-barrel, then it would cost you $240 billion, while buying Microsoft lock-stock-and-barrel would cost you $236 billion. (Aside for financial wonks: I’m simply looking up these market caps on Yahoo Finance, so, yes, among other nuances I’m glossing over here are differences between the companies’ take-over premiums, as well as all those very detail’y valuation issues concerning cash on hand, outstanding shares, online financial data accuracy, etc.)

Enough has been said about this state of affairs to obviate any need to talk directly about it, other than to reiterate what a lot of very smart people have said, because it is something I, too, have said:

 
Never in my wildest dreams did I expect
this to ever happen. Not even close.

 
So all hats are off to Steve Jobs, who has accomplished something that, quite literally, no one has ever accomplished before (home-run, massively successful products in computers, music and phones, in that order, with text publishing and gosh only knows what else perhaps next). And all hats are on with respect to the other, sorrier Steve — Steve Ballmer that is, CEO of MSFT, and successor to Bill Gates — he the opposite of Jobs in so many ways.

Instead, what I want to talk about in here is something that a lot of folks can use a good dose of help understanding: the difference between growth stocks and value stocks.

A lot of people have heard those phrases, but haven’t a clue what they mean.

As it happens, I can give you a clue and then some, and I can do it using the two Steves and their companies to light the way . . .

* * *

Way back when, I used to explain the growth vs. value dichotomy in terms of The Generals. There was General Motors, which was a value stock, and there was General Electric, which was a growth stock.

Now both of those companies have changed since I developed that explanation. GM has gone through a bankruptcy and near-death experience, and is still badly hobbled; at about the same time, GE investors (there are lots of us) learned, in a whole new way, that GE was half bank, and that some of Jack Welch’s magic (he being the CEO who really grew the bejeesus out of GE) owed a lot to Jack pedal’ing-to-the-metal’ing the bank part of GE.

So that old explanation is kaput.

* * *

Ah, but now we have Apple, which people think can grow like all get out, and Microsoft, which, while still huge and stupendously powerful as a result of its Windows monopoly and the follow-on cash gusher that is Office, just ain’t growing the way it used to.

And it shows on the investing front. If you had invested in MSFT in, say, 2003, just as the market was about to take off in tandem with the Iraq war, you’d have seen the share price since then hover all about, but always inside the $20 to $30 range. And during that same time you would also have seen MSFT make its first foray into the dividend-paying part of its life, via a whopper of a special dividend in 2003, and then its payout of a nice, regular dividend, all marking Microsoft’s descent from the lofty plane of being the growth-stock-to-end-all-growth-stocks to being part of the more pedestrian world of dividend-paying value stocks.

Kinda like going from being a brisk young hipster to being a boring ol‘ middle-aged dullard.

During that same time period the price of Apple shares went from $9 to $260 — roughly a 28-fold increase (market oldtimers out there no doubt remember that Qualcom did a single-year 29-bagger during the late 90s). And during that time, as has always been true, Apple never paid out even a penny’s worth of dividends.

So, looking backwards, Apple grew like all get out and never paid a dividend, while Microsoft plodded along, paying a steady stream of dividends.

Or, in the parlance I use with clients, Apple wealthflowed while Microsoft cashflowed — i.e., Apple shares appreciated but never (short of selling the shares) generated a cash flow, while Microsoft shares neither appreciated nor depreciated, but paid out a nice steady flow of cash.

* * *

But how about looking forward? That, as it happens, is what counts in investing. And here all we have to go on is the market’s vote about what the future might hold — data which is in a language all its own.

The main language the market uses in this context is one of ratios, as in what would I pay for a dollar’s worth of annual earnings in each company? According to Yahoo, the market has recently been saying that it is willing to pay about $14 for each $1 that MSFT earned, while that exact same market has also been saying that it is willing to pay about $22 for each $1 AAPL earned. So MSFT sells at a 14 to 1 ratio, while AAPL sells at a 22 to 1 ratio (and, yes, to those in the know and in with the financial wonk geekspeak world, what we’re talking about here are P/E ratios, said out loud as pee EE‘ ratios, and all of it being short for price to earnings ratios).

So if, say, Microsoft the company earned $10 billion per year, the market would value MSFT via its shares of stock at $140 billion (14 times the earnings, for that same 14 to 1 ratio), while Apple earning the same amount would result in the marketing valuing AAPL via its shares of stock at $220 billion (22 times the earnings, for that same 22 to 1 ratio).

But let’s get close-to-accurate here, because everything we need to know to do so is embedded in the numbers set out above. Extrapolating, interpolating, arithmeticing (but not looking up the actual data), it looks like last year MSFT actually earned something closer to $20 billion, while at the same time AAPL earned something closer to $10 billion. Yet the market is saying that both companies are worth about the same (more accurate still: MSFT earned $17 billion and AAPL earned $11 billion, but for the sake of simplicity lets stick with the $20 billion and the $10 billion).

That, my friends, is what growth and value stocks are all about: here we have two companies that the market deems to be worth about the same amount, yet the company trading as a value stock is, in terms of earnings, somewhere in the neighborhood of being twice as big as the growth stock.

More generally: the market values a dollar’s worth of earnings in a typical growth stock at, say, $20, but values a dollar’s worth of earnings in a typical value stock at, say, $10.

Think of it this way: if you were looking at buying an IOU (so you got paid every month by the person owing on the IOU), and had to choose between two IOUs that both cost $10k, but one of which kicks off $500 per year (a 5% return) while the other kicks off $100 per year (a 1% return), which would you want to buy?

(If you say it depends on the creditworthiness of the person owing the money, you’d be a smart person . . . )

Stock investing, as it happens, is not so straightforward as that. I mean, which would you have rather bought in 2003? AAPL or MSFT?

* * *

But which to buy now — value or growth?

In practice, for most normal folks the growth vs. value dichotomy is more about someone else’s marketing needs, rather than being something they need to be totally smart about in order to continuously improve their overall financial health. So the dichotomy is great for mutual fund companies because it means they can market growth funds as well as value funds as well as blend funds (a mixture of the two). It gives them more stuff to sell.

After all, what car company sells only one model? Doing so would be so 1910. Nope: in 2010, and for mutual fund companies, something much more than a single model is what the marketing doctors ordered.

But putting that aside for the time being, what’s good guidance for you in your quest to improve your overall financial health? Value or growth?

At any given time, one or the other is apt to look better than the other. So sometimes growth looks great. Sometimes value looks great. And by a smidgen of a smidgen, most academic research these days indicates that value just might do a smidgen of a smidgen better than growth over the long run.

From my perspective, though, your financial health is best served by (a) knowing the first thing about the G vs V dichotomy (i.e., the stuff written out above) and to then (b) make sure that your investments do not favor either one and, instead, are nicely exposed to both growth and value pretty much even-steven, and (c) to then completely ignore it, all the while making sure you are pretty much even-steven on the G vs. V dichotomy.

The good news on this front is that a lot of online financial accounts can display this info for you and that, if you are designing your own portfolio, then you can avoid this whole layer of complexity (Yay! It’s always good to peel away a layer of complexity, and get it out of your life permanently) by investing in index funds, many of which are, by definition, even-steven on the G vs V dichotomy. So your portfolio is automatically not too much of either . . . and forever more.

True, if you are a sophisticated investor, you are for sure going to pay close attention to your P/E ratios and such (unless you are a technician, which is a term of art for a type of investor who looks only at charts, and ignores fundamentals and ratios and such, and which is not even close to what we are talking about today . . . ).

But for normal people, not so much.

* * *

Now should AAPL’s ascent make you want to buy AAPL shares now? Could it do another 28-bagger? Or will it hit the same wall that MSFT hit, and as a result stop growing like all get out?

Time will tell.

One thing is for sure, though: if AAPL stops growing, and its shares start being priced as value shares rather than as growth shares (as happened to MSFT shares), then, all things being equal, the price of AAPL shares would fall, roughly, by half.

Now to open up this piece I admitted that I, and loads of other folks, never even came close to foreseeing that Apple would become a more valuable company than Microsoft. And though it’s hard to imagine Apple shares falling in half, experience teaches that it for sure can happen.

We have a model for how this would happen, in MSFT. As applied to AAPL, this would mean that one day Apple’s growth rate starts to drop some, so that its revenues over the next umpteen years, while increasing, are not increasing nearly so fast as they used to, while at the same time its valuation starts coming down from lofty growth valuations to everyday value valuations, so that it looks, in terms of P/E ratios and the like . . . just like Microsoft looks today.

Imagine that. Apple paying a dividend. Middle aged. No longer a hipster. It can happen.

But what do I know? Friedman’s Law of Symmetry says, among other things, that if I missed the up, then I shouldn’t be trusted to spot the down.

* * *

‘Til tomorrow, then, here’s to your financial health, and may it continuously improve . . . .

.

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